Discussion Paper Series 2020-E-9

Stock Return Predictability and Variance Risk Premia around the ZLB

Toshiaki Ogawa, Masato Ubukata, Toshiaki Watanabe

We make an empirical analysis of whether and how variance risk premia (VRP) contribute to predicting excess stock returns in the US and Japan. Our new findings to be added to the literature are that (i) the correlation between VRP and future excess returns in the US is insignificant when the risk-free rate is close to zero, and (ii) the correlation in Japan is significantly negative. To explain these findings, we also conduct a preliminary theoretical analysis with a structural model of asset pricing based on two assumptions: the zero lower bound (ZLB) for the risk-free rate, and a negative correlation between the consumption growth rate and the volatility-of-volatility. These allow excess returns to follow a hump-shaped pattern. This affects the sign and significance of the correlation of the returns with the VRP.

Keywords: Excess returns; Heterogeneous autoregressive model; Nikkei 225; Realized volatility; S&P500; Variance risk premium; Zero lower bound


Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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