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No. 732: How Does the Market Variance Risk Premium Vary over Time? Evidence from S&P 500 Variance Swap Investment Returns

Eirini Konstantinidi , University of Manchester
George Skiadopoulos , Queen Mary University of London University of Piraeus

October 27, 2014

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Abstract

We explore whether the market variance risk premium (VRP) can be predicted. First, we propose a novel approach to measure VRP which distinguishes the investment horizon from the variance swap's maturity. We extract VRP from actual rather than synthetic S&P 500 variance swap quotes, thus avoiding biases in VRP measurement. Next, we find that a deterioration of the economy and of the trading activity, increases VRP. These relations hold both in- and out-of-sample for various maturities and investment horizons and they are economically significant. Volatility trading strategies which condition on the detected relations outperform popular buy-and-hold strategies even after transaction costs are considered.

J.E.L classification codes: G13, G17

Keywords:Economic conditions, Predictability, Trading activity, Variance swaps, Variance risk premium, Volatility trading

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