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A0385
Title: Modelling variance risk premia via variance swap payoffs Authors:  Jeroen Rombouts - ESSEC Business School (France) [presenting]
Francesco Violante - IESEG School of Management (France)
Lars Stentoft - University of Western Ontario (Canada)
Abstract: An approach using synthetic variance swap payoffs is proposed to estimate the VRP and information related to extreme payoff events. Variance swap payoffs are highly volatile series, with time varying variance levels and extreme payoffs during volatile market conditions. To cope with these features, we use signal extraction techniques based on a state-space representation of the model and the Kalman-Hamilton filter. Since we know from financial theory that the VRP is positive, we impose this economic constraint when estimating the model. This approach allows us to obtain measurement error free estimates of the smooth component of VRP, and construct variables indicating agents' expectations under extreme market conditions. This information is shown to be very useful in predictive return regressions on the S\&P500, DJIA, NASDAQ and RUSSELL index markets.