*Please note a meeting password is required for this event.
Meeting ID: 869 417 248
The Department of Finance & Risk Engineering welcomes Dr. Steve Heston from the University of Maryland, College Park, as part of the Brooklyn Quant Experience (BQE) Lecture Series*. Dr. Steve Heston will present his talk "Recovering the Variance Premium".
This paper generalizes the Ross (2015) recovery theory of asset pricing. Ross requires asset prices to be stationary in order to recover the physical distribution of asset prices. In contrast, this paper allows growth, in order to accommodate the Black-Scholes model and nonstationary generalizations such as stochastic volatility. The generalized theory recovers information about equity risk premia and variance risk premia from options prices. When applied to the Heston (1993) option model, the theory predicts a negative variance risk premium and specifically predicts the value of the equity premium in terms of the variance premium (and vice versa). Recovery theory also identifies the stochastic discount factor as the reciprocal return on a model-free portfolio of options.
To test the theory, this paper constructs returns on one-month $VIX$ and three-month $VIX3M$ option portfolios from 2007-2018. These option returns provide estimates of realized risk premia. Recovery theory links the equity premium to the value of the conditional and unconditional variance premia. It also predicts that long-run implied variance from the $VIX3M$ option portfolio is a biased predictor of future one-month $VIX$ variance. Empirically, recovery theory simultaneously matches the average $S&P$ 500 equity premium, the average variance premium, and observed biases in the variance expectations hypothesis. Autocorrelation properties of $VIX$ indices imply a 12% annual equity premium.
Steve Heston graduated with a BS double major in Mathematics and Economics from the University of Maryland, College Park in 1983. He attended the Graduate School of Industrial Administration and earned an MBA in 1985 followed by a PhD in Finance in 1990. He has held previous faculty positions at Yale, Columbia, Washington University, and the University of Auckland in New Zealand. He has worked in the private sector with Goldman Sachs in Fixed Income Arbitrage and in Asset Management Quantitative Equities. He is known for analyzing options with stochastic volatility and international stock risk.
*The BQE Lecture series is held every Thursday at 6 p.m.
Attendance is free and highly encouraged. When possible, slides will be made available after the talk.