Decomposing the VIX: Implications for the predictability of stock returns

• DOI: 10.1111/fire.12245
• Publication Date: 2020-08-28T05:56:59Z
• Authors: K. Victor Chow; Wanjun Jiang; Bingxin Li; Jingrui Li
• Keywords: Variance risk premium; Predictability; Equity

Abstract The VIX index is not only a volatility but also polynomial combination of all possible higher moments in market return distribution under the risk‐neutral measure. This paper formulates as linear decomposition four fundamentally different elements: realized variance (RV), risk premium (VRP), tail (RT), and (TRP), respectively. Using an innovative nonparametric measure, we find that approximately one‐third VIX's formation attributed to TRP. In addition VRP, RT TRP are crucial components for predicting future returns on equity portfolios.