Finance and Economics Discussion Series

Divisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.









Dynamic Estimation of Volatility Risk Premia and Investor
Risk Aversion from Option-Implied and Realized Volatilities
















Tim Bollerslev, Michael Gibson, and Hao Zhou
2004-56

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS)
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of these papers.
Dynamic Estimation of Volatility Risk
Premia and Investor Risk Aversion from
Option-Implied and Realized Volatilities

Tim Bollerslev

Michael Gibson

Hao Zhou

First Draft: September 2004

The work of Bollerslev was supported by a grant from the National Science Foundation to the
NBER. We would like to thank Nellie Liang for useful discussions during this project. The views
presented here are solely those of the authors and do not necessarily represent those of the Federal
Reserve Board or its sta. Matthew Chesnes provided excellent research assistance.

Department of Economics, Duke University, Post Oce Box 90097, Durham NC 27708, and
NBER, USA, Email [email protected], Phone 919-660-1846, Fax 919-684-8974.

Division of Research and Statistics, Federal Reserve Board, Mail Stop 91, Washington DC
20551 USA, E-mail [email protected], Phone 202-452-2495, Fax 202-728-5887.

Division of Research and Statistics, Federal Reserve Board, Mail Stop 91, Washington DC
20551 USA, E-mail [email protected], Phone 202-452-3360, Fax 202-728-5887.
Abstract
This paper proposes a method for constructing a volatility risk premium, or investor
risk aversion, index. The method is intuitive and simple to implement, relying on the sam-
ple moments of the recently popularized model-free realized and option-implied volatility
measures. A small-scale Monte Carlo experiment suggests that the procedure works well in
practice. Implementing the procedure with actual S&P500 option-implied volatilities and
high-frequency ve-minute-based realized volatilities results in signicant temporal depen-
dencies in the estimated stochastic volatility risk premium, which we in turn relate to a set
of underlying macro-nance state variables. We also nd that the extracted volatility risk
premium helps predict future stock market returns.
JEL Classication: G12, G13, C51, C52.
Keywords: Stochastic Volatility Risk Premium, Model-Free Implied Volatility, Model-Free
Realized Volatility, Black-Scholes, GMM Estimation, Monte Carlo, Return Predictability.
1 Introduction
Model-free volatility measures have gured prominently in the recent academic and nancial
market practitioner literatures. More specically, several studies have argued for the use
of so-called model-free realized volatilities computed by summing squared returns from
high-frequency data over short time intervals during the trading day. As demonstrated in
the literature, these types of measures aord much more accurate ex-post observations of
the actual volatility than the more traditional sample variances based on daily or coarser
frequency data (Andersen et al., 2001; Barndor-Nielsen and Shephard, 2002; Meddahi, 2002;
Andersen et al., 2003a,b; Barndor-Nielsen and Shephard, 2004a; Andersen et al., 2004). In
parallel to these results, the recently developed so-called model-free implied volatilities
provide ex-ante (risk-neutral) expectations of the future volatilities. Importantly, and in
contrast to more traditional option-implied volatilities which are based on the Black-Scholes
pricing formula or some variant thereof, the model-free implied volatilities are computed
from option prices without the use of any particular option-pricing model (Britten-Jones
and Neuberger, 2000; Jiang and Tian, 2004; Lynch and Panigirtzoglou, 2003).
1
In this
paper, we combine these two new volatility measures to improve on existing estimates of the
risk premium associated with stochastic volatility risk and investor risk aversion.
Because the method we present here directly uses the model-free realized and implied
volatilities to extract the stochastic volatility risk premium, it is much easier to implement
than other methods in the literature, which typically rely on the joint estimation of both the
underlying asset return and the price(s) of one or more of its derivatives, leading to quite
complicated modeling and estimation (see, e.g., Bates, 1996; Chernov and Ghysels, 2000;
Benzoni, 2001; Pan, 2002; Eraker, 2004, among many others). In contrast, the method of
this paper relies on GMM estimation of the cross conditional moments between risk-neutral
and objective expectations of integrated volatility to identify the stochastic volatility risk
premium. As such, the method is simple to implement and can easily be extended to allow
for a time-varying volatility risk premium. Indeed, one feature of our estimation strategy
1
Market participants have also recently developed several new products realized variance futures, VIX
futures, and over-the-counter (OTC) variance swaps that are based on these two model-free volatility
measures. Specically, the Chicago Board Option Exchange (CBOE) recently changed its implied volatility
index (VIX) to use the model-free implied volatility formula of Britten-Jones and Neuberger (2000) and the
more popular S&P500 index options, while the CBOE Futures Exchange began to trade futures on the VIX
on March 26, 2004 and realized variance futures on the S&P500 on May 18, 2004. Demeter et al. (1999)
discuss OTC variance swaps.
1
is that it allows for a simple and robust characterization of any temporal variation in the
volatility risk premium, or investor risk aversion, possibly driven by a set of economic state
variables.
2
To justify the new estimation strategy, we perform a small scale Monte Carlo experi-
ment focusing on our ability to precisely estimate the risk premium parameter. While the
estimation strategy applies for a general class of stochastic volatility models, the Monte
Carlo study focuses on one such model, the Heston (1993) model. The Monte Carlo study
shows that using model-free implied volatility from options with one month to maturity
and realized volatility from ve-minute returns, we can estimate the volatility risk premium
nearly as well as if we were using the actual (unobserved and infeasible) risk-neutral implied
volatility and continuous time integrated volatility. However, using Black-Scholes implied
volatility and/or realized volatility from daily returns generally results in biased and (highly)
inecient estimates of the risk premium parameter and unreliable statistical inference.
To illustrate the procedure empirically, we apply the method to estimate the volatility
risk premium associated with the S&P500 market index. We extend the method to allow
two types of time variation in the stochastic volatility risk premium. In the rst, it follows
an autoregressive process. In the second, it varies over time with other macro-nance vari-
ables. We nd statistically signicant eects on the volatility risk premium from several
macro-nance variables, including the market volatility itself, the price-earnings (P/E) ratio
of the market, a credit spread, industrial production, the producer price index, and nonfarm
employment.
3
Our results give structure to the intuitive notion that the dierence between
implied and realized volatilities reects a volatility risk premium that responds to economic
state variables, and should be of direct interest to market participants and monetary poli-
cymakers alike who study the links between the nancial markets and the overall economy.
Interestingly, we also nd that the estimated time-varying volatility risk premium index helps
2
The general strategy developed here is also related to the literature on market implied risk aversion (see,
At-Sahalia et al., 2001; Rosenberg and Engle, 2002; Tarashev et al., 2003; Bliss and Panigirtzoglou, 2004,
e.g.). The closest approach in the literature is by Garcia et al. (2001), who estimate jointly the risk-neutral
and objective dynamics, using a series expansion of option price implied volatility around the Black-Scholes
formula.
3
For directly traded assets like equities or bonds, the links between the risk premiumexpected excess
returnand macro-nance state variables are already well established. For example, the equity risk premium
is predicted by the dividendprice ratio and short-term interest rates (Campbell, 1987; Fama and French,
1988; Campbell and Shiller, 1988a,b) and bond risk premia are predicted by forward rates (Fama and Bliss,
1987; Cochrane and Piazzesi, 2004). However, studies of the links between the volatility risk premium and
macroeconomic shocks are rare.
2
to predict future stock market returns better than other well-established predictor variables,
including the consumption-wealth ratio (CAY) of Lettau and Ludvigson (2001).
The rest of the paper is organized as follows. Section 2 outlines our simple GMM esti-
mation of the stochastic volatility risk premium based on model-free implied and realized
volatilities. We also extend the basic model to allow for a time-varying risk premium or
one driven by macroeconomic variables. Section 3 provides nite sample evidence that our
estimator performs very well in a simulation setting. Section 4 applies the estimator to the
S&P500 market index, establishing the aforementioned temporal variation in the volatility
risk premium and its link to important macro-nance variables. Section 5 concludes.
2 Identication and Estimation
Consider the general continuous-time stochastic volatility model for the logarithmic stock
price process (p
t
= log S
t
),
dp
t
=
t
()dt +

V
t
dB
t
,
dV
t
= ( V
t
)dt +
t
()dW
t
,
(1)
where the instantaneous corr(dB
t
, dW
t
) = denotes the familiar leverage eect, and the
functions
t
() and
t
() must satisfy the usual regularity conditions. Assuming no arbitrage
and a linear volatility risk premium, the corresponding risk-neutral distribution then takes
the form
dp
t
= r

t
dt +

V
t
dB

t
,
dV
t
=

V
t
)dt +
t
()dW

t
,
(2)
where corr(dB

t
, dW

t
) = and r

t
denotes the risk-free interest rate. Importantly, the risk-
neutral parameters in (2) are directly related to the parameters of the actual price process
in equation (1) by the relationships,

= + and

= /( + ), where refers to the

volatility risk premium parameter of interest. Note that the functional forms of
t
() and

t
() are completely exible as long as they avoid arbitrage.
2.1 Model-Free Volatility Measures and Moment Restrictions
The point-in-time volatility V
t
entering the stochastic volatility model above is latent and
its consistent estimation through ltering is complicated by a host of market microstructure
complications. Alternatively, the model-free realized volatility measures aord a simple
3
way of quantifying the integrated volatility over non-trivial time intervals. In our notation,
let V
t,t+
denote the realized volatility computed by summing the squared high-frequency
returns over the [t, t + ] time-interval:
V
t,t+
=
n

i=1
_
p
t+
i
n
()
p
t+
i1
n
()
_
2
(3)
It follows then by the theory of quadratic variation (see, e.g., Andersen et al. (2003a), for a
recent survey of the realized volatility literature),
lim
n
V
t,t+
a.s.

_
t+
t
V
s
ds (4)
In other words, when n is large relative to , the measurement error in the realized volatility
should be small, that is: V
t,t+

_
t+
t
V
s
ds.
4
Moments for the integrated and realized volatility for the model in (1) have previously
been derived by Bollerslev and Zhou (2002) (see also Meddahi (2002) and Andersen et al.
(2004)). In particular, it follows that the rst conditional moment satises
5
E(V
t+,t+2
|G
t
) =

E(V
t,t+
|G
t
) +

(5)
where the coecients

= e

and

=
_
1 e

_
are functions of the underlying
parameters and of (1).
Using option prices, it is also possible to construct a model-free measure of the risk-
neutral expectation of the integrated volatility. In particular, let IV

t,t+
denote the time t
volatility measure computed as a weighted average, or integral, of a continuum of -maturity
options,
IV

t,t+
= 2
_

0
C(t + , K) C(t, K)
K
2
dK (6)
4
The asymptotic distribution (for n and xed) of the realized volatility error has been formally
characterized by Barndor-Nielsen and Shephard (2002) and Meddahi (2002), while Barndor-Nielsen and
Shephard (2004b) have recently extended the same asymptotic distributional results to explicitly allow for
leverage eects.
5
In deriving the conditional moments for the integrated volatility, it is useful to distinguish between two
information setsthe continuous sigma-algebra F
t
= {V
s
; s t}, generated by the point-in-time volatility
process, and the discrete sigma-algebra G
t
= {V
ts1,ts
; s = 0, 1, 2, , }, generated by the integrated
volatility series. Obviously, the coarser ltration is nested in the ner ltration (i.e., G
t
F
t
), and by the
Law of Iterated Expectations, E[E(|F
t
)|G
t
] = E(|G
t
).
4
where C(t, K) denotes the price of a European call option maturing at time t with strike
price K. As shown by Britten-Jones and Neuberger (2000), this model-free implied volatility
then equals the true risk-neutral expectation of the integrated volatility,
IV

t,t+
= E

(V
t,t+
| G
t
) , (7)
where E

() refers to the expectation under the risk-neutral measure. Although the original
derivation of this important result in Britten-Jones and Neuberger (2000) assumes that the
underlying price path is continuous, this same result has recently been extended by Jiang
and Tian (2004) to the case of jump diusions. Moreover, Jiang and Tian (2004) also
demonstrates that the integral in the formula for IV

t,t+
may be accurately approximated
from a nite number of options in empirically realistic situations.
Combining these results, it now becomes possible to directly and analytically link the
expectation of the integrated volatility under the risk-neutral dynamics in (2) with the
objective expectation of the integrated volatility under (1). As formally shown by Bollerslev
and Zhou (2004),
E(V
t,t+
| G
t
) = A

IV

t,t+
+B

, (8)
where A

=
(1e

)/
(1e

)/

and B

= [ (1 e

)/] A

[ (1 e

)/

] are
functions of the underlying parameters , , and . This equation, in conjunction with
the moment restriction in (5), provides the necessary identication of the risk premium
parameter, .
2.2 Volatility Risk Premium and Relative Risk Aversion
There is an intimate link between the stochastic volatility risk premium and the representa-
tive agents risk aversion. In particular, assuming a linear volatility risk premium along with
the Heston (1993) version of the stochastic volatility model in (1) in which
t
() =

V
t
, it
follows that
V
t
= cov
t
_
dm
t
m
t
, dV
t
_
where m
t
denotes the pricing kernel, or marginal utility of wealth. Moreover, assuming that
the representative agent has a power utility function
U
t
=
W
1
t
1
5
and holds the market portfolio, the marginal utility equals
m
t
= S

t
.
It follows then by Itos formula that
6
V
t
= cov
t
_
dS
t
S
t
, dV
t
_
= V
t
.
Thus, in this situation the risk aversion coecient is directly proportional to the volatility
risk premium
=

. (9)
In fact, given the estimated values of = 0.8 and = 1.2 for our data set, is approx-
imately equal to the representative investors risk aversion, . This same result may hold
more generally in a nonlinear form, but to avoid imposing additional restrictive assumptions
on the preference structure and the underlying dynamics, we will maintain only the minimal
assumptions in (1) and (2). However, we will at times use the phrases volatility risk premium
and investor risk aversion interchangeably based on the above argument.
2.3 GMM Estimation and Statistical Inference
Using the moment conditions (5) and (8), we can now construct a standard GMM type esti-
mator. However, to allow for overidentifying restrictions, we augment the moment conditions
with a lagged instrument of realized volatility, resulting in the following four dimensional
system of equations:
f
t
() =
_

_
V
t+,t+2

V
t,t+

(V
t+,t+2

V
t,t+

)V
t,t
V
t,t+
A

IV

t,t+
B

(V
t,t+
A

IV

t,t+
B

)V
t,t
_

_
(10)
where = (, , )

. By construction E[f
t
(
0
)|G
t
] = 0, and the corresponding GMM estimator
is dened by

T
= arg min g
T
()

Wg
T
(), where g
T
() refers to the sample mean of the mo-
ment conditions, g
T
() 1/T

T2
t=1
f
t
(), and W denotes the asymptotic covariance matrix
of g
T
(
0
) (Hansen, 1982). Under standard regularity conditions, the minimized value of the
6
A similar argument is made by Bakshi and Kapadia (2003).
6
objective function J = min

g
T
()

Wg
T
() multiplied by the sample size should be asymptot-
ically chi-square distributed, TJ X
2
(1), allowing for an omnibus test of the overidentifying
restrictions. Moreover, inference concerning the individual parameters is readily available
from the standard formula for the asymptotic covariance matrix, (f
t
()/

Wf
t
()/)/T.
Of particular interest is the test for the risk premium parameter, . Since the lag structure in
the moment conditions in equations (5) and (8) implies a complex error dependence, we also
use a heteroscedasticity and autocorrelation consistent robust covariance matrix estimator
with a Bartlett-kernel and a lag length of ve in implementing the estimator (Newey and
West, 1987).
2.4 Time-varying Risk Premia and Dependence on Macro-Finance
Variables
A constant risk premium parameter may not be a realistic assumption. As shown above,
under particular model assumptions a constant volatility risk premium parameter implies a
constant coecient of relative risk aversion, which many other studies have found to be too
restrictive in describing observed asset return dynamics. Constant relative risk aversion is
also not consistent with more general utility functions like habit persistence.
7
We therefore
relax the assumption of a constant risk premium parameter by rst allowing the parameter
to vary over time with shocks to realized volatility and, second, by linking the risk premium
parameter directly to macroeconomic state variables.
As a rst step, we consider an AR(1) specication for the volatility risk premium param-
eter

t+
= a + b
t
+ cu
t
, (11)
where we allow the time-variation in the risk premium to be driven by the tted error in the
cross moment between the realized and implied volatility, u
t+
= V
t,t+
A

IV

t,t+
B

.
This formulation has a precedent in ARCH-GARCH type modeling, where the shock to
the volatility equation comes from the tted mean equations error term. Importantly, it
is also consistent with the information requirement for no-arbitrage. Another economically
appealing feature of this specication is that the risk premium parameter (or the underlying
7
Campbell and Cochrane (1999) use habit persistence to generate time-varying risk aversion. Brandt and
Wang (2003) further explore the link between time-varying risk aversion with economic growth and ination
uncertainty.
7
risk aversion parameter) is constrained to move somewhat slowly in discrete time, while the
return and volatility processes evolve instantaneously in continuous time. To identify the
additional two parameters a and b, an instrument of lag squared realized volatility is applied
to the moment conditions (5), and (8), which leaves the same single degree of freedom for
the chi-square omnibus test.
One major advantage of introducing the time-varying volatility risk premium is to explain
better the discrepancy between risk-neutral implied volatility and the objective expectation
of integrated volatility. It would be interesting if the dierence between implied and realized
volatility could be explained by macro-nance variables in a manner consistent with the
option pricing framework. To explore such a possibility, we further specify the volatility risk
premium parameter as an AR(1) process with shocks coming from a set of macro-nance
variables,

t+
= a + b
t
+
K

k
c
k
state
t,k
(12)
where state
t,k
will be chosen from around thirty popular candidate variables.
Previous eorts to explain time-varying volatility risk premia with economic variables
have been rare and quite challenging. The strategy outlined above has the advantages
of simplicity (identifying the risk premium from the cross moment between realized and
implied volatility) and consistency with no-arbitrage. In principle, all macro-nance variables
can serve as instruments for the cross moment (8), except for the realized volatility which
would be redundant. When actually implementing the estimation below we add the lagged
realized volatility, the lagged squared realized volatility, and the lagged implied volatility
as instruments for the cross moment, while leaving the moment for the realized volatility
in (5) the same as the constant risk premium case. This in turn results in the same X
2
(1)
asymptotic distribution for the GMM omnibus test.
3 Finite Sample Experiment
3.1 Experimental Design
To determine the nite sample performance of the GMM estimator based on the moment
conditions described above, we conducted a small scale Monte Carlo study for the specialized
Heston (1993) version of the model in (1) and (2) with
t
() =

V
t
. To illustrate the
8
advantage of the new model-free volatility measures, we estimated the model using three
dierent implied volatilities:
1. RNIV: risk-neutral expectation of integrated volatility (this is, of course, not observ-
able in practice but can be calculated inside the simulations where we know both the
latent volatility state V
t
and the risk neutral parameters

and

);
2. MFIV: model-free implied volatility computed from one-month maturity option prices
using a truncated and discretized version of equation (6);
3. BSIV: Black-Scholes implied volatility from a one-month maturity, at-the-money op-
tion as a (misspecied) proxy for RNIV.
We also use three dierent realized volatility measures to assess how the mis-measurement
of realized volatility aects the estimation:
1. Integrated Volatility: The monthly true integrated volatility
_
t+
t
V
s
ds (again, this
is not observable in practice but can be calculated inside the simulations);
2. Realized Volatility, 5-minute: monthly realized volatilities computed from ve-
minute returns;
3. Realized Volatility, daily: monthly realized volatilities computed from daily returns.
The dynamics of (1) are simulated with the Euler method. We calculate model-free implied
volatility for a given level of V
t
with the discrete version of (6) presented by Jiang and
Tian (2004). The call option prices needed to compute model-free implied volatility are
computed with the Heston (1993) formula. The Black-Scholes implied volatility is generated
by calculating the price of an at-the-money call and then inverting the Black-Scholes formula
to extract the implied volatility.
The accuracy of the asymptotic approximations are illustrated by contrasting the results
for sample sizes of 150 and 600. The total number of Monte Carlo replications is 500. To
focus on the volatility risk premium in the simulation study, the drift of the stock return in
(1) and the risk-free rate in (2) are both set equal to zero. The benchmark scenario is labeled
(a) and sets = 0.10, = 0.25, = 0.10, = 0.20, = 0.50. Three additional variations
we consider are (b) high volatility persistence, or = 0.03; (c) high volatility-of-volatility,
or = 0.20; and (d) pronounced leverage, or = 0.80.
8
8
The rst three designs are the same as in Bollerslev and Zhou (2002), and the estimation results for
the and parameters (available upon request) mirror the results reported therein based on the moment
9
3.2 Monte Carlo Evidence
Tables 1-3 summarize the parameter estimation for the volatility risk premium. The use
of model-free implied volatility (MFIV) achieves a similar root-mean-squared error (RMSE)
and convergence rate as the true infeasible risk-neutral implied volatility (RNIV). On the
other hand, the misspecied Black-Scholes implied volatility (BSIV) shows slow convergence
in estimating the volatility risk premium. Also, using realized volatility from ve-minute
returns (over a monthly horizon) has virtually the same small bias and high eciency as
the estimates based on the (infeasible) integrated volatility. In contrast, using the realized
volatility from daily returns generally results in larger bias and signicantly lower eciency.
Figures 1-3 report the Wald test for the risk premium parameter, which should be asymp-
totically X
2
(1) distributed. In the cases of (infeasible) integrated volatility and ve-minute
realized volatility, the test statistics for the MFIV and RNIV measures are generally indis-
tinguishable and closely approximated by the asymptotic distribution, the only exception
being the high volatility persistence scenario (b) for which the MFIV measure results in
slight over-rejection. In contrast, the (misspecied) BSIV measure shows clear evidence of
over-rejection for all of the dierent scenarios. When the realized volatility is constructed
from daily squared returns, the Wald test systematically loses power to detect any misspeci-
cation, and the RNIV and MFIV measures now both show some under-rejection bias, while
the over-rejection bias for the BSIV measure is somewhat mitigated.
9
In a sum, the Monte Carlo results clearly demonstrate the ability to accurately estimate
the volatility risk premium from the model-free implied volatilities along with the realized
volatilities from ve-minute returns. On the other hand, the use of Black-Scholes implied
volatilities and/or realized volatilities from daily returns both produce biased and inecient
estimates, and generally do not allow for reliable inference concerning the true value of the
risk premium parameter.
conditions for the model in (1) only.
9
The GMM omnibus test also has the correct size for the RNIV and MFIV measures, but often cannot
reject for the misspecied BSIV. This is because even for BSIV the objective moment (5) is still correctly
specied, only the cross moment (8) is misspecied. These additional graphs are omitted to conserve space
but available upon request.
10
4 Estimates for the Market Volatility Risk Premium
4.1 Data Sources and Summary Statistics
Our empirical analysis is based on monthly implied and realized volatilities for the S&P500
index from January 1990 through May 2004. For the risk-neutral implied volatility measure,
we rely on the VIX index provided by the Chicago Board of Options Exchange (CBOE). The
VIX index, available back to January 1990, is based on the liquid S&P500 index options,
and more importantly, it is calculated with the model-free approach in Britten-Jones and
Neuberger (2000).
10
As shown in the Monte Carlo study, the model-free implied volatility
should be a good approximation to the true (unobserved) risk-neutral expectation of the
integrated volatility, and, in particular, a much better approximation than the one aorded
by the Black-Scholes implied volatility.
Our realized volatilities are based on the summation of the ve-minute squared returns
on the S&P500 index within the month.
11
Thus, for a typical month with 22 trading days,
we have 2278 = 1, 716 ve-minute returns, where the 78 ve-minute subintervals cover the
normal trading hours from 9:30am to 4:00pm. Again, as indicated by the Monte Carlo sim-
ulations in the previous section, the monthly realized volatilities based on these ve-minute
returns should provide a very good approximation to the true (unobserved) continuous-time
integrated volatility, and, in particular, a much better approximation than the one based on
daily squared returns.
Figure 4 plots realized volatility, implied volatility, and their dierence. (Here and
throughout the paper, monthly standard deviations are annualized by multiplying by

12.)
It is clear that both volatility measures increased during the latter half of the sample, al-
though they have also both decreased more recently. Summary statistics for the two volatility
measures are reported in Table 4. Realized volatility is systematically lower than implied
volatility, and its unconditional distribution deviates more from the normal. Both measures
exhibit pronounced serial correlation with extremely slow decay in their autocorrelations,
suggestive long-memory type features.
There is a long history of market participants (and some academic researchers) using
the level of the VIX implied volatility as a gauge of market fear or, in the economists
10
In September 2003, CBOE replaced the old VIX index, based on S&P100 options and Black-Scholes
implied volatility, with the new VIX index based on S&P500 options and model-free implied volatility.
Historical data on both the old and new VIX are directly available from the CBOE.
11
The high-frequency data for the S&P500 index is provided by the Institute of Financial Markets.
11
jargon, investor risk aversion. Along similar lines, the dierence between the implied and
realized volatilities have also been used as a benchmark for the market-implied risk aversion.
Unfortunately, the raw dierence, as depicted in the bottom panel in Figure 4, is typically
very noisy and uninformative, and basically just trends with the level of volatility. A more
structured approach for extracting the volatility risk premium (or implied risk aversion), as
discussed in the previous sections, thus holds the promise of revealing a deeper understanding
of the way in which the volatility risk premium evolves over time, and its relationship to the
macroeconomy. We next turn to a discussion of our pertinent estimation results.
4.2 GMM Estimation of Time Varying Risk Premia
Table 5 reports the GMM estimation results for the three volatility risk premium specica-
tions: (i) a constant ; (ii) a time-varying
t+
driven by the error from the cross moment
as in equation (11); and (iii) a time-varying
t+
determined by the macro-nance variables
as in equation (12).
12
First, restricting the risk premium to be constant results in a highly signicant estimate
of -1.79. However, the chi-square omnibus test of overidentifying restrictions rejects the
overall specication at the 10% (although not at the 5%) level.
The second column of the table presents the result allowing for temporal variation in
the risk premium driven by the error from the cross moment. The corresponding estimated
coecient (c = 0.02) is highly statistically signicant. The estimates for this specication
also point toward a high degree of persistence (b = 0.80) in the volatility risk premium,
with an implied average value for the full sample of a/(1 b) = 1.99. Yet, the overall
specication test continues to reject the model at the 10% (but not at the 5%) level.
To circumvent these shortcomings, the third column presents the results obtained by
explicitly including the macro-nance covariates. To select the macro-nance variables in
the time-varying risk premium specication, we did an extensive search with 29 monthly
data series (listed in Table 8). If part of the temporal variation in investor risk aversion
reects investors focusing on dierent aspects of the economy at dierent points in time, as
seems likely, some exibility in specifying the set of covariates seems both appropriate and
unavoidable. Hence, we select the group of variables that jointly achieves the highest p-
12
In order to conserve space, we only report the results pertaining to the parameters for the volatility
risk premium. The results for the other parameters in the model are directly in line with previous results
reported in the literature, and consistent with the monthly summary statistics in Table 3, all point toward
a high degree of volatility persistence in the (latent) V
t
process.
12
value of the GMM omnibus specication test and that are signicant (at the 5% level) based
on their individual t-test statistics.
13
To facilitate the subsequent discussion, the resulting
seven variables have all been standardized to have mean zero and variance one so that their
marginal contribution to the time-varying risk premium are directly comparable.
14
The results for the autoregressive part of the specication implies an average risk premium
of a/(1 b) = 1.82, and, without guring in the dynamic impact of the macro state
variables, an even higher degree of persistence, b = 0.93. As necessitated by the specication
search, all of the individual parameters for the macro-nance covariates are statistically
signicant at the 5% level, and the overall GMM specication test is greatly improved, with
a p-value of 0.92. The resulting estimate for the volatility risk premium, along with the
seven macro-nance input variables, are plotted in Figure 5.
Both the signs and magnitudes of the macro-nance shock coecients are important in
understanding the time-variation of the volatility risk premium. Sticking to the convention
that () represents the risk premium, or risk aversion, the realized volatility has the biggest
contribution (-0.32) and a positive impact (i.e., when volatility is high so is risk aversion).
The impact of AAA bond spread over Treasuries (0.19) likely reects a business cycle eect
(i.e., credit spreads tend to be high before a downturn which usually coincides with low risk
aversion). Conversely, housing starts have a positive impact on the risk premium (-0.19) (i.e.,
a real estate boom usually precedes higher risk aversion). The S&P 500 P/E ratio is the
fourth most important factor (0.14), and impacts the premium negatively (i.e., everything
else equal, higher P/E ratios lowers the degree of risk aversion). The fth variable in the
table is industrial production growth (0.10), which also has a negative impact (i.e., higher
growth leads to a lower volatility risk premium). On the contrary, the sixth CPI ination
variable leads to higher risk aversion (-0.05). Finally, the last signicant macro state variable,
payroll employment, marginally raises the volatility risk premium (-0.04), possibly as a result
of wage pressure.
13
We are, of course, aware of the danger of data mining that such a specication search presents. However,
we have attempted to limit the degree of data mining by choosing a limited set of candidate macro-nance
covariates, listed in Table 8. Also, because our estimation relies on GMM, it is not necessarily the case
that adding more covariates always improves the t of the model, as would be the case with linear OLS
estimation.
14
For stationary variables the unit is the level, while for non-stationary variables the unit is the logarithmic
change for the past twelve months.
13
4.3 Contrasting Strategies For Estimating A Time-Varying Risk
Premium
Our approach for estimating the time-varying volatility risk premium can be contrasted
with other approaches in the literature for estimating time-varying risk premia. One such
approach is to vary the risk premium parameter each time period to best match that periods
market data. In the context of volatility modeling, that approach would vary the risk
premium parameter to match each months dierence between realized and implied volatility.
Such an approach would produce the time-varying risk premium shown in the middle panel
of Figure 6, the general shape of which matches the earlier plot in the bottom panel of Figure
4.
As previously noted, the problem with this approach is that by attributing each wiggle
in the data to changes in the risk premium, it produces an excessively volatile time series of
monthly risk premia. Economic theory argues that an assets risk premium should depend on
deep structural parameters. For example, in the consumption CAPM (C-CAPM), an assets
risk premium varies with investors risk aversion and the assets covariance with investors
consumption. By denition, deep structural parameters should be relatively stable over
time. Yet the approach of period-by-period estimation of a time-varying risk premia forces
the parameters to vary (almost independently) from one period to the next. As such, we
nd the monthly volatility risk premium series shown in the middle panel of Figure 6 to be
implausibly volatile.
15
A second approach for estimating investors risk appetite, more popular among market
participants, is to construct a weighted-average of macro-nance variables.
16
The bottom
panel of Figure 6 shows such a weighted-average index constructed from the macro-nance
variables listed in Table 8.
17
In addition to concerns that such indexes are too ad hoc to be
reliable, indexes constructed in this way also tend to be excessively and implausibly volatile.
A third approach to estimating risk premium parameters comes from the macroeconomic,
or consumption-based asset pricing literature. This approach often assumes that risk premia
are constant, or if the premia are allowed to vary over time, they end up being implausibly
15
Several recent papers have charts that look similar to the middle panel of Figure 6. For example, see
Rosenberg and Engle (2002) page 363, Tarashev et al. (2003) page 62, and Bliss and Panigirtzoglou (2004)
page 425.
16
Chaboud (2003) discusses several such indexes constructed by J.P. Morgan, State Street Bank, and
Credit Suisse First Boston.
17
Following the practice in industry, the bottom panel of Figure 6 plots an average index (negative value)
of 29 macro-nance variables that are standardized as mean zero and variance one.
14
smooth. For example, the estimated risk premium of Brandt and Wang (2003) does not even
pick out recessions, except for the 1978-82 monetary experiment period.
A fourth strand of the literature focuses on models in which the risk premium are modeled
as varying over longer-run business cycle frequencies. For example, Campbell and Cochrane
(1999) generate time variation in risk aversion through habit formation in which the level of
habit reacts only gradually to changes in consumption. Such a modeling strategy explicitly
prevents the risk premia from being excessively variable in the short-run. In a similar vein,
Cochrane and Piazzesi (2004) model a slowly varying risk premia on Treasury bonds as a
function of current forward rates.
Our method and results fall squarely within this fourth strand of the literature. The
top panel of Figure 6 plots our estimated volatility risk premium parameter based on the
model involving the seven macro-nance covariates. Peaks and troughs in the series are
generally multiple years apart, and reassuringly the series is void of the excessive month-
by-month uctuations that plague both of the other two series in the gure. The estimated
risk premium also rises sharply during the two NBER-dated macroeconomic recessions (the
shaded areas in the plots), as well as the periods of slow recovery and job growth after
the 1991 and 2001 recessions. Moreover, the peaks in the series are readily identiable with
major macroeconomic or nancial market developments, including the 1994 rate hike and soft
landing, the 1998 Russian debt crisis, and the bursting of the stock market bubble in 2000.
There is also a peak in the risk premium in 1996 that does not appear to directly line up with
any major economic or nancial event, except perhaps the worry about over-valuation in the
stock market sometimes labeled as the period of Irrational Exuberance. Interestingly, the
estimates also suggest that the risk premium rises fairly sharply but declines only gradually.
4.4 Risk Premium Variation and Stock Return Predictability
Our characterization of the volatility risk premium has the potential of being informative
about other risk premia in the economy. To illustrate, we compare its predictive power for
aggregate stock market returns with that of other traditionally-used macro-nance variables.
To that end, the top panel of Table 6 reports the results of simple univariate regressions of
the monthly S&P500 excess returns on the most signicant individual variables from the
pool of covariates listed in Table 8. As evidenced by the results, the extracted volatility risk
15
premium has the highest predictive power with an R
2
of 3.67%.
18
The next best predictor
is the S&P500 P/E ratio with an R
2
of 2.80%. Next in order are industrial production and
nonfarm payrolls with R
2
s of 1.53% and 1.06%, respectively. Dividend yields - a signicant
predictor according to many other studies - only explains 0.85% of the monthly return
variation. All-in-all, these results are consistent with previous ndings that macroeconomic
state variables do predict returns, though the predictability measured by R
2
is usually in
the low single digits. Nonetheless, it is noteworthy that of all the predictor variables, the
volatility risk premium results in the single highest R
2
.
Combining all of the marginally signicant variables into a single multiple regression,
results in the estimates shown in the bottom panel of Table 6. Interestingly, none of the
macro-nance variable remains signicant when the volatility risk premium is included, while
only the P/E ratio is signicant in the regression excluding the premium. Of course, the
estimate for the volatility risk premium already incorporates some of the same macroeco-
nomic variables (see Table 5), so the nding that these variables are driven out when
included together with the premium is not necessarily that surprising. However, the macro
variables entering the model for
t+
only impact the returns indirectly through the tempo-
ral variation in the premium, and the volatility risk premium itself is also estimated from a
very dierent set of moment conditions based on the model-free realized and options implied
volatilities.
Our examination of the monthly stock excess return in Table 6 singles out the volatility
risk premium (which we interpret as a proxy for risk aversion) and the stock market PE ratio
(which we interpret as a proxy for fundamental risk) as the two most important predictor
variables. Table 7 augments these results with regressions involving longer-run quarterly
excess returns spanning 1990Q1 through 2003Q2. In addition to the volatility risk premium
and the PE ratio from the last month of the previous quarter, we also include the quarterly
consumption-wealth ratio in these regressions. The consumption-wealth ratio, termed CAY,
has previously been established by (Lettau and Ludvigson, 2001) as an important explana-
tory variable for longer horizon returns. The rst three regressions in the table show that
each of the three variables is indeed individually signicant. At the same time, it is notewor-
thy that the risk premium results in the highest individual R
2
of 11.6%, much higher than
the monthly R
2
of 3.7%. Adding the P/E ratio and/or the CAY variable further increase the
18
The use of the volatility risk premium as a second-stage regressor suers from a standard errors-in-
variables type problem, resulting in too large a standard error for the estimated slope coecient.
16
quarterly R
2
s in excess of 14%. The risk premium remains signicant in all of the multiple
regressions, while combining the P/E ratio and the CAY variable in the same regression
renders both insignicant, and does not increase the R
2
by much. As such, these results
further reinforce the earlier ndings for the monthly returns in Table 6 and the role of the
estimated volatility risk premium as a new and powerful stock market predictor over longer
quarterly horizons.
5 Conclusion
This paper develops a simple consistent approach for estimating the volatility risk premium.
The approach exploits the linkage between the objective and risk-neutral expectations of the
integrated volatility. The estimation is facilitated by the use of newly available model-free
realized volatilities based on high-frequency intraday data along with model-free option-
implied volatilities. The approach allows us to explicitly link any temporal variation in the
risk premium to underlying state variables within an internally consistent and simple-to-
implement GMM estimation framework.
A small scale Monte Carlo experiment indicates that the procedure performs well in
estimating the volatility risk premium in empirically realistic situations. In contrast, the
estimates based on the Black-Scholes implied volatilities and/or monthly sample variances
based on daily squared returns result in highly inecient and statistically unreliable esti-
mates of the risk premium. Applying the methodology to the S&P500 market index, we
nd signicant evidence for temporal variation in the volatility risk premium, which we di-
rectly link to a set of underlying macro-nance state variables. The extracted volatility risk
premium is also found to be helpful in predicting the return on the market itself.
The volatility risk premium (or risk aversion) extracted in our paper diers sharply
from other approaches in the literature. In particular, earlier estimates relying directly on
period-by-period dierences in the estimated risk-neutral and objective distributions tend
to produce implausibly volatile estimates. On the other hand, earlier procedures based on
structural macroeconomic/consumption-type pricing models typically result in implausibly
smooth estimates. In contrast, the model-free realized and implied volatility-based procedure
developed here results in a volatility risk premium (or risk aversion index) that avoids the
excessive period-by-period random uctuations yet responds to recessions, nancial crises,
and other economic events in an empirically realistic fashion.
17
It would be interesting to more closely compare and contrast the risk aversion index esti-
mated here to other popular gauges of investor fear or market sentiment. Along these lines,
it would also be interesting to explore the evidence from other markets, both domestically
and internationally. How do the estimated risk premia correlate across dierent markets and
countries? The results in the paper for the S&P500 indicate that the volatility risk premium
for the current month is useful in predicting the next months return. Again, what about
other markets? Does the estimated risk aversion index for the aggregate stock market help
in predicting bond market premia? Better estimates of the volatility risk premium could
also result in more accurate prices for derivatives. We leave further work along these lines
for future research.
18
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Table 1: Monte Carlo Result for with Risk-Neutral Implied Volatility
Mean Bias Median Bias Root-MSE
T = 150 T = 600 T = 150 T = 600 T = 150 T = 600
Scenario (a), Benchmark Case
= 0.10, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. -0.0046 -0.0015 -0.0041 -0.0013 0.0202 0.0091
Realized, 5-min. -0.0043 -0.0014 -0.0027 -0.0014 0.0201 0.0090
Realized, 1-day -0.0129 -0.0036 -0.0169 -0.0040 0.0576 0.0260
Scenario (b), High Volatility Persistence
= 0.03, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. -0.0097 -0.0029 -0.0079 -0.0017 0.0244 0.0099
Realized, 5-min. -0.0088 -0.0026 -0.0059 -0.0014 0.0237 0.0098
Realized, 1-day -0.0172 -0.0051 -0.0187 -0.0039 0.0615 0.0275
Scenario (c), High Volatility-of-Volatility
= 0.10, = 0.20, = 0.20, = 0.20, = 0.50
Integrated Vol. -0.0166 -0.0054 -0.0127 -0.0049 0.0463 0.0193
Realized, 5-min. -0.0162 -0.0054 -0.0119 -0.0048 0.0457 0.0190
Realized, 1-day -0.0278 -0.0089 -0.0288 -0.0085 0.0804 0.0342
Scenario (d), High Leverage
= 0.10, = 0.20, = 0.20, = 0.20, = 0.80
Integrated Vol. -0.0046 -0.0016 -0.0040 -0.0015 0.0200 0.0093
Realized, 5-min. -0.0042 -0.0014 -0.0043 -0.0012 0.0200 0.0092
Realized, 1-day -0.0130 -0.0032 -0.0165 -0.0025 0.0569 0.0253
23
Table 2: Monte Carlo Result for with Model-Free Implied Volatility
Mean Bias Median Bias Root-MSE
T = 150 T = 600 T = 150 T = 600 T = 150 T = 600
Scenario (a), Benchmark Case
= 0.10, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. 0.0013 0.0044 0.0015 0.0048 0.0199 0.0101
Realized, 5-min. 0.0017 0.0045 0.0030 0.0045 0.0199 0.0101
Realized, 1-day -0.0068 0.0021 -0.0103 0.0017 0.0569 0.0258
Scenario (b), High Volatility Persistence
= 0.03, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. -0.0005 0.0064 0.0000 0.0071 0.0248 0.0130
Realized, 5-min. 0.0003 0.0066 0.0020 0.0068 0.0244 0.0130
Realized, 1-day -0.0081 0.0036 -0.0093 0.0053 0.0598 0.0276
Scenario (c), High Volatility-of-Volatility
= 0.10, = 0.20, = 0.20, = 0.20, = 0.50
Integrated Vol. -0.0034 0.0075 -0.0008 0.0078 0.0475 0.0221
Realized, 5-min. -0.0030 0.0077 -0.0018 0.0086 0.0471 0.0219
Realized, 1-day -0.0166 0.0029 -0.0170 0.0041 0.0796 0.0341
Scenario (d), High Leverage
= 0.10, = 0.20, = 0.20, = 0.20, = 0.80
Integrated Vol. 0.0016 0.0045 0.0021 0.0046 0.0198 0.0103
Realized, 5-min. 0.0020 0.0047 0.0016 0.0048 0.0198 0.0104
Realized, 1-day -0.0068 0.0029 -0.0101 0.0035 0.0561 0.0253
24
Table 3: Monte Carlo Result for with Black-Scholes Implied Volatility
Mean Bias Median Bias Root-MSE
T = 150 T = 600 T = 150 T = 600 T = 150 T = 600
Scenario (a), Benchmark Case
= 0.10, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. 0.0089 0.0119 0.0094 0.0122 0.0209 0.0147
Realized, 5-min. 0.0092 0.0120 0.0106 0.0121 0.0211 0.0148
Realized, 1-day 0.0010 0.0100 -0.0019 0.0094 0.0562 0.0276
Scenario (b), High Volatility Persistence
= 0.03, = 0.20, = 0.10, = 0.20, = 0.50
Integrated Vol. 0.0045 0.0107 0.0065 0.0120 0.0214 0.0139
Realized, 5-min. 0.0055 0.0111 0.0079 0.0118 0.0214 0.0142
Realized, 1-day -0.0015 0.0094 -0.0007 0.0105 0.0601 0.0285
Scenario (c), High Volatility-of-Volatility
= 0.10, = 0.20, = 0.20, = 0.20, = 0.50
Integrated Vol. 0.0215 0.0321 0.0247 0.0324 0.0444 0.0361
Realized, 5-min. 0.0220 0.0321 0.0258 0.0322 0.0443 0.0361
Realized, 1-day 0.0136 0.0312 0.0144 0.0311 0.0742 0.0450
Scenario (d), High Leverage
= 0.10, = 0.20, = 0.20, = 0.20, = 0.80
Integrated Vol. 0.0127 0.0156 0.0134 0.0156 0.0227 0.0179
Realized, 5-min. 0.0131 0.0158 0.0128 0.0160 0.0230 0.0181
Realized, 1-day 0.0041 0.0141 0.0002 0.0153 0.0555 0.0288
25
Table 4: Summary Statistics for Monthly Implied and Realized Volatilities
Statistics Realized Volatility Implied Volatility
Mean 12.675 20.075
Std. Dev. 5.838 6.385
Skewness 1.210 0.844
Kurtosis 4.627 3.872
Minimum 4.731 10.630
5% Qntl. 5.924 11.733
25% Qntl. 7.933 14.793
50% Qntl. 11.562 19.520
75% Qntl. 15.420 24.190
95% Qntl. 24.618 31.166
Maximum 36.606 44.280

1
0.809 0.827

2
0.676 0.692

3
0.607 0.595

4
0.537 0.556

5
0.548 0.552

6
0.546 0.525

7
0.516 0.498

8
0.530 0.490

9
0.528 0.507

10
0.528 0.536
26
Table 5: Estimation of Volatility Risk Premium
Constant Time-Varying Macro-Finance
-1.7925 (0.2160)
a -0.3935 (0.1070) -0.1222 (0.0509)
b 0.8026 (0.0695) 0.9328 (0.0303)
c 0.0221 (0.0027)
c
1
Realized Volatility -0.3191 (0.0422)
c
2
Moody AAA Bond Spread 0.1938 (0.0337)
c
3
Housing Start -0.1907 (0.0551)
c
4
S&P500 P/E Ratio 0.1396 (0.0148)
c
5
Industrial Production 0.0970 (0.0261)
c
6
Producer Price Index -0.0467 (0.0230)
c
7
Payroll Employment -0.0404 (0.0186)
X
2
(d.o.f. = 1) (p-Value) 2.8885 (0.0892) 2.7215 (0.0990) 0.1687 (0.9191)
All macro-nance shock variables are standardized as mean zero and variance one, so that
their marginal contributions to the risk premium are directly comparable. The growth vari-
ables (Industrial Production, Producer Price Index, and Payroll Employment)are in terms
of the logarithmic dierence over the past twelve months. In empirical application, the lag
length of the Newy-West weighting matrix is chosen to be 25, to accommodate more complex
dynamics and potential specication error.
27
Table 6: Monthly Stock Market Return Predictability
Variables Intercept (s.e.) Slope (s.e.) R-Square
Volatility Risk Premium -18.5125 (10.5826) 12.4880 (5.1847) 0.0367
S&P500 PE Ratio 35.9389 (13.7503) -1.2719 (0.5658) 0.0280
Industrial Production -0.9257 ( 5.4952) 1.9922 (1.2255) 0.0153
Nonfarm Payroll Employment -0.3110 ( 5.4777) 3.6432 (2.6236) 0.0106
26 Other Macro-Finance Variables <0.0100
Joint Estimation Including
t
Excluding
t
Variables Parameter (s.e.) Parameter (s.e.)
Intercept 3.5760 (20.2995) 32.6190 (15.3063)
Volatility Risk Premium 8.3377 ( 5.4925)
S&P500 PE Ratio -0.7055 ( 0.5684) -1.2592 ( 0.5854)
Industrial Production 2.0651 ( 2.2621) 2.7192 ( 2.2043)
Nonfarm Payroll Employment -1.9441 ( 4.6999) -3.3062 ( 4.6570)
R-Square 0.0502 0.0389
The table reports the predictive regressions for the monthly excess return of S&P500 index
measured in annualized percentage term. Industrial Production and Payroll Employment
numbers are the past year logarithmic changes in annualized percentages.
Table 7: Quarterly Stock Market Return Predictability
Intercept (s.e.) Risk Premium (s.e.) PE Ratio (s.e.) CAY (s.e.) R-Square
-22.0391 (12.8401) 13.6314 (6.2762) 0.1163
41.0442 (16.2894) -1.5429 (0.6923) 0.1034
2.4129 ( 4.3077) 5.3777 (2.0306) 0.0854
8.7403 (17.5761) 9.5126 (5.4502) -0.9460 (0.5894) 0.1445
-16.7554 (13.5454) 10.4940 (6.8287) 3.1917 (1.7862) 0.1402
29.7368 (27.8876) -1.0978 (1.1394) 2.4763 (3.3519) 0.1129
2.4033 (23.7001) 9.0313 (5.6439) -0.6624 (0.9622) 1.7457 (3.0405) 0.1491
To be comparable, our data set is transformed into quarterly frequency, dating from 1990Q1
to 2003Q2. CAY stands for the consumption wealth ratio as in Lettau and Ludvigson
(2001), and the data is downloaded from their website.
28
Table 8: List of Macro-Finance Variables
Macro-Finance Variables Data Source
S&P500 Realized Volatility Constructed from IFM (CME)
S&P500 Implied Volatility CBOE
S&P500 Market Return Standard & Poors
S&P500 PE Ratio Standard & Poors
S&P500 Dividend Yield Standard & Poors
NYSE Trading Volume NYSE
Unemployment Rate Bureau of Labor Statistics
Nonfarm Payroll Employment Bureau of Labor Statistics
Industrial Capacity Utilization Federal Reserve
Industrial Production Federal Reserve
CPI Ination Bureau of Labor Statistics
Producer Price Index Bureau of Labor Statistics
Expected CPI Ination Michigan Survey
Treasury Spread 5yr-6mn Federal Reserve
Treasury Spread 10yr-6mn Federal Reserve
Mortgage Spread (over 10yr Treasury) Federal Reserve
Swap Spread (over 10yr Treasury) Bloomberg
AAA Corporate Spread (over 10yr Treasury) Moody
BAA Corporate Spread (over 10yr Treasury) Moody
AA Corporate Spread (over 10yr Treasury) Merrill Lynch
BBB Corporate Spread (over 10yr Treasury) Merrill Lynch
Consumer Sentiment Michigan Survey
Consumer Sentiment (Expected) Michigan Survey
Consumer Condence Conference Board
Consumer Condence (Expected) Conference Board
Housing Permit Number HUD
Housing Start Number HUD
Money Supply (M2) Federal Reserve
Business Cycle Indicator NBER
29
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (d)
Figure 1: Wald Test for Risk Premium with Continuous Integrated Volatility.
X-axis is nominal level of test and Y-axis is probability of rejection. Dotted line is uniform
reference, dash line is T = 150, and solid line is T = 600.
30
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (d)
Figure 2: Wald Test for Risk Premium with Five-Minute Realized Volatility.
X-axis is nominal level of test and Y-axis is probability of rejection. Dotted line is uniform
reference, dash line is T = 150, and solid line is T = 600.
31
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (a)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (b)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (c)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
RNIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
MFIV Scenario (d)
0 0.5 1
0
0.2
0.4
0.6
0.8
1
BSIV Scenario (d)
Figure 3: Wald Test for Risk Premium with One-Day Realized Volatility.
X-axis is nominal level of test and Y-axis is probability of rejection. Dotted line is uniform
reference, dash line is T = 150, and solid line is T = 600.
32
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
0
10
20
30
40
50
S&P500 Index Realized Volatility in Annualized Standard Deviation
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
0
10
20
30
40
50
S&P500 Index Implied Volatility in Annualized Standard Deviation
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
10
5
0
5
10
15
20
25
Difference between Implied Volatility and Realized Volatility
Figure 4: Model-Free Realized and Implied Volatilities
33
Jan90 Jan95 Jan00
0
1
2
3
Volatility Risk Premium
Jan90 Jan95 Jan00
0
2
4
6
Realized Volatility
Jan90 Jan95 Jan00
2
1
0
1
2
3
Moody AAA Bond Spread
Jan90 Jan95 Jan00
6
4
2
0
2
New House Start Number
Jan90 Jan95 Jan00
2
1
0
1
2
3
S&P500 PE Ratio
Jan90 Jan95 Jan00
3
2
1
0
1
2
Industrial Production
Jan90 Jan95 Jan00
2
1
0
1
2
3
Producer Price Index
Jan90 Jan95 Jan00
2
1
0
1
Nonfarm Payroll Employment
Figure 5: Macro-Finance Inputs for Volatility Risk Premium
34
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
1
0
1
2
3
4
TimeVarying Volatility Risk Premium () Projected onto MacroFinance Variables
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
0
0.5
1
1.5
2
ad hoc Extraction of Volatility Risk Premium () PeriodbyPeriod
Jan90 Jul92 Jan95 Jul97 Jan00 Jul02
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
Average Index of 29 Standardized MacroFinance Variables (Negative Value)
Jun92 Dec94
94 Rate Hike
Soft Landing
Sep96
"Irrational
Exuberance"
Nov98
Russian
LTCM
Crisis
Jun00
Stock
Internet
Bubble
Bust
9/11
Nov02
Corporate Scandal
PreIraq War Fear
2001
Recession
9091
Recession
Anemic Recovery
Slow Job Growth
Figure 6: Time-Varying Volatility Risk Premia and Other Indices
35