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
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