A Global Factor in Variance Risk Premia and Local Bond Pricing

36 Pages Posted: 22 Dec 2015

Date Written: December 2015

Abstract

In a world of interconnected financial markets it is plausible that risk appetite — an important factor in asset pricing — is determined globally. By constructing an estimate of variance risk premia (VRP) for UK, US and euro-area equity markets, we are able to estimate international variance risk premia and use them to construct a proxy for global risk aversion. The impact of this time-varying risk aversion proxy on bond risk premia is then analysed within an arbitrage-free term structure model of UK interest rates, where it is introduced explicitly as a pricing factor. By linking VRP to a stochastic discount factor, we find that the risk aversion factor has significantly affected UK government bond yields. The changes in the risk aversion factor have been particularly important in the period of the 2008–09 financial crisis, with medium maturity yields being affected the most.

Keywords: Affine term structure models, option implied volatility, realized volatility, risk aversion

JEL Classification: C22, C52, G12, E43

Suggested Citation

Kaminska, Iryna and Roberts-Sklar, Matt, A Global Factor in Variance Risk Premia and Local Bond Pricing (December 2015). Bank of England Working Paper No. 576, Available at SSRN: https://ssrn.com/abstract=2706503 or http://dx.doi.org/10.2139/ssrn.2706503

Iryna Kaminska (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Matt Roberts-Sklar

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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