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10692 Words Sep 14th, 2013 43 Pages
Journal of Banking & Finance 37 (2013) 3388–3400

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The cross-sectional relation between conditional heteroskedasticity, the implied volatility smile, and the variance risk premium
Louis H. Ederington a,⇑, Wei Guan b a b

Finance Division, Michael F. Price College of Business, University of Oklahoma, 205A Adams Hall, Norman, OK 73019, USA College of Business, University of South Florida St. Petersburg, 140 Seventh Avenue South, St. Petersburg, FL 33701, USA

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This paper estimates how the shape of the implied volatility smile and the size of the variance risk
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For instance, in most markets, the conditional variance tends to rise following large absolute return shocks and fall following periods of very small price movements. To the extent that fluctuations in the variance of returns are associated with return shocks, as GARCH model estimations indicate, investors should anticipate greater future variance fluctuations in markets in which the variance responds sharply to return shocks than in markets in which the impact of the same size shock on the conditional variance is slight. This is the idea explored in the present paper. In particular, we investigate how variations in the implied volatility smile and in the variance risk premium across different markets relate to differences in
⇑ Corresponding author. Tel.: +1 405 325 5591.
E-mail addresses: (L.H. Ederington), (W. Guan). 0378-4266/$ - see front matter Ó 2013 Elsevier B.V. All rights reserved.

how conditional volatility responds to surprise return shocks as measured by GARCH-type models. Consider, for instance, the most studied implied volatility smile – that on options on US equity indices, such as the S&P 500. It is well-known that Black–Scholes (BS) implied volatilities on US

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