Profiting from Fear: A Study of the Variance Risk Premium in the Trump Era

Louise Mering & Kirsten Vedel Møller

Student thesis: Master thesis

Abstract

The Variance Risk Premium (“VRP”), constituting the spread between option-implied and actual realized variance, has historically proven a stable and dominant predictor of future stock returns, especially at the quarterly horizon. Motivated by the extraordinarily low market volatility along with increased political uncertainty evident in recent years, we not only confirm the VRP’s ability to predict a nontrivial fraction of stock returns on the S&P 500 index, but we find a strengthened effect after the financial crisis, albeit at a slightly longer horizon. Viewing the VRP as an indicator of investor fear, we thus demonstrate that it is possible to ‘profit from fear’ across the sample period. However, in a post-US election setting, we find that the VRP has lost its dominant predictive ability. By using President Trump’s Twitter Feed as a proxy for political events, we discover that Trump does not act as a catalyst for market volatility, but rather acts as a risk reliever contrary to common conviction. Hence, our findings indicate that a change in current investor sentiment has occurred: a disconnect between actual volatility and investor fear could potentially be driving the change in predictability, with investors strongly overestimating actual crash risk given the current level of volatility, while Trump seems to be alleviating some of this fear.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2018
Number of pages213
SupervisorsSøren Plesner