Premium Essay



Submitted By hotransang
Words 10706
Pages 43
Journal of Banking & Finance 37 (2013) 3388–3400

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The cross-sectional relation between conditional heteroskedasticity, the implied volatility smile, and the variance risk premium
Louis H. Ederington a,⇑, Wei Guan b a b

Finance Division, Michael F. Price College of Business, University of Oklahoma, 205A Adams Hall, Norman, OK 73019, USA College of Business, University of South Florida St. Petersburg, 140 Seventh Avenue South, St. Petersburg, FL 33701, USA

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This paper estimates how the shape of the implied volatility smile and the size of the variance risk premium relate to parameters of GARCH-type time-series models measuring how conditional volatility responds to return shocks. Markets in which return shocks lead to large increases in conditional volatility tend to have larger variance risk premia than markets in which the impact on conditional volatility is slight. Markets in which negative (positive) return shocks lead to larger increases in future volatility than positive (negative) return shocks tend to have downward (upward) sloping implied volatility smiles. Also, differences in how volatility responds to return shocks as measured by GARCH-type models explain much, but not all, of the variations in excess kurtosis and multi-period skewness across different markets. Ó 2013 Elsevier B.V. All rights reserved.

Article history: Received 11 October 2012 Accepted 14 April 2013 Available online 17 May 2013 JEL classification: G13 G10 G12 Keywords: Implied volatility Volatility smile Variance risk premium GARCH Conditional heteroskedasticity

1. Introduction Along with jump risk, a leading explanation for both the implied volatility smile and the variance risk premium is stochastic

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