Asset Pricing Implications of Volatility Term Structure Risk

I find that stocks with high sensitivities to changes in the V IX slope exhibit high returns on average. The price of V IX slope risk is approximately 2.5% annually, statistically significant and cannot be explained by other common factors, such as the market excess return, size, book-to-market, momentum, liquidity, market volatility, and the variance risk premium. I provide a theoretical model that supports my empirical results. The model extends current rare disaster models to include disasters of different lengths. My model implies that a downward sloping V IX term structure anticipates a potential long disaster and vice versa. The current level of market volatility is a standard indicator of market-wide risk. The market volatility term structure, which is calculated from prices of options with different expirations, reflects the market’s expectation of future volatility of different horizons. So the market volatility term structure incorporates information that is not captured by the market volatility itself. In particular, the slope of the volatility term structure captures the expected trend in volatility. I investigate in this paper whether the market volatility term structure slope is a priced source of risk. The time-varying market volatility term structure slope reflects changes in expectations of future market risk-return, thus, it should induce changes in the investment opportunity set and should be a state variable. The Intertemporal Capital Asset Pricing Model (ICAPM) of Merton (1973) then predicts that changes in the market volatility term structure must be a priced risk factor in the cross-section of risky asset returns. Stocks with different sensitivities to changes of the volatility term structure slope should have different expected returns. Therefore the first goal of this paper is to investigate if the market volatility term structure is priced in the cross-section of expected stock returns. I want to both determine whether the market volatility term structure is a priced risk factor and estimate the price of volatility term structure risk. Recent work by Ang, Hodrick, Xing and Zhang (2006) demonstrates that market volatility risk is priced in the cross-section of stock returns. While past studies have focused on pricing models of the volatility term structure (Britten-Jones and Neuberger (2006), Jiang and Tian (2005), Carr and Wu (2009), among others), the implications of the market volatility term structure on the cross-section of stock returns have yet to be studied. I use the V IX term structure to proxy for the market volatility term structure. The V IX is the market’s 30-day volatility implied from S&P500 index option prices. The V IX term structure is the market’s implied volatility at different time horizons. I use the V IX slope to represent the V IX term structure, and I introduce two measures for the V IX slope. I do not directly use the V IX slope as the proxy because it is highly correlated with the V IX itself and this could affect the robustness of the empirical test results. The first measure I use is the “slope” principal component of the V IX term structure, which I call PSlope. The second measure is the return of a V IX futures trading strategy that I propose. The strategy captures V IX futures roll yields by long and short V IX futures with different expirations, and I refer to this measure as V Strat. Both measures are worth