Good and Bad Variance Premia and Expected Returns

Abstract

We measure 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 1 and 2 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.