Good and Bad Variance Premia and Expected Returns

We measure “good” and “bad” variance premia that capture risk compensations for the realized variation in positive and negative market returns, respectively. The two variance premium components jointly predict excess returns over the next one and two years with statistically significant positive (negative) coefficients on the good (bad) component. The R²s reach about 10% for aggregate equity and portfolio returns and 20% for corporate bond returns. To explain the new empirical evidence, we develop a model that highlights the differential impact of upside and downside risk on equity and variance risk premia.

The online appendix is available at https://doi.org/10.1287/mnsc.2017.2890.

This paper was accepted by Neng Wang, finance.