Variance Risk Premium and Return Predictability: Evidence from the Chinese SSE 50 ETF Options

The variance risk premium (VRP) reflects the degree of risk aversion of investors and the overestimation of the probability of extreme losses. We examine a variety of variance risk premiums, including both the upside and downside variance risk premiums, in the Chinese stock market. We find that there is strong presence of variance risk premiums in the Chinese stock market. Evidence on the corresponding delta-hedging portfolios confirms that investors are willing to pay the premium to hedge against the variance risk. We further investigate the predictability of variance risk premiums on Chinese stock markets. Our results show that the predictability limit is up to six months. More surprisingly, the predictive power mainly comes from the upside variance risk premium rather than the downside variance risk premium. The realized variances also have predictive power in the Chinese market while the risk-neutral variances do not.