Variance Risk Dynamics, Variance Risk Premia, and Optimal Variance Swap Investments

60 Pages Posted: 24 May 2006 Last revised: 19 Nov 2007

See all articles by Markus Leippold

Markus Leippold

University of Zurich; Swiss Finance Institute

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Daniel Egloff

QuantAlea GmbH

Date Written: November 16, 2007

Abstract

With increasing appreciation of the fact that stock return variance is stochastic and variance risk is heavily priced, the industry has created a series of variance derivative products to span variance risk. The variance swap contract is the most actively traded of these products. It pays at expiry the difference between the realized return variance and a fixed rate, called the variance swap rate, determined at the inception of the contract. We obtain a decade worth of variance swap rate quotes at five maturities. With the data, we first exploit the information in both the time series and the term structure of the variance swap rates to analyze the return variance rate dynamics and market pricing of variance risk. We then study both theoretically and empirically how investors can use variance swap contracts across different maturities to span the variance risk and to revise their dynamic asset allocation decisions. We find that with the swap contract to span the variance risk, an investor increases her investment in the underlying stock.

In addition, the investor's indirect utility increases significantly when allowed to span the volatility risk using variance swap contracts. Finally, an out-of-sample study confirms that the gains from including variance swaps into the portfolio mix are large.

Keywords: Return variance swap, equity index options, term structure

JEL Classification: G12, G13, C52

Suggested Citation

Leippold, Markus and Wu, Liuren and Egloff, Daniel, Variance Risk Dynamics, Variance Risk Premia, and Optimal Variance Swap Investments (November 16, 2007). EFA 2006 Zurich Meetings Paper, Available at SSRN: https://ssrn.com/abstract=903728 or http://dx.doi.org/10.2139/ssrn.903728

Markus Leippold (Contact Author)

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

Daniel Egloff

QuantAlea GmbH ( email )

Wasserfuristrasse 42
Wiesendangen, 8542
Switzerland
+41 44 520 0117 (Phone)

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