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201354 Pap

201354 Pap

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Published by: caitlynharvey on Aug 22, 2013
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Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary AffairsFederal Reserve Board, Washington, D.C.Volatility of Volatility and Tail Risk PremiumsYang-Ho Park
NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.
Volatility of Volatility and Tail Risk Premiums
Yang-Ho Park
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.
JEL Classification 
: 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: yang-ho.park@frb.gov.
1 Introduction
The recent financial crisis has provoked an interest in tail risk hedging strategiesthat are structured to generate positive payoffs in bad states of the world in whichasset values plunge, market volatility soars, funding/market liquidity drops, and in-stitutional investors are forced to deleverage their risk exposures because of highermargin and haircut rates. Despite the growing interest in tail risk hedges, little isknown about their risk premiums and thus their expected returns. The financial me-dia expresses skepticism about the efficacy of tail risk hedges because the increaseddemand following the 2008 financial crisis has made them more expensive.
Againstthis backdrop, the objective of this paper is to propose a new measure of marketwidetail risk and examine its relation to expected returns on two popular forms of tailrisk hedges: the out-of-the-money (OTM) S&P 500 (SPX) put options and the OTMVIX call options.As a new measure of tail risk, this paper suggests using a model-free, risk-neutralmeasure of the volatility of volatility, which we call the VVIX index, that is obtainedby applying the approach of Bakshi, Kapadia, and Madan (2003) to a cross section of the VIX options. The market’s perception of tail risk can affect stock index dynamicsthrough two stochastic channels: a jump process and a stochastic volatility processwith a leverage effect, which is a negative correlation between changes of prices andvolatility. Whereas most of the existing papers identify tail risk through the lens of a jump process, this paper takes the distinct perspective that tail risk informationcan be impounded into the volatility of stochastic volatility as even a small changein that variable can have a critical influence on left tails of return distributions. Inaddition, we provide evidence that the VVIX index is more relevant for measuringtail risk than the VIX index, which is commonly called the Wall Street fear index.A central hypothesis tested in this paper is the negative relation between tail riskand expected returns on tail risk hedging strategies. When tail risk is high, investors,whether risk-averse representative agents or financially constrained intermediaries,will be willing to pay a higher price for a tail risk hedging asset. That is, a higherlevel of tail risk increases the current prices of tail risk hedges, and thus, lowers theirsubsequent returns over the next period. The negative relation is consistent with the
For example, Barclaysexchange-traded note on the first two front-month VIX futures lostmore than one half of its value in the first half of 2012.

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