Abstract
We derive an analytic relation between equity risk premium and the term structure of variance risk premium (VRP). Motivated by this result, we estimate the VRP term structure using a general and fully analytical discrete-time option pricing framework featuring multiple volatility components and multiple risk premia. We confirm the importance of VRP in improving option pricing performances and show the ability of multi-component GARCH models to produce realistic hump-shaped VRP term structure. We finally uncover the strong predictive power of the shape of the VRP term structure, summarized by its slope, on future stock-index returns.
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