Volatility of Volatility and Tail Risk Premiums
Federal Reserve BoardAugust 1, 2013
This paper reports on tail risk premiums in two tail risk hedging strategies: the S&P500 puts and the VIX calls. As a new measure of tail risk, we suggest using a model-free, risk-neutral measure of the volatility of volatility implied by a cross section of the VIX options,which we call the VVIX index. The tail risk measured by the VVIX index has forecastingpower for future tail risk hedge returns. Speciﬁcally, consistent with the literature on raredisasters, an increase in the VVIX index raises the current prices of tail risk hedges and thuslowers their subsequent returns over the next three to four weeks. Furthermore, we ﬁndthat volatility of volatility risk and its associated risk premium both signiﬁcantly contributeto the forecasting power of the VVIX index, and that the predictability largely results fromthe integrated volatility of volatility rather than volatility jumps.
: G12; G13
: Volatility of volatility; tail risk; rare disaster; option returns; risk premiums;and VIX options
We are very grateful for the comments and suggestions from Celso Brunetti, Garland Durham,Michael Gordy, Zhaogang Song, Hao Zhou, and seminar participants at the 23
FDIC DerivativesSecurities and Risk Management Conference and Yonsei University. This paper beneﬁts from theexcellent research assistance of Nicole Abruzzo. We also thank Tim Bollerslev and Viktor Todorov forsharing the fear index and Jian Du and Nikunj Kapadia for sharing the jump/tail index. Disclaimer:The analysis and conclusions set forth are those of the authors and do not indicate concurrence bythe Board of Governors or other members of its research staﬀ. Send correspondence to Yang-HoPark, Risk Analysis Section, Board of Governors of the Federal Reserve System, 20th & C Streets,NW, Washington, D.C., 20551, Tel:(202) 452-3177, e-mail: email@example.com.