Predictability of VRP: Other International Evidence
The intertemporal CAPM model of Merton (Econometrica, 41:867–887, 1973) demonstrates that the aggregate market risk premium is determined by the uncertainty of underlying returns, quantified by the return variance. When holding the market portfolio, however, an investor is also bearing the uncertainty of the variance itself. Just like that the equity premium demanded by investors is a result of fear to the uncertainty of future returns, the variance risk premium, defined as the difference between risk-neutral and physical expected variances, is also required to compensate for the risk of the uncertain variance. Several recent studies document the link between risk preference and variance risk premium. In particular, Bakshi and Madan (Manag Sci, 52:1945–1956, 2006) argue that the variance risk premium is approximately determined by the risk aversion parameter and the higher order moments of underlying returns. In a similar vein, Bollerslev et al. (J Econ, 160:102–118, 2011) assume an affine version of the stochastic volatility model in Heston (Rev Financ Stud, 6:327–343, 1993) and show that the variance risk premium is linearly related to the risk preference of individual agents. Other investigations in this area include Bekaert and Engstrom (Asset return dynamics under bad environment-good environment fundamentals. Working Paper, NBER, 2010), Todorov (Rev Financ Stud, 23:345–383, 2010), and Gabaix (Q J Econ, 127:645–700, 2012).