The Role of Variance Risk Premium in Derivative Pricing: Modeling, Estimation and Impact

Abstract

This paper estimates a model where variance risk premiums (VRP) is not fully explained by equity risk premiums (ERP). This separation can be detected thanks to a new breed of GARCH models with enough innovations to disconnect returns from variances. This type of risk-neutralization is compatible with continuous-time settings. We document that volatility index (VI) term structures, VI futures, and equity options, could be highly sensitive to changes in VRP. When the model is jointly estimated a consistent and sizable VRP emerges; suggesting that joint estimation with VI futures has an edge based on total likelihood and numerical advantage.