Dynamics of variance risk premium: Evidence from India

Extant empirical evidence suggests that variance risk might not be priced in markets that witness high retail participation. We examine and reject this hypothesis using data from Indian markets. We employ both model-dependent and model-free approaches in our analysis. Our result is robust to alternate specifications of volatility, sampling frequencies and sample periods. We then examine the dynamics of variance risk premium. Specifically, we split realized variance into its two components: jumps and continuous variance. We find that only past continuous variance is significant in forecasting short-term synthetic variance swap returns; realized jumps do not have any predictive power. These results survive inclusion of classical risk factors. These findings suggest that only the continuous component of realized variance has significant impact on variance risk premium.