International Finance Discussion Papers (IFDP)
Variance Risk Premium Components and International Stock Return Predictability
Juan M. Londono and Nancy R. Xu
In this paper, we document and explain the distinct behaviors of U.S. downside and upside variance risk premiums (DVP and UVP, respectively) and their international stock return predictability patterns. DVP, the compensation for bearing downside variance risk, is positive, highly correlated with the total variance premium, and countercyclical, whereas UVP is, on average, borderline positive and procyclical with large negative spikes around episodes of market turmoil. We then provide robust evidence that decomposing VP into its downside and upside components significantly improves domestic and international stock return predictability. DVP is a robust predictor at four to six months and exhibits a hump-shaped pattern, whereas UVP performs the best at very short horizons. These stylized facts highlight the importance of acknowledging asymmetry in equity risk premiums. Hence, in the second part of the paper, we rationalize the economic sources of DVP and UVP in an international dynamic asset pricing model featuring asymmetric and time-varying risk aversion and economic uncertainty in a partially integrated world economy. We show that DVP is mostly driven by the upside movements of risk aversion, whereas UVP loads significantly and negatively on downside economic uncertainty. Moreover, we find that DVP (UVP) transmits to international markets mostly through financial integration (real economic integration).
Keywords: Variance risk premium, downside variance risk premium, international stock markets, asymmetric state variables, stock return predictability
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