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Variance Risk Premium in Energy Markets: Ex-Ante and Ex-Post Perspectives

This paper introduces the ex-ante estimation of the variance risk premium. The novel methodology proposed is applied to forecast variance risk premium in energy markets, capturing the future degree of aversion of investors towards energy variance risks. We analyze the ex-ante variance risk premium of two energy indices, XLE and USO, during the period that spans from 2011 to 2022, and compare them to that of the SPX, the benchmark for the equity market. In the computation of the ex-ante variance risk premium, simple GARCH and Markov-switching GARCH models are exploited to forecast the realized variance, while variance swap rates are retrieved from the volatility indices VXXLE, OVX, and VIX of the three market indices. We find that the ex-ante variance risk premium succeeds to forecast the imminent periods of financial distress empirically detected in the abrupt surges and plunges of the ex-post variance risk premium. In particular, USO shows higher magnitudes of the variance risk premium than XLE and SPX, predicting that investors require on average higher premiums to bear oil variance risks.

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Keywords: Variance risk premium, Energy markets, Variance swaps, Markov-switching GARCH

DOI: 10.5547/01956574.43.SI1.gmor

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Published in Volume 43, Special Issue of the bi-monthly journal of the IAEE's Energy Economics Education Foundation.


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