Understanding Risk Premia in Index Option Prices

Roman Kozhan

Anthony Neuberger

Paul Schneider

August 12, 2010

Abstract
We explore the reasons why out-of-the-money index puts trade on much higher im-
plied volatilities than out-of-the-money calls. We develop a trading strategy that exploits
the skew in implied volatility, and show that it has a simple interpretation. The pay-o
to the strategy is identical to that on a swap whose oating leg is equal to the covariation
between returns and changes in implied variance. The interpretation does not depend
on any specic pricing model. We use the strategy to show that approximately half
of the skew in implied volatility is due to the negative correlation between returns and
implied volatility, and the other half can be considered a skew risk premium. We also
nd empirical evidence that this skew risk premium is closely related to the variance
risk premium.
1 Introduction
There is a substantial literature on risk premia
1
in equity index option prices. One strand
focuses on the dierence between implied volatility and realized volatility. The empirical
observation that implied volatility is on average higher than realized is seen by many as
evidence for the existence of a volatility or variance risk premium. A second strand of the
literature addresses the pronounced skew observed in equity index implied volatility; low strike
options trade at higher implied volatilities than high strike options. Many authors have argued

We are thankful to Bjrn Eraker, Gordon Gemmill, Ciara Rogerson, Thomas Ruf, Mark Salmon, Anders
Trolle, Pierre de Vos, and to participants of the WBS lunch seminar, and the WBS conference on Derivatives,
Volatility, and Correlation for valuable comments.

Warwick Business School, University of Warwick, Scarman Road, Coventry, CV4 7AL, UK; e-mail:
{roman.kozhan,anthony.neuberger,paul.schneider}@wbs.ac.uk
1
Following the literature we use the term risk premium to mean an expected abnormal return without
taking a view on whether it results from investors risk aversion or some other feature of preferences such as
a liquidity preference.
1
that this cannot be explained entirely by the skew in the distribution of index returns. Writing
deep out of the money puts appears to be an abnormally protable strategy. This fact can be
seen as evidence for the existence of a crash or skew risk premium.
The early literature on implied and realized volatility was bedevilled by the lack of a
robust theoretical link between implied and expected realized volatility. For example Coval
and Shumway (2001) and Bakshi and Kapadia (2003) look at holding returns on options -
typically at-the-money options. Black-Scholes option pricing theory says that the two should
be identical, but it is not clear whether the dierence between the two should be interpreted
as a failure of the option pricing theory, a breakdown in market eciency or evidence of
priced risk factors. It was only with the development of model-free implied volatility (MFIV)
(Britten-Jones and Neuberger 2002, Jiang and Tian 2005) that it became possible to develop
clean and precise tests for the existence of risk premia in option prices. The key observation
is that it is possible to replicate a variance swap using vanilla options. The replication is
not dependent on any particular specication for asset price dynamics. The prot from a
variance swap is equal to the dierence between realized and implied variance. The MFIV is a
particular average of the implied variance of vanilla options. Thus, examination of the prots
from a variance swap (as in Carr and Wu 2009) provides a precise and essentially model-free
way of examining the existence and behavior of risk premia that aect the average level of
option prices.
In this paper we develop an analogous strategy to examine the skew in option prices. We
show that it is possible to replicate a skew swap in a way that is essentially model-free. The
model free implied skew (MFIS) is a measure of the skew in implied volatility it reects the
dierence in implied volatility between high strike (i.e. strike higher than the forward price)
and low strike options. The pay-o to a skew swap is the dierence between realized skew and
implied skew. Realized skew is the covariation between returns and implied variance. The
skew swap leg is expected covariation between returns and implied variance under the pricing
measure, an interpretation that the measure developed in this paper adds to the literature over
the skew measure developed by Bakshi et al. (2003). The pay-o from skew swaps provides
a way of testing for the existence and behavior of risk premia implicit in the skew in implied
volatility without introducing the distorting lens of a mis-specied option pricing model.
We apply the skew swap technology to S&P 500 option data, and provide evidence that
there does indeed exist a skew risk premium in the US equity index market. We show that
almost half of the implied skew in index option prices can be explained by the negative
correlation between returns and volatility, but the remainder of the skew is a risk premium.
2
The skew risk premium is closely related to the variance risk premium. The realized return
on skew swaps is highly correlated to the realized return on skew swaps.
2
When one type
of swap is hedged with the other, the expected prot is close to zero. Furthermore, there is
evidence that the risk premium on both skew swaps and variance swaps is time varying, and
that there is a single common factor driving both premia.
The existence of a negative variance risk premium means that entering into variance swaps
on the US equity market, receiving xed and paying oating, has on average been protable.
The strategy loses money when volatility is unexpectedly high. Given the strong negative
correlation between volatility and skew, this means that the strategy tends to lose money
when skew is larger (more negative) than expected.
3
So the strategy of going short variance is
also one of going short skew. What we demonstrate is that writing variance swaps is protable
precisely because the investor is also going short skew. If the variance swap writer hedges out
skew risk, the abnormal prots disappear.
To understand why the skew swap technology has power in identifying risk premia in option
prices, it is useful to review the evidence on the apparent over-pricing of index put options. A
number of authors (Jackwerth (2000),Coval and Shumway (2001), At-Sahalia et al. (2001),
Bakshi and Kapadia (2003), Bollen and Whaley (2004), and Driessen and Maenhout (2007))
have documented the high negative returns earned by the buyers of out-of-the-money index
puts. But, as Bondarenko (2003) and Broadie et al. (2009) argue, it is hard to interpret these
ndings. Inference is complicated for various reasons.
The distribution of monthly option holding returns has a large standard deviation, is
negatively skewed, and is highly leptokurtic. In most months the return is -100 per cent; in
those months where the option ends up in the money, the potential upside is unlimited. With
index options having traded only since the mid to late-1980s, and with monthly expiries, the
number of observations is of the order of 200. With such a distribution of returns and such a
limited sample, the power to reject the null of zero abnormal returns is weak.
A further fundamental problem with exploring option returns through buy-and-hold strate-
gies is that the risk characteristics of options are themselves volatile. For example, a one month
index put which is initially 6 per cent out-of-the-money has a delta (sensitivity to the index)
of 0.16 and a vega (sensitivity to volatility) of 0.07. Two weeks later the delta could be either
0.34 or 0.01, and its gamma could be 0.08 or 0.0064
4
.
2
Theoretical, parametric evidence in Feunou et al. (2009) suggests a tight relation between the variance
risk premium, the skewness (not the skewness risk premium) of index returns and the equity premium.
3
A similar argumentation can be found in Jones (2003) for time-series correlation and variance.
4
The example is based on a Black-Scholes model with a volatility of 20%, with a plus or minus one standard
3
Finally, out-of-the-money puts are exposed both to index return risk (delta) and volatility
risk (vega), both of which are known to be priced. To investigate the put premium puzzle,
portfolio returns need to be corrected for the premia associated with these risks. There are
two simple ways of doing this. Strategies can be devised that are delta and vega neutral. The
hedge is sensitive to the choice of model; a position that is delta and vega neutral according
to one model may have substantial index and volatility exposure according to another. The
second way to correct for known priced risks is to compute empirical hedge ratios by regressing
holding returns on the relevant risk factors. This suers from the problem that the risk
exposures are neither stable within each month nor constant across months, so the hedging is
only approximate.
The skew swap strategy addresses these problems. Instead of asking whether one particular
derivative claim (the out-of-the-money put option) is over-priced, it asks whether the strong
negative relation between implied volatility and strike is justied by the price dynamics of
the underlying asset. This is equivalent to asking whether skew swaps have a zero expected
pay-o. The pay-o to a skew swap has much nicer distributional properties than the pay-
o to an equivalent buy-and-hold option strategy. It has a lower standard deviation, and is
closer to a Gaussian. The superior statistical power of our technology over inferences based
on buy-and-hold returns enables us to circumvent the critique in Broadie et al. (2009) that it
is not easy to reject out-of-the-money put mispricing relative to some parametric model. The
risk characteristics of the strategy are stable both within months and across months.
The remainder of the paper is organized as follows: Section 2 provides the model-free
approach to constructing the skew swap strategy and how to quantify the skew risk premium.
Section 3outlines a general equilibrium model that endogenously generates skew, variance
risk premia and skew risk premia. Section 4 describes the data and empirical methodology
performed in the paper. Section 5 discusses the implications of the empirical results, Section
6 provides robustness checks, and Section 7 concludes.
2 Theory
For exposition and intuition we develop the theory rst in a standard continuous-time friction-
free framework, characterized by a ltered probability space, with a xed horizon T. We
assume that both the risk-free interest rate and the dividend yield on the index are zero. This
is just a normalization and has no impact on the analysis. We assume continuous trading,
deviation return over the following two weeks.
4
that prices follow a diusion, and that calls and puts for all strikes are available. We also
explore the eect of relaxing these assumptions, allowing for discrete rebalancing, and prices
that jump.
X
t
denotes the price of an index future and C
t,T
(K) and P
t,T
(K) denote the prices of a
European call and put with strike K that expire at the horizon date T, respectively.
BS
t,T
(K) is
the implied Black-Scholes volatility of the call (or put) option with strike K. We assume that
the market is arbitrage free. This ensures the existence of a probability measure Q (the pricing
measure) under which the gains process associated with any admissible trading strategy is a
martingale (Harrison and Kreps 1979). References to expectations are under the Q measure
unless stated otherwise.
Given the importance of the parallel with variance swaps, we rst set out the main results
from that literature. We then go on to develop the theory of skew swaps.
2.1 The Variance Swap
Here, we consider the Log Contract L
t,T
whose pay-o is log X
t
. The Log Contract can be
synthesized as a portfolio of conventional options
L
t,T
= X
t
1
_
Xt
0
P
t,T
(K)
K
2
dK
_

Xt
C
t,T
(K)
K
2
dK. (1)
Note that the Log Contract is short all options if options generally earn negative abnormal
returns, so too will the Log Contract. In a Black-Scholes world, where X
t
has constant
volatility , the price of the Log Contract would be
L
t,T
= log X
t

1
2

2
(T t).
Dene the implied variance of the Log Contract as
v
l
t,T
2 (log X
t
L
t,T
) (2)
(the superscript l denotes the Log Contract). In a Black-Scholes world v
l
t,T
=
2
(T t), but
in general v
l
is stochastic, and follows a diusion. We can use

Ito calculus to get
dL
t,T
=
dX
t
X
t

1
2
_
dX
t
X
t
_
2

1
2
dv
l
t,T
. (3)
Now consider a strategy of shorting two Log Contracts at time 0. Delta hedge by holding at
any time t
2
Xt
forward contracts on the index. If wealth at time t is W
t,T
then the wealth
5
process is
dW
t,T
= 2
dXt
Xt
2dL
t,T
= dv
l
t,T
+
_
dXt
Xt
_
2
. (4)
If initial wealth is 0, then terminal wealth is
W
T,T
=
_
T
t=0
_
dXt
Xt
_
2
v
l
0,T
.
The strategy synthesizes a variance swap. The oating leg is the realized variance over the
period. The xed leg is the implied variance of the Log Contract. Since the strategy involves
buying options at all strikes and then some delta hedging, the protability of the strategy can
be regarded as a measure of the risk premia in option prices across all strikes.
2.2 The Skew Swap
To develop a handle on the risk-neutral skew we also consider an Entropy Contract E whose
pay-o is X
t
log X
t
. The Entropy Contract can be synthesized as a portfolio of conventional
options
E
t,T
= X
t
1 +
_
Xt
0
P
t,T
(K)
K
dK +
_

Xt
C
t,T
(K)
K
dK. (5)
In a Black-Scholes world, where X
t
has constant volatility , the price of the Log and Contract
would be
E
t,T
= X
t
log X
t
+
1
2
X
t

2
(T t).
Dene the implied variance of the Entropy Contract as
v
e
t,T
2
_
E
t,T
X
t
log X
t
_
(6)
(the superscript e denotes the Entropy Contract). In a Black-Scholes world v
l
t,T
= v
e
t,T
=

2
(T t), but in general the two implied variances dier, and v
e
follows a diusion. We can
use

Ito calculus to get
dE
t,T
=
_
1 + log X
t
+
1
2
v
e
t,T
_
dX
t
+X
t
1
2
_
dX
t
X
t
_
2
+
1
2
X
t
dv
e
t,T
+
1
2
dX
t
dv
e
t,T
.
Now consider a strategy of going long two Log Contracts and
2
X
0
Entropy contracts and short
2(2+log X
0
+
1
2
v
e
0,T
)
X
0
forward contracts on the index at time 0. Then dynamically rebalance the
position to ensure that at any subsequent time t the portfolio is long
2
Xt
Entropy Contracts
and short
2(2+log Xt+
1
2
v
e
t,T
)
Xt
forward contracts. If the wealth at time t is W
t,T
then the wealth
6
process is
dW
t,T
= 2
_
dE
t,T
X
t
+ dL
t,T

_
2 + log X
t
+
1
2
v
e
t,T
_
dX
t
X
t
_
= dv
e
t,T
dv
l
t,T
+ dv
e
t,T
_
dX
t
X
t
_
.
(7)
If initial wealth is 0, then terminal wealth is
W
T,T
=
_
T
t=0
dv
e
t,T
_
dXt
Xt
_

_
v
e
0,T
v
l
0,T
_
. (8)
The strategy synthesizes a skew swap. The oating leg is the covariation between returns
and changes to implied (entropy) variance over the period. The xed leg is the dierence
between the implied variance of the Entropy Contract and the Log Contract.
Dene s
t,T
v
e
t,T
v
l
t,T
. Combining equations (1), (2), (5) and (6), using put-call parity,
and equating prices at time t we get
s
t,T
=
_

Xt
KXt
K
2
Xt
C
t,T
(K)dK
_
Xt
0
XtK
K
2
Xt
P
t,T
(K)dK
= 2
_

1
1
Xt
(C
t,T
(X
t
) / P
t,T
(X
t
/)) d. (9)
As is clear from the rst line of (9), s is increasing in the price, and therefore the implied
volatility, of high strike options, and decreasing in the implied volatility of low strike options.
Carr et al. (1998a) introduced the helpful idea of put-call symmetry. The implied volatility
smile is symmetrical if the implied volatilities of two options with the same absolute log-
moneyness are the same, so
BS
t,T
_
Xt

_
=
BS
t,T
(X
t
) for all . This is equivalent to the condition
P
t,T
_
Xt

_
=
C
t,T
(Xt)

. The second line of (9) shows that s = 0 not only when the implied
volatility is at, but also when it is symmetrical i.e. when it is unskewed.
From (2) and (6), and replacing the price of contracts by their expected pay-os we get
v
l
t,T
= 2E
Q
t
_
log
_
X
T
X
t
__
; (10)
v
e
t,T
= 2E
Q
t
__
X
T
X
t
_
log
_
X
T
X
t
__
. (11)
Using r
t,T
for the net return,
X
T
Xt
1, we can express s as
s
t,T
= 2E
Q
t
[(2 +r
t,T
) log (1 +r
t,T
)] = E
Q
t
_
r
3
t,T
+O
_
r
4
t,T
_
/3.
The Taylor approximation in the second line makes use of the fact that E
Q
t
[r
t,T
] = 0. Pulling
together the dierent properties of s we have:
7
Proposition 1. The dierence s between the entropy implied variance and the log implied
variance, has the following properties:
1. if implied volatility across strikes is symmetrical about the forward price, s = 0
2. s is increasing in the implied volatility of high strike (strike above the forward price)
options and decreasing in the implied volatility of low strike options
3. to rst order, s is proportional to the third moment of the returns on the asset (under
the pricing measure).
Proof. Appendix A.1.
In light of this, we refer to s as the implied skew. We maintain that the implied skew
is a good measure of the extent to which out-of-the-money puts are expensive relative to
out-of-the-money calls. The other signicant result we have demonstrated (see eq. (8)) is
Proposition 2. The implied skew at time t is also the fair price for the xed leg of a skew
swap over the period [t, T]. Equivalently,
s
t,T
= E
Q
t
__
T
t=0
dv
e
t,T
dXt
Xt
_
. (12)
Proof. Appendix A.2.
This suggests that the question of whether out-of-the-money puts are over-priced is equiv-
alent to asking whether the returns on skew swaps are excessive. The latter question should
in principle be easier to answer from a statistical and economic perspective because the risk
exposure from holding a skew swap does not vary as the index price moves. The skew swap
pays the covariation between returns and changes in implied variance.
By relaxing the assumption that the portfolio may be rebalanced continuously at dened
intervals, we can adjust our basic ideas for empirical work, accounting for discrete observations.
Suppose that the portfolio used in strategies (4) and (7) is only rebalanced N times over the
period, at intervals of length t = T/N. The notation is modied slightly. Dierences are
forward looking, so X
t
means X
t+t
X
t
, and r
t
= X
t
/X
t
. Using exactly the same strategies
as in (4) and (7), we get
8
Proposition 3. By trading the underlying, Log and Entropy contracts, rebalancing at discrete
intervals, the pay-o P
C
t,T
from the skew swap can be synthesized
P
C
0,T
=
_
N1

n=0
r
nt
v
e
nt,T
_
s
0,T
+
N1

n=0
f(r
nt
), where (13)
f(x) (4 + 2x) log(1 +x) 4x = 1/3x
3
+O(x
4
). (14)
The variance counterpart to eq. (13) is
P
V
0,T
=
N1

n=0
r
2
nt
v
l
0,T
+
N1

n=0
g(r
nt
), where (15)
g(x) 2(x log(1 +x)) x
2
=
2x
3
3
+O(x
4
). (16)
The terms in square brackets are the discrete counterparts of the pay-os in strategies (4)
and (7); discrete rebalancing induces a disturbance of

f(r
t
) into the skew swap strategy.
The magnitude of the disturbance relative to the covariance term is an empirical question. The
presence of the disturbance term shows why the assumption of a diusion is necessary. If there
are jumps, Proposition 3 does not converge to its diusion counterparts as the dierencing
interval goes to zero.
3 Parametric Evidence in General Equilibrium
In this section we outline an ane general equilibrium model in the spirit of Eraker (2008b)
and Eraker and Shaliastovich (2008). Our goal is to assess the joint behavior of variance
premia and skew premia from rst principles to develop economic intuition. Epstein-Zin
analysis yields risk premia for the driving uncertainties directly from the preferences of the
representative agent. This grants much improved economic intuition over a pure no-arbitrage
consideration, which merely puts technical structure on risk premia. We do not give full
coverage of the mathematics of the model here; the interested reader is referred to Eraker
(2008a), Eraker and Shaliastovich (2008), and Eraker (2008b).
Our starting point is the discrete-time recursive utility function of the representative agent
U
t
=
_
(1 )C
1

t
+E
P
t
_
U
1
t+1

_

1
, (17)
with
=
1
1
1

.
9
Here, is the subjective discount factor, is the intertemporal elasticity of substitution, and
is the local risk aversion coecient.
The recursive Epstein-Zin preference structure leads to the Euler equation
E
P
t
_

_
C
t+1
C
t
_

R
1
c,t+1
R
i,t+1
_
= 1, (18)
where R
c,t
is the return on the aggregate wealth portfolio which pays consumption as its
dividends, and R
i,t
is the return on an arbitrary asset. For parsimony we assume that the
S&P 500 index is a representation of this wealth portfolio.
The model is formulated in terms of log consumption growth log C, log dividend growth
log D, and a stochastic variance driver V . Under the objective probability measure P the
model has a representation in SDE form
d log C
t
=
c
dt +
_
V
t
dW
C
t
d log D
t
=
c
dt +
d
_
V
t
dW
C
t
+
d
_
V
t
dW
D
t
dV
t
= [
V
(v V
t
) l
1

V
v] dt +
V
_
V
t
dW
V
t
+dN
t
,
(19)
where N
t
is a Poisson counter with state-dependent jump intensity l
1
V
t
. The random variable
is Gamma distributed
(r,
V
/r) , with moment generating function (20)
(u) =
_
1
u
V
r
_
r
, (21)
independent of the state variables. The model is taken from Eraker (2008b). Appendix
B.1 develops an equilibrium solution. Inspecting eqs. (36) and (37) reveals the presence
of negative correlation (leverage eect) between the S&P 500 and consumption variance for
negative values of the B parameter from the log price - dividend ratio dened in eq. (31) as
an equlibrium outcome, even though the variance driver in (19) is exogenously uncorrelated
with consumption. The leverage eect induces skew into the distribution of log returns. The
model is therefore potentially capable of reecting the skew in the observed implied volatility
surface.
In Appendix B.2.1 we develop the necessary tools to price nancial instruments in the
Epstein-Zin economy. Appendix B.2.2 establishes methods to price Log contracts (see Section
2.1) and Entropy contracts (see Section 2.2) in an economy where interest rates are not
normalized to zero. The expressions for v
l
and v
e
in eqs. (50) and (52) reveal that variance
and skew risk premia dened in eqs. (55) and (54) below both linearly depend on consumption
10
variance. Even though this nding is based on a simplistic, and most likely misspecied model
it suggests that variance and skew premia are time-varying and more importantly that they
should be strongly correlated. We test this a priori economic intuition using the model-free
estimates for variance and skew premia in Section 5 below.
4 Data and Methodology
We use OptionMetrics historical option price and implied volatility data based on closing
quotes at the CBOE. Our sample starts in January 1996 and ends in December 2009. We
use European options written on the S&P 500 spot index to compute skew swap rates and
variance rates using formulae (1) and (9), respectively. The data set includes closing bid and
ask quotes for each option contract along with the corresponding strike prices, Black-Scholes
implied volatilities, the interest rate zero-yield curve, and closing spot prices of the underlying.
From the data we lter out all entries with non-standard settlements.
At each maturity we rst interpolate implied volatilities along all available strike prices
using a cubic spline method. For strike prices below and above the lowest and the highest
available strikes we use the implied volatilities at the lowest and the highest strike price
respectively; this is the same procedure that Carr and Wu (2009) performed. Given the set of
interpolated-extrapolated implied volatilities we compute option prices C(K) and P(K) for
dierent strike prices, Log and Entropy contract implied variances v
l
t,T
, v
e
t,T
and the skew swap
rate s
t,T
at day t and maturity T. To account for our normalized economy all computations
are performed in terms of index forward prices by discounting spot prices with the interest
rate and dividends.
We compute realized variance and covariance between two maturity dates T
1
and T
2
using
the following formulae
RV
T
1
,T
2

365
T
2
T
1
T
2

t=T
1
+1
_
F
t,T
2
F
t1,T
2
F
t1,T
2
_
2
RC
T
1
,T
2

365
T
2
T
1
T
2

t=T
1
+1
_
F
t,T
2
F
t1,T
2
F
t1,T
2
_

_
v
e
t,T
2
v
e
t1,T
2
_
,
where F
t,T
denotes the time-t forward price of the underlying with maturity date T.
We compute implied variance and implied skew from options with maturities 1, 2 and
3 months. Table 1 contains summary statistics of the implied variance of Log and Entropy
contracts, realized variance, and realized covariance, skew swap rate for the S&P 500 index
options.
11
Table 1: Descriptive statistics
This table presents descriptive statistics for the variables used in the analysis. v
l
and v
e
denote implied vari-
ances of the Log Contract and Entropy Contracts, respectively, RV and RC realized variance and covariance,
s denotes the volatility skew of the S&P 500 index. Columns under Mean, Std. Dev, Min, Median and Max
report the sample average, standard deviation, minimum value, median and maximum value, respectively.
Panel A contains results for options with maturity up to 1 month; Panel B reports descriptive statistics for
options with maturity up to 2 months; Panel C reports descriptive statistics for options with maturity up to
3 months. The sample period is from January 1996 to December 2009.
Variable Mean Std. Dev Min Median Max
Panel A: 1 month options
v
e
100 5.94 6.73 1.11 4.33 56.93
v
l
100 5.67 6.19 1.08 4.24 52.69
RV 100 4.89 8.11 0.44 2.77 69.12
s 100 -0.27 0.57 -5.20 -0.12 -0.03
RC100 -0.15 0.50 -4.04 -0.04 0.05
Panel B: 2 months options
v
e
100 5.90 5.32 1.15 4.78 42.96
v
l
100 5.54 4.75 1.12 4.56 37.98
RV 100 4.77 7.24 0.54 2.81 60.29
s 100 -0.35 0.59 -4.98 -0.19 -0.03
RC100 -0.25 0.77 -6.44 -0.07 0.01
Panel C: 3 months options
v
e
100 5.55 4.96 1.24 4.39 40.94
v
l
100 5.20 4.38 1.19 4.18 35.59
RV 100 4.60 6.59 0.53 2.96 51.98
s 100 -0.35 0.62 -5.35 -0.18 -0.01
RC100 -0.30 0.83 -7.12 -0.10 0.002
All numbers are annualized. An entry for variance of 5.67 corresponds to an annualized
volatility of

0.0567 or 24 per cent. We observe that average realized variance is substantially

lower than implied variance, which is consistent with the existence of a negative variance risk
premium. This is a well established empirical fact (see, for example, Bakshi and Kapadia
2003, Carr and Wu 2009). Similarly, average realized skew is substantially smaller (in absolute
terms) than average implied skew at least at the one and two month maturities, pointing to the
existence of a skew risk premium. Variation in realized covariance is higher than the variation
in skew. Entropy variance is higher than log variance, pointing at a negative skew on average.
In fact the skew is negative throughout the sample period. Unsurprisingly, implied variance
and implied skew are less variable than realized variance and skew at all horizons
5
.
5
This is true if variability is measured by the coecient of variation. The standard deviation of realized
skew in one month options is actually lower than that of the implied skew.
12
Table 2: Correlations
This table presents pairwise correlations between the implied variance of Log and Entropy Contracts (v
l
,
respectively v
e
), realized variance (RV ), realized covariance (RC), and skew (s) of the S&P 500 index. The
table contains results for options with maturity up to 1, 2 and 3 months. All correlation coecients are
statistically signicant at 5% level. The sample period is from January 1996 to December 2009.
1 month options 2 months options 3 months options
v
l
RV s RC v
l
RV s RC v
l
RV s RC
v
e
0.999 0.744 -0.946 -0.752 0.999 0.569 -0.956 -0.562 0.999 0.484 -0.954 -0.485
v
l
1.000 0.743 -0.954 -0.755 1.000 0.569 -0.945 -0.557 1.000 0.488 -0.941 -0.485
RV 1.000 -0.704 -0.934 1.000 -0.536 -0.941 1.000 -0.428 -0.941
s 1.000 0.744 1.000 0.578 1.000 0.463
Table 2 reports the pair-wise correlations between variables. The log and entropy variance
measures are highly correlated with each other. Both measures are also negatively correlated
with skew, so when implied variance goes up, the absolute size of the skew increases also.
Realized variance is positively correlated with implied variance, as is realized skew with implied
skew. Realized variance and realized skew are highly negatively correlated with each other at
all horizons.
5 Empirical Results
In this section we rst establish empirically the existence of a skew risk premium using model-
free arguments. We then test whether the expectations hypothesis holds in the market for
realized covariance. Furthermore, we investigate how the risk premium is related to market
excess returns and the variance risk premium. We focus on the one month horizon.
5.1 Existence and Time Variability of the Skew Risk Premium
In a risk-neutral world Equation (12) indicates that the skew swap rate s should be an unbiased
expectation of the realized covariance between implied variance and index returns. Theoretical
considerations and empirical evidence in Bakshi et al. (2003) suggest that risk aversion induces
a negative skew in the index return distribution (conditional on excess kurtosis), however, and
we therefore expect a failure of the expectations hypothesis.
As noted in the previous Section, Table 1 reveals that on average the absolute value of
implied skew s is larger than the realized covariance. This is an indication of the presence of a
skew risk premium. To address this question more formally we test the expectation hypothesis
13
Table 3: Realized Covariance vs. Implied Skew
This table presents the estimation results of regressions RC
T1,T
=
0
+
1
s
T1,T
+ u
T
and RV
T1,T
=

0
+
1
v
l
T1,T
+w
T
based on one month S&P 500 index options. Standard t-statistics are given in parentheses.
F-stat provides F statistic values for a Wald test with H
0
:
0
= 0 and
1
= 1. Standard errors are adjusted
for autocorrelation. The sample period is from January 1996 to December 2009.
Const s

R
2
F-stat
Skew
0.00021
(1.12)
0.6558
(11.0)
55.37% 37.1
Variance
-0.00418
(-1.41)
0.8950
(10.0)
55.26% 4.38
by estimating the following time-series regressions
RC
T1,T
=
0
+
1
s
T1,T
+u
T
. (22)
As the expectation hypothesis of the implied skew is closely related to the expectation hy-
pothesis in implied volatility, we also estimate the corresponding variance regression
RV
T1,T
=
0
+
1
v
l
T1,T
+w
T
. (23)
Table 3 shows that implied skew does forecast realized skew and implied variance does
forecast realized variance. While the two intercepts are insignicantly dierent from zero, the
slopes are signicantly smaller than one in both cases. The intercept in the variance regression
in Table 3 deviates from Carr and Wu (2009) due to the dierent (extended) sample period.
We formally test the expectation hypothesis by means of a Wald test. Specically, we test
the null hypothesis of validity of the restrictions
H
0
:
0
= 0 and
1
= 1
versus the alternative that at least one of the restrictions is not valid. Column F-stat of Table
3 provides the values of the values of F-statistic for the test of the specied hypothesis. The
Wald test rejects the expectation hypothesis at 5% level for both variance and skew. This
suggests the presence of substantial time variability in the risk premia associated with variance
and skew.
5.2 Skew Risk Premium
The previous section indicates the existence of a variance and a skew risk premium. The
sample averages of the realized skew and variance should therefore statistically dier from
average implied skew and variance.
14
Table 4: Descriptive statistics for risk premia
This table presents descriptive statistics for skew and variance risk premia. We dene

SRP
t,T
RC
t,T
s
t,T
,

V RP
t,T
RV
t,T
v
l
t,T
, SRP
t,T
100(RC
t,T
s
t,T
)/s
t,T
and V RP
t,T
100(RV
t,T
v
l
t,T
)/v
l
t,T
. Columns
under Mean, Std. Dev, Min, Median and Max report the sample average, standard deviation, minimum value,
median and maximum value, respectively. T-stat column reports the value of t-statistic on the signicance of
the mean risk premia. SR columns contains annualized Sharpe ratios for the corresponding strategies. The
sample period is from January 1996 to December 2009.
Variable Mean Std. Dev Min Median Max T-stat SR

SRP 0.114 0.389 -3.299 0.073 2.154 3.77

V RP -1.042 5.467 -16.27 -1.243 55.42 -2.44

SRP -48.50 100.1 -199.3 -71.80 760.4 -6.21 -1.68
V RP -21.76 59.34 -82.65 -35.55 404.7 -4.71 -1.27
To assess the risk premia in a model-free way we construct a time series of realized prot
from the trading strategies outlined in the theory section 2. We dene prots as

SRP
t,T

100 (RC
t,T
s
t,T
) and

V RP
t,T
100 (RV
t,T
v
l
t,T
) and returns (which we call skew
and variance risk premia henceforth) as SRP
t,T
100 (RC
t,T
s
t,T
)/s
t,T
and V RP
t,T

100 (RV
t,T
v
l
t,T
)/v
l
t,T
. The two denitions of risk premia represent two ways of computing
prots for skew and variance swap strategies. The rst denition represents the average dollar
prot and loss for each $100 s and $100 v
l
investment in the variance swap contract. The
second one represents the rate of return of the strategy per $100 investment. Table 4 reports
the summary statistics of the prots and returns from skew and variance swaps strategies.
Table 4 suggests that approximately half of the implied skew in index option prices can
be explained by the negative correlation between returns and volatility, with the other half of
the skew being a risk premium. The sample averages of the skew and variance risk premia are
negative (

SRP is positive only because the skew swap rate s is negative), and the t-statistics
show that mean risk premia are signicantly dierent from zero. We conclude that investors
are willing to accept a signicantly negative average return to long skew and variance swaps
on the S&P indices.
To compare the protability of the skew swap strategy versus the variance swap strategy,
we additionally provide the corresponding annualized Sharpe ratios in Table 4. The skew
swap strategy has higher risk-adjusted protability than the variance swap strategy.
15
Table 5: Skew and Variance Risk Premia
This table presents estimation results of the following skew and variance risk premia regressions:
SRP
T1,T
=
0
+
1
V RP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+u
T
V RP
T1,T
=
0
+
1
SRP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+w
Ti
.
SRP and V RP denote returns from skew and variance swap strategies, ER denotes index excess return,
HML, SMB and UMD correspond to Fama-French and momentum risk factors. T-statistics are given in
parentheses. Standard errors are adjusted for autocorrelation. The sample period is January 1996 to December
2009.
Skew
Const V RP ER HML SMB UMD

R
2
-0.1527
(-1.50)
1.5132
(5.50)
0.1490
(0.98)
72.05%
-0.1436
(-1.38)
1.5209
(5.20)
0.1704
(0.88)
-0.2990
(-1.23)
-0.2106
(-1.01)
0.1005
(0.57)
72.52%
Variance
Const SRP ER HML SMB UMD

R
2
-0.0126
(-0.24)
0.4332
(6.25)
-0.2678
(-4.18)
77.19%
-0.0157
(-0.33)
0.4188
(6.24)
-0.3162
(-4.19)
0.0189
(0.11)
-0.1372
(-0.88)
-0.2403
(-3.04)
78.43%
5.3 Skew versus Variance Risk Premium
Having established empirically the existence and time-series behavior of the skew risk pre-
mium we are now interested in the question whether it is driven by a source of risk premium
independent from equity and the variance risk premia. More specically, we ask the question
whether variance and skew risk premia are driven by the same source of risk.
In order to assess the relation between the skew risk premium and the variance risk pre-
mium documented in Carr and Wu (2009), we regress the prot from buying a covariance
swap against the variance risk premium and the index excess returns over the corresponding
period
SRP
T1,T
=
0
+
1
V RP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+u
T
, (24)
where ER
T1,T
denotes the excess market return from day T 1 to T, HML, SMB and UMD
correspond to Fama-French and the momentum factors. We also estimate a similar regression
of the variance risk premium to verify if it can be explained by the skew risk premium:
V RP
T1,T
=
0
+
1
SRP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+w
T
. (25)
Results of the estimations are provided in Table 5. This highlights the close relationship
16
Table 6: Determinants of Skew and Variance Risk Premia
This table presents the estimation results of the following system of equations:
(
SRP
T,T+1
=
0
+
1
SRP
T1,T
+
2
V RP
T1,T
+
3
s
T,T+1
+
4
v
l
T,T+1
+
5
ER
T1,T
+u
T
V RP
T,T+1
=
0
+
1
SRP
T1,T
+
2
V RP
T1,T
+
3
s
T,T+1
+
4
v
l
T,T+1
+
5
ER
T1,T
+w
T
.
SRP and V RP denote returns from skew and variance swap strategies, ER denotes index excess return, s and
v
l
denote implied skew and log-contract variance. Wald test column reports the p-values of of the Wald test

2
statistic for testing the coecient restriction hypothesis H
0
:
i
=
i
, i = 1, ..., 5. F test column provides
values of the F-statistic for the overall signicance of the regression. T-statistics for coecient signicance are
given in parentheses. Standard errors are adjusted for autocorrelation. The sample period is January 1996 to
December 2009.
Dep. Var. Const lagSRP lagV RP s v
l
lagER

R
2
F test Wald test
SRP
-0.6017
(-4.08)
-0.0605
(-0.39)
0.3783
(1.43)
99.323
(2.11)
7.3573
(1.89)
-0.1598
(-0.96)
3.89% 2.31
0.2490
V RP
-0.2545
(-2.95)
-0.0809
(-0.90)
0.2929
(1.84)
49.597
(1.80)
3.2822
(1.44)
-0.1535
(-1.58)
6.05% 3.08
between variance and skew swaps. As we have seen (Table 4) the writer of a skew swap earns
a risk premium. But in doing so, the writer also takes on signicant variance risk. Once that
is hedged by buying variance swaps, and market risk is also hedged, the premium is lost, and
the writer of the skew swap earns a negative return that is statistically insignicant. Similarly
the writer of the variance swap is exposed to skew risk (the connection of the variance risk
premium and the well-known leverage eect, has been highlighted in the literature (Carr and
Wu 2009, Bollerslev et al. 2009, Driessen and Maenhout 2007, Jones 2003)), and once that is
hedged away the prot from writing variance swaps also vanishes.
5.4 Determinants of Skew Risk Premia
The evidence presented so far suggests that skew risk does attract a premium, but that it
is hard to distinguish from the variance risk premium. It seems quite plausible that the two
premia are in fact the same and that they both derive from an exposure to some common
factor. The general equilibrium model described in Section 3 provides an example of how this
might work. Although innovations to consumption and to the volatility of consumption are
uncorrelated, innovations to the market index and to its volatility are negatively correlated.
Both variance swaps and skew swaps on the market index attract risk premia that are time
varying and proportional to the volatility of consumption. In order to verify if the two risk
premia are indeed driven by a single common factor, we run the system of predictive regressions
of the returns from the swap strategies on the lagged factors. Predicted components should
17
serve as proxies for the risk premia. We specify the system in the following way:
_
SRP
T,T+1
=
0
+
1
SRP
T1,T
+
2
V RP
T1,T
+
3
s
T,T+1
+
4
v
l
T,T+1
+
5
ER
T1,T
+u
T
V RP
T,T+1
=
0
+
1
SRP
T1,T
+
2
V RP
T1,T
+
3
s
T,T+1
+
4
v
l
T,T+1
+
5
ER
T1,T
+w
T
.
If risk premia are the same (or proportional) that we would expect that the factor loadings
(coecients in front of the regressors) should be proportional. That is,
H
0
:
i
=
i
, for some value > 0 and i = 0, ..., 5.
In order to test this hypothesis we have to determine the value of the ratio coecient . We
argue that it should be equal to the ratio of the means of two risk premia distributions, that
is
=
E[SRP
T,T+1
]
E[V RP
T,T+1
]
.
Hence, we test this coecient restrictions by means of Wald test for = 2.228. Table 6
provides the estimation and test results.
Table 6 suggests that there is indeed some predictability in both skew risk premia and
variance risk premia. The individual coecients are not in general highly signicant we
have seen that the independent variables are quite strongly correlated with each other and
the Wald Test cannot reject the hypothesis that the conditional expectation of the two risk
premia are directly proportional to each other.
6 Robustness Check
In this section we perform a robustness check to ensure that our results are not driven by
a specic sample selection. For this purpose we split our sample into two parts. The rst
subsample ranges from January 1996 to December 2002 and the second one starts from January
2003 to December 2009. The estimation results are given in Table 7. It shows that the skew risk
premium has become more pronounced recently while variance risk premium was dominating
in the rst part of our sample. In the rst subsample the intercept of the variance risk
premium regression is borderline signicant while it is not signicant for the skew regression.
In the second subsample, the skew risk premium does not disappear after hedging against the
variance risk premium. The adjusted coecient of the determination remains high in both
regressions and during both sample periods and even increases during the most recent data.
Both skew and variance risk premia are highly signicant across both samples.
18
Table 7: Skew and Variance Risk Premia: Sub-samples
This table presents robustness check of the estimation results of the skew and variance risk premia regressions
SRP
T1,T
=
0
+
1
V RP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+u
T
V RP
T1,T
=
0
+
1
SRP
T1,T
+
2
ER
T1,T
+
3
HML
T1,T
+
4
SMB
T1,T
+
5
UMD
T1,T
+w
T
.
across two periods: January 1996 December 2002 and January 2003 December 2009. SRP and V RP
denote returns from skew and variance swap strategies, ER denotes index excess return, HML, SMB and
UMD correspond to Fama-French and momentum risk factors. T-statistics are given in parentheses. Standard
errors are adjusted for autocorrelation.
January 1996 December 2002
Skew
Const V RP ER HML SMB UMD

R
2
-0.0412
(-0.19)
1.7382
(3.05)
0.3008
(1.39)
64.10%
-0.0443
(-0.20)
1.7766
(2.93)
0.3826
(1.34)
0.3099
(0.63)
0.2506
(0.60)
0.1492
(0.84)
64.37%
Variance
Const SRP ER HML SMB UMD

R
2
-0.0838
(-1.88)
0.3579
(8.56)
-0.2588
(-4.11)
70.08%
-0.0774
(-1.85)
0.3402
(9.38)
-0.3341
(-4.56)
-0.3617
(-1.66)
-0.4397
(-2.02)
-0.1509
(-1.79)
72.38%
January 2003 December 2009
Skew
Const V RP ER HML SMB UMD

R
2
-0.2402
(-3.52)
1.3146
(7.93)
-0.0545
(-0.43)
82.93%
-0.2176
(-2.82)
1.3507
(6.92)
0.0152
(0.09)
-0.5830
(-1.38)
-0.3064
(-0.71)
-0.0855
(-0.59)
83.73%
Variance
Const SRP ER HML SMB UMD

R
2
0.0755
(1.64)
0.5410
(10.1)
-0.1928
(-2.43)
84.60%
0.0459
(1.07)
0.5106
(11.0)
-0.2885
(-3.42)
0.4698
(1.79)
0.0191
(0.08)
-0.1396
(-1.59)
86.52%
7 Conclusions
In this paper we have developed a methodology for investigating the out-of-the-money index
put puzzle. We have identied a strategy that exploits the apparent over-pricing of low strike
put options relative to high strike options. It has a number of advantages over a simple buy-
and-hold strategy including that it exploits the relative pricing of ITM and OTM options,
that it has a risk prole that is essentially constant within months and stable across months,
and that it incorporates a hedge of the exposure to the underlying asset that is model-free. It
also has a simple model-free interpretation. The strategy is to replicate a skew swap, paying
xed and receiving the covariance between returns and changes in variance. In eect, the
strategy trades option-implied skew for realized skew. We apply the technology to options on
the US S&P 500 index. The leverage eect means that the oating leg is generally negative.
19
The xed leg, which is the implied skew, is also negative throughout our sample period.
Using this technology, we nd that OTM put returns actually are excessively low. Buying
skew swaps is signicantly protable on average. While the leverage eect present in the US
index market accounts for part of the skew in option prices, roughly half the skew is due to a
premium on skew risk.
The absolute size of the skew is highly correlated with the level of volatility and the prot
from buying skew swaps is highly correlated with the prot from writing variance swaps.
When implied variance rises unexpectedly, the writer of the variance swap loses money (on a
mark-to-market basis); but the rise in implied variance tends to be associated with an increase
in negative skewness, thereby causing the buyer of the skew swap to lose money. This suggests
that variance swaps and skew swaps create similar kinds of risk exposure.
The risk premia on skew and variance swaps exhibit signicant time variation. We present
evidence that there is a single factor driving both risk premia. This suggests that the ex-
planation of the OTM put price puzzle and of the existence of a signicant variance risk
premium (Carr and Wu 2009) are the same. While we provide no empirical evidence suggest-
ing why skew and variance should attract a risk premium we show, in a general equilibrium
model based on Eraker (2008b), that a model where the volatility of aggregate consumption
is subject to stochastic shocks, the risk aversion of the representative agent induces not only
a leverage eect, but also a time-varying skew and variance risk premium that are perfectly
correlated with each other.
Many interesting questions suggest themselves for future research: What exactly is the
relation between realized covariance, the leverage eect, realized variance, and variance of
variance? In a general equilibrium context Bollerslev et al. (2009) obtain interesting con-
nections of volatility of variance only to the variance risk premium. How does the fear of
rare events inuence the skew (again an answer is provided in Todorov and Bollerslev (2009)
only for variance risk premia). Are there parametric models which are able to reproduce the
time-series properties?
20
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Eraker, B.: 2008a, Ane general equilibrium models, Management Science pp. 2068 2080.
Eraker, B.: 2008b, The volatility premium. Working paper, University of Wisconsin.
Eraker, B. and Shaliastovich, I.: 2008, An equilibrium guide to designing ane models, Math-
ematical Finance 18(4), 519 543.
Feunou, B., Fontaine, J.-S. and Tedongap, R.: 2009, The equity premium and the volatil-
ity spread: The role of risk-neutral skewness, Technical report, Duke University, Bank of
Canada, and Stockholm School of Economics.
Harrison, M. and Kreps, D.: 1979, Martingales and arbitrage in multiperiod securities markets,
Journal of Economic Theory 20, 381408.
Jackwerth, J.: 2000, Recovering risk aversion from option prices and realized returns, Review
of Financial Studies 13, 433451.
Jiang, G. J. and Tian, Y. S.: 2005, The model-free implied volatility and its information
content, Review of Financial Studies 18(4), 13051342.
Jones, C. S.: 2003, The dynamics of stochastic volatility: evidence from underlying and
options markets, Journal of Econometrics 116, 181224.
Todorov, V. and Bollerslev, T.: 2009, Tails, fears and risk premia, Technical report, North-
western University and Duke University.
22
A Proofs
A.1 Proof of Proposition 1
Parts 1) and 2) A European claim G with pay-o g(X
T
) can be replicated using a portfolio
of puts and calls, together with cash and forward contracts
G = g(x)L +g

(x)F(x) +
_
x
0
g

(k)P(k)dk +
_

x
g

(k)C(k)dk
with arbitrary x, where P(k) (C(k)) is a put (call) with strike k and maturity T, L = 1 is
cash, and F(x) is a forward contract with strike x (Bakshi and Madan 2000).
With x = X
t
, and equating the prices of equivalent portfolios at time t
L
t,T
= log X
t

_
Xt
0
1
k
2
P
t
(k)dk
_

Xt
1
k
2
C
t
(k)dk,
E
t,T
= X
t
log X
t
+
_
Xt
0
1
k
P
t
(k)dk +
_

Xt
1
k
C
t
(k)dk
(26)
where C
t
(K) and P
t
(K) are the prices of calls and puts at time t. Comparing (26) with the
denition of the Log and Entropy contracts gives
s
t,T
= v
e
t,T
v
l
t,T
=
2
X
t
__
Xt
0
k X
t
k
2

_

Xt
X
t
k
k
2
C
t
(k)dk
_
(27)
and 1) follows immediately. Carr et al. (1998b) dene put-call symmetry to mean that prices
of out-of-the-money puts and calls are related
C
t
(X
t
) = P
t
(X
t
/), all > 0 (28)
Put-call symmetry is equivalent to requiring that
I
t
(k), the Black-Scholes implied volatility of
a call or put option with strike k and maturity T at time t, is symmetrical about the forward
price

I
t
(X
t
) =
I
t
(X
t
/). (29)
Putting (28) into (27) gives s
t,T
= 0.
Part 3) From the denition of the Log and the Entropy Contract
v
l
t,T
= 2E
Q
t
[log X
t
log X
T
] , and v
e
t,T
= 2E
Q
t
_
X
T
X
t
(log X
T
log X
t
)
_
.
Writing x
t
for the return (X
T
X
t
)/X
t
we write
v
l
t,T
= 2E
Q
t
[log(1 +x
t
)] , and v
e
t,T
= 2E
Q
t
[(1 +x
t
) log(1 +x
t
) +x
t
log X
t
] .
23
Using a Taylor series expansion, and recalling that the expectation of x
t
under Q is zero we
have
v
l
t,T
= E
Q
t
_
x
2
t

2
3
x
3
t
+
_
, and v
e
t,T
= 2E
Q
t
_
x
2
t

1
3
x
3
t
+
_
.
A.2 Proof of Proposition 2
Consider the following strategy:
6
Go long 2 Log contracts, and 2/X
t
Entropy contracts, and
short 2(2 + log X
t
+
1
2
v
e
t,T
)/X
t
of the underlying. The change of wealth is
dW = 2dL +
2
X
dE
_
4 + 2 log X +v
e
X
_
dX
= dv
e
dv
l
+
dX
X
dv
e
.
Terminal wealth is given by
P
C
= W
T
= v
l
t,T
v
e
t,T
+
_
T
t
dX
u
X
u
dv
e
u,T
=
_
T
t
dX
u
X
u
dv
e
u,T
s
t,T
(30)
so
s
t,T
= E
Q
t
__
T
t
dX
u
X
u
dv
e
u,T
_
.
B General Equilibrium Model
B.1 The Epstein-Zin Economy in General Equilibrium
We put Y (log C, log D, V ) from system (19). We reproduce the analysis in Eraker (2008b),
by introducing a linearization of the discrete-time log return of the consumption asset
log R
c,t+1
log
P
t+1
+D
t+1
P
t

0
+
1
v
t+1
v
t
+ log D
t+1
log D
t
,
and assuming an ane solution to the log price dividend ratio (here we already anticipate
zero loadings on log consumption and log dividends)
v
t
log P
t
log D
t
= A +BV
t
, (31)
6
This portfolio can be described as a gamma and delta hedged Entropy contract, where the gamma hedging
is done using the Log contract.
24
where

1
=
e
E
P
[vt]
1 +e
E
P
[vt]
, and

0
= log
_
(1
1
)
1
1

1
1

.
The fundamental theorem of asset pricing yields the coecients
1
and B as (numerical)
solutions of the roots of the following two expressions
l
1
__
1
B
1

V
r
_
r
1
_
+
(B
1

2
(B
1

2
V
2
V
+ 2) 2B
2
+( 1)
2
)
2
2
, and
B
1
( v
V
l
1
v
V
) + (B(1
1
) v + log()) +
_
1
1

c
log (
1
) .
Having solved for the equilibrium we derive the Q dynamics of the system (19) (Q processes
carry a sign).
d log C = (
c
V
t
)dt +
_
V
t
d

W
C
t
d log D = (
c

d
V
t
)dt +
d
_
V
t
d

W
c
t
+
d
_
V
t
d

W
D
t
dV
t
=
_

V
(v V
t
) l
1

V
v BV
t
(1 )
1

2
V

dt +
V
_
V
t
d

W
V
t
+

d

N,
where

_
r,

V
r + (1 )
1
B
V
_
, with mgf (32)
(u) =
_
1
u
V
B(1 )
1

V
+r
_
r
, and (33)

l
1
=
_
1 +
(1 )
1
B
V
r
_
r
l
1
, (34)
and the market price of Brownian motion risk is given by
=
_
_
_
_

0
B(1 )
1
_
_
_
_
. (35)
The P and Q dynamics of the log S&P 500 price jointly with the variance driver are
d log P
t
= (
c
+B[
V
(v V
t
) l
1
v
V
]) dt +
d
_
V
t
dW
C
t
+
d
_
V
t
dW
D
t
+B
V
_
V
t
dW
V
t
+BdN
t
dV
t
= [
V
(v V
t
) l
1
v
V
] dt +
V
_
V
t
dW
V
t
+dN
t
,
(36)
25
respectively
d log P
t
= B
_

V
( v V
t
) l
1
v
V
BV
t
(1 )
1

2
V
_
+
c
V
t

d
+
d
_
V
t
d

W
C
t
+
d
_
V
t
d

W
D
t
+B
V
_
V
t
d

W
V
t
+B

d

N
t
dV
t
=
_

V
(v V
t
) l
1
v
V
BV
t
(1 )
1

2
V

dt +
V
_
V
t
d

W
V
t
+

d

N
t
.
(37)
Note that due to no-arbitrage the Q drift of log P is the dierence between the instantaneous
short rate and the continuous dividend yield. The instantaneous short rate in the Epstein-Zin
economy is endogenous to the economy. By no-arbitrage it is given by
R(Y
t
)
0
+

1
Y
t
, (38)
where

1
=
_
_
_
_
0
0
l
1

l
1
+
1
2
_
B( 1)
1
_
B( 1)
1

2
V
+ 2
V
2
_
+ 2B( 1)
2
_
_
_
_
_
, (39)

0
= B( 1) v (
1
(
V
1) + 1) +
c
log() + ( 1) log (
1
) . (40)
B.2 Pricing Variance Swaps and Skew Swaps
B.2.1 Ane Discounted Fourier Transform
To lighten notation in the following we denote with X (log C, log D, V, log P). This process
is somewhat unusual in that three Brownian motions drive four processes, but it is nevertheless
ane. In this section we will continue to abbreviate E
P
[f(X
t+
) | F
t
] with E
P
t
[f(X
t+
)]. X
can be represented in SDE form
dX
t
=
M
(X
t
)dt +(X
t
)dW
t
+

M
dN
M
t

M
(x) = M
M
+K
M
x,
(x)(x)

= Hx
under probability measure M {P, Q}. We have
K
Q
=
_
_
_
_
_
_
0 0 0
0 0
d
0
0 0 B(1 )
1

2
V

V
0
0 0 B
2
(1 )
1

2
V
B
V

d
0
_
_
_
_
_
_
, K
P
=
_
_
_
_
_
_
0 0 0 0
0 0 0 0
0 0
V
0
0 0 B
V
0
_
_
_
_
_
_
,
26
M
Q
= M
P
=
_
_
_
_
_
_
_

c
v
V
l
1
v
V
B( v
V
l
1
v
V
) +
c
_
_
_
_
_
_
_
, (X
t
) =
_
_
_
_
_
_
_

V 0 0

V
d

V
d
0
0 0

V
V

V
d

V
d
B

V
V
_
_
_
_
_
_
_
,
H =
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
0
4
0
4
0
4
0
4
0
4
0
4
0
4
0
4
_
_
_
_
_
_
_
1

d
0

d
_
_
_
_
_
_
_
_
_
_
_
_
_
_

2
d
+
2
d
0

2
d
+
2
d
_
_
_
_
_
_
_
_
_
_
_
_
_
_
0
0

2
V
B
2
V
_
_
_
_
_
_
_
_
_
_
_
_
_
_

2
d
+
2
d
B
2
V
B
2

2
V
+
2
d
+
2
d
_
_
_
_
_
_
_
0
4
0
4
0
4
0
4
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
,
where 0
n
denotes a column vector with n zeros. Jumps are distributed according to

Q
=
_
_
_
_
_
_
0
0

_
_
_
_
_
_
,

P
=
_
_
_
_
_
_
0
0

B
_
_
_
_
_
_
, (41)
where

has moment generating function (33) and has moment-generating function (21) and
jumps arrive with intensity
l
M
V
t
, where l
M
=
_
_
_
_
_
_
0
0
l
M
1
0
_
_
_
_
_
_
. (42)
We get the joint jump transform of

M
, : R
4
R
+
through

M
(u) = E
M
_
e
u
3
+u
4
B

= E
M
_
e
(u
3
+u
4
B)

=
M
(u
3
+u
4
B). (43)
We also dene

1
(0, 0,
3
, 0)

,
0

0
,
and therefore r
t
=
0
+

1
X
t
, reecting the enlarged state space.
The (discounted) characteristic function : R
+
C
4
C
4
R
2
R
+
R C is of the
ane exponential ane form (Due et al. 2000, under regularity)
(, u, v, X
t
) (, u, X
t
)(, u, v, X
t
) E
M
t
_
v

X
t+
e

R
T
t
R(Ys)ds
e
u

X
t+
_
< , (44)
27
where
(, u, X
t
) = e
(u,)+(u,)Xt
(, u, v, X
t
) = (u, v, ) +(u, v, )X
t
,
and = T t. The coecients , , , and solve the generalized Riccati equations

=
1
+ (K
M
)

+
1
2

H +l
M
(() 1) , (u, 0) = u

(45)

=
0
+M
M
, (u, 0) = 0 (46)
= (K
M
)

H +l
M
(), (u, v, 0) = v

(47)
= M
M
, (u, v, 0) = 0, (48)
and u = (u
1
, u
2
, u
3
, u
4
)

, and v = (v
1
, v
2
, v
3
, v
4
)

. For convenience we dene the initial

conditions
u
0
= v
0
(0, 0, 0, 0)

, u
P
= v
P
(0, 0, 0, 1)

.
The system of ordinary dierential equations (45)-(48) can be solved numerically.
B.2.2 Log and Entropy Contracts In Stochastic Interest Rate Economy
Eqs. (10) and (11) need to be slightly adapted to reect the presence of stochastic interest
rates which are endogenous to the Epstein-Zin economy. First, the forward price F
t,T
with
maturity T for an asset paying a continuous dividend yield can be obtained through
0 = E
Q
t
_
P
T
F
t,T
B
T
_
,
where B
t
denotes the instantaneous bank account and therefore
F
t,T
=
1
p
t,T
E
Q
t
_
e

R
T
t
rs ds
P
T
_
,
where
p
t,T
= E
Q
t
_
e

R
T
t
rsds
_
= (, u
0
, X
t
).
In terms of the extended transform (44) the forward price is therefore given by
F
t,T
=
(, u
P
, X
t
)
(, u
0
, X
t
)
. (49)
Note that expression (49) diers from
Pt
p
t,T
, which would be the forward price if P did not
pay continuous dividends. Forward prices for a maturity T are martingales under the Q
T
28
probability measure, which is associated with the zero coupon bond numeraire which the
following computation shows
E
Q
T
t
[F
T,T
] = E
Q
T
t
[P
T
] = E
Q
t
_
e

R
T
t
rsds
p
t,T
P
T
_
= F
t,T
To maintain the martingale requirement from the theoretical section (2) we can therefore
rewrite eq. (10) as
v
l
t,T
= 2E
Q
T
t
_
log
_
F
T,T
F
t,T
__
= 2
_
E
Q
T
t
[log P
T
] log F
t,T

= 2
_
1
p
t,T
E
Q
t
_
e

R
T
t
rsds
log P
T
_
log F
t,T
_
.
(50)
In terms of the extended transform (44) the log contract can be represented as
v
l
t,T
= 2
_
1
(, u
0
, X
t
)
(, u
0
, X
t
)(, u
0
, v
P
, X
t
) log
(, u
P
, X
t
)
(, u
0
, X
t
)
_
= 2 [(u
0
, v
p
, ) +(u
0
, ) (u
p
, ) + (
V
(u
0
, v
p
, ) +
V
(u
0
, )
V
(u
p
, ))V
t
]
(51)
Careful inspection of the ODE (45)-(48) reveals that the price of a log contract is ane in
the stochastic variance variable.
A similar analysis can be done for the entropy contract. From payo Equation (11) we
have
v
e
t,T
= 2E
Q
T
t
_
F
T,T
F
t,T
log
F
T,T
F
t,T
_
=
2
F
t,T
_
E
Q
T
t
[P
T
log P
T
] E
Q
T
t
[F
T,T
] log F
t,T
_
= 2
_
1
F
t,T
p
t,T
E
Q
t
_
e

R
T
t
rsds
P
T
log P
T
_
log F
t,T
_
.
(52)
Again this has a representation in terms of the extended transform (44)
v
e
t,T
= 2
_
(, u
0
, X
t
)
(, u
P
, X
t
)(, u
0
, X
t
)
(, u
P
, X
t
)(, u
P
, v
P
, X
t
) log
(, u
P
, X
t
)
(, u
0
, X
t
)
_
= 2 [(u
P
, v
P
, ) +(u
0
, ) (u
P
, ) + (
V
(u
P
, v
P
, ) +(u
0
, )
V
(u
P
, ))V
t
] .
(53)
Again,
P
(u
P
, v
P
, ) cancels with
P
(u
P
, ) leaving state dependence only on V . The entropy
contract, and hence the skew swap lag, is therefore also ane in the stochastic variance
variable.
From Equation (12) we dene skew risk premia in the Epstein-Zin economy as
SRP
EP
t,T
2
_
E
P
t
_
F
T,T
F
t,T
log
F
T,T
F
t,T
_
+E
P
t
_
log
_
F
T,T
F
t,T
___
(v
e
t,T
v
l
t,T
). (54)
In the same fashion variance premia are dened as
V RP
EP
t,T
2E
P
t
_
log
_
F
T,T
F
t,T
__
v
l
t,T
. (55)
29