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Title: Dynamics of variance risk premia, inverstors' sentiment and international return predictability Authors:  Jeroen Rombouts - ESSEC Business School (France) [presenting]
Francesco Violante - ENSAE ParisTech (France)
Lars Stentoft - Copenhagen Business School (Denmark)
Abstract: A flexible approach is proposed for retrieving the variance risk premia (VRP) which delivers more refined, precise and realistic estimates of the market price of risk. We define a class of structural time series models that isolates as structural components the dynamics of the physical variance and, by embedding its expectations into the model, the price attached by the market to the variance risk (i.e. the VRP). In fact, by doing this we deconstruct the mechanism of formation of the variance expectations under the risk neutral measure. Given the latent nature of the variables of interest of which only imprecise approximations are observable (i.e. high frequency return based variance measures and option implied risk neutral variance expectations), we advocate the use of methodologies based on signal extraction techniques. We advocate the inclusion of interactions and discontinuities, with emphasis on structural breaks, extreme events, uncertainty due to heteroskedasticity, correlations and spillovers, as being essential to replicate complex dynamics and interdependencies between the physical variance and its risk neutral expectation. In an empirical application to the S\&P500, we address the excess return puzzle by disentangling the predictability stemming from the part of the variance risk premium associated with normal sized price fluctuations from that associated with extreme tail events, i.e. tail risk.