Dynamic estimation of volatility risk premia and investor risk aversion from option-implied and realized volatilities

This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment confirms that the procedure works well in practice. Implementing the procedure with actual S&P500 option-implied volatilities and high-frequency five-minute-based realized volatilities indicates significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns. (C) 2010 Elsevier B.V. All rights reserved.