Resolution of Policy Uncertainty and Sudden Declines in Volatility

Abstract

We introduce downward volatility jumps into a general non-affine modeling framework of the term structure of variance. With variance swaps and S&P 500 returns, we find that downward volatility jumps are associated with a resolution of policy uncertainty, in particular through statements from Federal Open Market Committee meetings and speeches of the Federal Reserve chairman. We also find that such jumps are priced with positive risk premia, which reflect the price of the put protection offered by the Federal Reserve. Ignoring downward volatility jumps may lead to an exaggeration of the negative total variance risk premia, hence a biased-interpretation of the price of tail events. We also find variance risk premia tend to be insignificant or even positive at the inception of crises. On the modeling side, we explore the structural differences and relative goodness-of-fits of factor specifications, and find that the log-volatility model with two Ornstein-Uhlenbeck factors and double-sided jumps are superior in capturing volatility dynamics and pricing variance swaps.