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Title: A cross-sectional analysis of the variance risk premium Authors:  Bruno Feunou - Bank of Canada (Canada)
Ricardo Lopez Aliouchkin - Syracuse University (United States)
Romeo Tedongap - ESSEC Business School Paris-Singapore (France) [presenting]
Lai Xu - Syracuse University (United States)
Abstract: Using a large cross-section of equity options and returns, the total individual firm variance risk premium (VRP) is decomposed into a good and bad component. These two components reflect compensation for upward and downward risk, respectively. We find that firms with a high bad variance risk premium (VRPb) have extremely high average returns. Specifically, going long a portfolio consisting of firms with high VRPb and going short a portfolio of firms with low VRPb yields annual expected returns of 15.7\%. This result remains significant in double portfolio sorts where we control for individual firms' skewness and exposure to market skewness. VRPb also helps to explain the cross-section of expected stock returns beyond traditional asset pricing factors, firm characteristics and semi-variances. Furthermore, VRPb is important economically, with a two-standard-deviation increase in VRPb associated with a 19.0\% rise in expected annual stock returns. We develop an equilibrium-based asset pricing model that captures these facts.