A Theory of Volatility Spreads

Abstract

This study formalizes the departure between risk-neutral and physical index return volatilities, termed volatility spreads. Theoretically, the departure between risk neutral and physical index volatility is connected to the higher-order physical return moments and the parameters of the pricing kernel process. This theory predicts positive volatility spreads when investors are risk averse, and when the physical index distribution is negatively skewed and leptokurtic. Our empirical evidence is supportive of the theoretical implications of risk aversion, exposure to tail events, and fatter left-tails of the physical index distribution in markets where volatility is traded.

Keywords: risk-neutral volatility, physical volatility, pricing kernels, risk aversion, fat-tails

JEL Classification: G10, G11, G12