Skip to main content
×
Home
    • Aa
    • Aa

Volatility Trading: What Is the Role of the Long-Run Volatility Component?

  • Guofu Zhou (a1) and Yingzi Zhu (a2)
Abstract
Abstract

We study an investor’s asset allocation problem with a recursive utility and with tradable volatility that follows a 2-factor stochastic volatility model. Consistent with previous findings under the additive utility, we show that the investor can benefit substantially from volatility trading due to hedging demand. Unlike existing studies, we find that the impact of elasticity of intertemporal substitution (EIS) on investment decisions is of 1st-order importance. Moreover, the investor can incur significant economic losses due to model and/or parameter misspecifications where the EIS better captures the investor’s attitude toward risk than the risk aversion parameter.

Copyright
Linked references
Hide All

This list contains references from the content that can be linked to their source. For a full set of references and notes please see the PDF or HTML where available.

T. Adrian , and J. Rosenberg . “Stock Returns and Volatility: Pricing the Short-Run and Long-Run Components of Market Risk.” Journal of Finance, 63 (2008), 29973030.

G. Bakshi , and N. Kapadia . “Delta Hedged Gains and the Negative Market Volatility Risk Premium.” Review of Financial Studies, 16 (2003), 527566.

T. G Bali . “The Intertemporal Relation between Expected Returns and Risk.” Journal of Financial Economics, 87 (2008), 101131.

T. G. Bali , and R. F. Engle . “The Intertemporal Capital Asset Pricing Model with Dynamic Conditional Correlations.” Journal of Monetary Economics, 57 (2010), 377390.

T. G. Bali , and L. Peng . “Is There a Risk-Return Trade-Off? Evidence from High-Frequency Data.” Journal of Applied Econometrics, 21 (2006), 11691198.

B. Bansal , and A. Yaron . “Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles.” Journal of Finance, 59 (2004), 14811509.

J. Beeler , and J. Y. Campbell . “The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment.” Critical Finance Review, 1 (2012), 141182.

J. Y. Campbell , and L. M. Viceira . Strategic Asset Allocation. Oxford, UK: Oxford University Press (2002).

P. Carr , and L. Wu . “A Tale of Two Indices.” Journal of Derivatives, 13 (2006), 1329.

G. Chacko , and L. M. Viceira . “Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets.” Review of Financial Studies, 18 (2005), 13691402.

M. Chernov ; E. Ghysels ; A. R. Gallant ; and G. Tauchen . “Alternative Models for Stock Price Dynamics.” Journal of Econometrics, 116 (2003), 225257.

P. Christoffersen ; K. Jacobs ; C. Ornthanalai ; and Y. Wang . “Option Valuation with Long-Run and Short-Run Volatility Components.” Journal of Financial Economics, 90 (2008), 272297.

D. Duffie , and L. G. Epstein . “Stochastic Differential Utility.” Econometrica, 60 (1992), 353394.

D. Duffie ; J. Pan ; and K. Singleton . “Transform Analysis and Asset Pricing for Affine Jump-Diffusions.” Econometrica, 68 (2000), 13431376.

L. G. Epstein , and S. Zin . “Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework.” Econometrica, 57 (1989), 937969.

H. Guo , and R. F. Whitelaw . “Uncovering the Risk-Return Relation in the Stock Market.” Journal of Finance, 61 (2006), 14331463.

S. L Heston . “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options.” Review of Financial Studies, 6 (1993), 327343.

R. Kan , and G. Zhou . “A New Variance Bound on the Stochastic Discount Factor.” Journal of Business, 79 (2006), 941961.

S. Kandel , and R. F. Stambaugh . “On the Predictability of Stock Returns: An Asset-Allocation Perspective.” Journal of Finance, 51 (1996), 385424.

T. C Koopmans . “Stationary Utility and Impatience.” Econometrica, 28 (1960), 287309.

D. M. Kreps , and E. L. Porteus . “Temporal Resolution of Uncertainty and Dynamic Choice Theory.” Econometrica, 46 (1978), 185200.

J. Liu Portfolio Selection in Stochastic Environments.” Review of Financial Studies, 20 (2007), 139.

J. Liu , and J. Pan . “Dynamic Derivative Strategies.” Journal of Financial Economics, 69 (2003), 401430.

R. C Merton . “Optimum Consumption and Portfolio Rules in a Continuous-Time Model.” Journal of Economic Theory, 3 (1971), 373413.

C. R Plott . “Rational Choice in Experimental Markets.” Journal of Business, 59 (1986), S301S327.

M. Schroder , and C. Skiadas . “Optimal Consumption and Portfolio Selection with Stochastic Differential Utility.” Journal of Economic Theory, 89 (1999), 68126.

J. A Wachter . “Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets.” Journal of Financial and Quantitative Analysis, 37 (2002), 6391.

Y. Xia Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation.” Journal of Finance, 56 (2001), 205246.

Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *
×

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 36 *
Loading metrics...

Abstract views

Total abstract views: 124 *
Loading metrics...

* Views captured on Cambridge Core between September 2016 - 30th May 2017. This data will be updated every 24 hours.