Modeling the Variance Risk Premium of Equity Indices: The Role of Dependence and Contagion

Abstract

The variance risk premium (VRP) refers to the premium demanded for holding assets whose variance is exposed to stochastic shocks. This paper identifies a new modeling framework for equity indices and presents for the first time explicit analytical formulas for their VRP in a multivariate stochastic volatility setting, which includes multivariate non-Gaussian Ornstein--Uhlenbeck processes and Wishart processes. Moreover, we propose to incorporate contagion within the equity index via a multivariate Hawkes process and find that the resulting dynamics of the VRP represent a convincing alternative to the models studied in the literature up to date. We show that our new model can explain the key stylized facts of both equity indices and individual assets and their corresponding VRP, while some popular (multivariate) stochastic volatility models may fail.