Macroeconomic Determinants of Stock Market Volatility and

Volatility Risk-Premiums
+
Valentina Corradi
University of Warwick
Walter Distaso
Imperial College Business School
Antonio Mele
London School of Economics
First draft: July 22, 2005. This version: October 26, 2009.
Abstract
How ooos slock maikol volalilily iolalo lo lho Lusinoss cyclo Wo oovolop, ano oslimalo, a
no-aiLiliago moool lo sluoy lho cyclical piopoilios of slock volalilily ano lho iisk-piomiums
lho maikol ioquiios lo Loai lho iisk of luclualions in lhis volalilily. 1ho lovol of slock maikol
volalilily cannol Lo oxplainoo Ly lho moio oxislonco of lho Lusinoss cyclo. Ialhoi, il iolalos
lo lho piosonco of somo unoLsoivoo facloi. Al lho samo limo, oui moool piooicls lhal such an
unoLsoivaLlo facloi cannol oxplain lho ups ano oowns slock volalilily oxpoiioncos ovoi limo
lho volalilily of volalilily." Insloao, lho volalilily of slock volalilily iolalos lo lho Lusinoss
cyclo. Finally, volalilily iisk-piomiums aio sliongly counloicyclical, ovon moio so lhan slock
volalilily, ano aio pailially iosponsiLlo foi lho laigo swings in lho VIX inoox occuiioo ouiing
lho 2007-2000 suLpiimo ciisis, which oui moool ooos capluio in oul-of-samplo oxpoiimonls.
JEL: C1, C82, L87, L44, G18, G17
Keywords: Aggiogalo slock maikol volalilily; volalilily iisk-piomiums; volalilily of volalilily;
Lusinoss cyclo; no-aiLiliago iosliiclions; simulalion-Lasoo infoionco
+
Wo fhunl Yucino Aif-Suhuliu, Alossunoio !oLoi, !oinuio Dunus, Muicolo Foinunoos, Chiisfiun Julliuio,
Muil Sulnon, Gooigo 1uuchon, \ilfoi 1oooiov, uno soninui puificipunfs uf LDHLC-Nico, Luiopoun Confiul
!unl, HLC Luusunno, IL !usinoss School (Muoiio), fho Univoisifios of Auihus (CHLA1LS), Goofho, Louvuin uno
Wuiwicl, fho 2006 Lonoon-Oxfoio Finunciul Lcononofiics Sfuoy Gioup, fho 2006 confoionco on Houlizoo \olufilify
(Monfioul), fho 200S CLMMAI confoionco uf UCL, fho 200S Inpoiiul Collogo Finunciul Lcononofiics Confoionco,
fho 200S Aoun Snifh Assof Iiicing Confoionco uf Lonoon !usinoss School, fho 200S LSL-FMG confoionco on
Infogiufing hisfoiicul oufu uno nuilof oxpocfufions in fnunciul ocononofiics," fho 200S Noifh Anoiicun Sunnoi
Moofing of fho Lcononofiic Sociofy (Cuinogio), uno fho 200S SI1L Sunnoi Woilshop uf Sfunfoio Univoisify
foi vuluuLlo connonfs. \ulonfinu Coiiuoi uno Wulfoi Disfuso giufofully uclnowloogo fnunciul suppoif fion fho
LSHC unooi fho giunf HLS-062-28-0811. Anfonio Molo fhunls fho !iifish LISHC foi fnunciul suppoif viu giunf
LIC220S1. 1ho usuul oiscluinoi upplios.
1
1 Introduction
Unooislanoing lho oiigins of slock maikol volalilily has long Loon a lopic of consiooiaLlo inloiosl
lo Lolh policy makois ano maikol piaclilionois. Iolicy makois aio inloiosloo in lho main ooloi-
minanls of volalilily ano in ils spillovoi olocls on ioal aclivily. Maikol piaclilionois aio mainly
inloiosloo in lho oiiocl olocls limo-vaiying volalilily oxoils on lho piicing ano hooging of plain
vanilla oplions ano moio oxolic ooiivalivos. In Lolh casos, foiocasling slock maikol volalilily
conslilulos a foimioaLlo challongo Lul also a funoamonlal insliumonl lo manago lho iisks facoo
Ly lhoso inslilulions.
Many availaLlo moools uso lalonl faclois lo oxplain lho oynamics of slock maikol volalilily.
Foi oxamplo, in lho coloLialoo Hoslon`s (1008) moool, slock volalilily is oxogonously oiivon Ly
somo unoLsoivaLlo facloi coiiolaloo wilh lho assol ioluins. Yol such an unoLsoivaLlo facloi ooos
nol Loai an oconomic inloipiolalion. Moioovoi, lho moool implios, Ly assumplion, lhal volalilily
cannol Lo foiocasl Ly maciooconomic faclois such as inousliial pioouclion oi inlalion. 1his
ciicumslanco is counloifaclual. Inoooo, lhoio is sliong ovioonco lhal slock maikol volalilily has
a voiy pionouncoo Lusinoss cyclo palloin, Loing highoi ouiing iocossions lhan ouiing oxpansions;
soo, o.g., Schwoil (1080a,L), Hamillon ano Lin (1006), oi Lianol ano Kang (2004).
In lhis papoi, wo oovolop a no-aiLiliago moool in which slock maikol volalilily is oxplicilly
iolaloo lo a numLoi of maciooconomic ano unoLsoivaLlo faclois. 1ho oislinclivo foaluio of lho
moool is lhal slock volalilily is linkoo lo lhoso faclois Ly no-aiLiliago iosliiclions. 1ho moool is
also analylically convonionl: unooi faiily slanoaio conoilions on lho oynamics of lho faclois ano
iisk-avoision coiioclions, oui moool is solvoo in closoo-foim, ano is amonaLlo lo ompiiical woik.
Wo uso lho moool lo quanlilalivoly assoss how aggiogalo slock maikol volalilily ano volalilily-
iolaloo iisk-piomiums chango in iosponso lo Lusinoss cyclo conoilions. Oui moool fully capluios
lho piocyclical naluio of aggiogalo ioluins ano lho counloicyclical Lohavioi of slock volalilily lhal
wo havo Loon sooing in lho oala foi a long limo. Wo show a funoamonlal iosull: slock volalilily
coulo nol Lo oxplainoo Ly maciooconomic faclois only. Oui moool, iigoiously oslimaloo lhiough
simulalion-Lasoo infoionco molhoos, shows lhal lho piosonco of somo unoLsoivaLlo ano poisislonl
facloi is nooooo lo suslain lho lovol of slock volalilily lhal malchos ils ompiiical counloipail. Al
lho samo limo, oui moool iovoals lhal lho piosonco of maciooconomic faclois is nooooo lo oxplain
lho vaiiaLilily of slock volalilily aiouno ils lovollho volalilily of aggiogalo slock volalilily. 1hal
such a vol-vol" mighl Lo iolaloo lo lho Lusinoss cyclo is inoooo a plausiLlo hypolhosis, allhough
cloaily, lho ups ano oowns slock volalilily oxpoiioncos ovoi lho Lusinoss cyclo aio a piooiclion
of lho moool in lino wilh lho oala, nol a iosliiclion imposoo whilo oslimaling lho moool. Such
a now piopoily wo uncovoi, ano moool, Liings now ano piaclical implicalions. Foi oxamplo,
Lusinoss cyclo foiocaslois mighl loain lhal nol only ooos slock maikol volalilily havo piooicling
powoi, as oiscussoo Lolow; vol-vol" is also a polonlial piooicloi of lho Lusinoss cyclo.
2
1ho socono sol of ompiiical iosulls iolalos lo lho oslimalion of volalilily-iolaloo iisk-piomiums.
In Lioao loims, lho volalilily iisk-piomium is oolnoo as lho oiloionco Lolwoon lho oxpoclalion
of fuluio slock maikol volalilily unooi lho iisk-noulial ano lho liuo pioLaLilily. Il quanlilos
how much a iopiosonlalivo agonl is willing lo pay lo onsuio lhal volalilily will nol iaiso Loyono
his own oxpoclalions. 1hus, il is a voiy inluilivo ano gonoial moasuio of iisk-avoision. Wo lno
lhal lhis volalilily iisk-piomium is sliongly counloicyclical, ovon moio so lhan slock volalilily.
Iiocisoly, volalilily iisk-piomiums aio lypically nol voiy volalilo, allhough in Lao limos, lhoy may
incioaso lo oxliomoly high lovols, ano quilo quickly. Wo unooilako a slioss losl of lho moool ovoi
a pailiculaily uncoilain poiioo, which incluoos lho 2007-2000 suLpiimo luimoil. Ouis is a slioss
losl, as (i) wo oslimalo lho moool using posl-wai oala up lo 2006, ano (ii) fooo lho pioviously
oslimaloo moool wilh maciooconomic oala iolaloo lo lho suLpiimo ciisis. Wo compaio lho
moool`s piooiclions foi lho ciisis wilh lho aclual Lohavioi of Lolh slock volalilily ano lho iisk-
aojusloo oxpoclalion of fuluio volalilily, which is lho now VIX inoox. 1ho moool succossfully
capluios lho oiamalic movomonls in lho VIX inoox, ano piooicls lhal counloicyclical volalilily
iisk-piomiums aio laigoly iosponsiLlo foi lho laigo swings in lho VIX occuiioo ouiing lho ciisis.
In facl, wo show lhal ovoi lhis ciisis, as woll as in piovious iocossions, movomonls in lho VIX
inoox aio ooloiminoo Ly changos in such counloicyclical iisk-piomiums, nol Ly changos in lho
oxpocloo fuluio volalilily.
Related literature
Stock volatility and volatility risk-premiums 1ho cyclical piopoilios of aggiogalo slock
maikol volalilily havo Loon lho focus of ioconl ompiiical iosoaich, allhough oaily woik iolaling
slock volalilily lo maciooconomic vaiiaLlos oalos Lack lo King, Sonlana ano Waohwani (1004),
who ioly on a no-aiLiliago moool. In a compiohonsivo inloinalional sluoy, Lnglo ano Iangol
(2008) lno lhal high fioquoncy aggiogalo slock volalilily has Lolh a shoil-iun ano long-iun
compononl, ano suggosl lhal lho long-iun compononl is iolaloo lo lho Lusinoss cyclo. Aoiian
ano IosonLoig (2008) show lhal lho shoil- ano long- iun compononls of aggiogalo volalilily aio
Lolh piicoo, cioss-soclionally. 1hoy also iolalo lho long-iun compononl of aggiogalo volalilily
lo lho Lusinoss cyclo. Finally, CampLoll, Lollau, Malkiol ano Xu (2001), Lloom (2000), Lloom,
Floolollo ano Jaimovich (2000) ano Foinaii ano Molo (2000) show lhal capilal maikols uncoi-
lainly holps oxplain fuluio luclualions in ioal oconomic aclivily. Oui focus on lho volalilily
iisk-piomiums iolalos, insloao, lo lho sominal woik of Dumas (100), Lakshi ano Maoan (2000),
Liillon-Jonos ano NouLoigoi (2000), ano Caii ano Maoan (2001), which has moio ioconlly slim-
ulaloo an incioasing inloiosl in lho oynamics ano ooloiminanls of lho volalilily iisk-piomium
(soo, foi oxamplo, Lakshi ano Maoan (2006) ano Caii ano Wu (2000)). NolaLly, in sominal
woik, Lolloislov, GiLson ano Zhou (2004) ano Lolloislov ano Zhou (2006) unvoil, ompiiically, a
sliong iolalion Lolwoon lhis volalilily iisk-piomium ano a numLoi of maciooconomic faclois.
8
Oui conliiLulion hingos upon, ano oxpanos, ovoi lhis giowing liloialuio, in lhal wo foimulalo
ano oslimalo a fully-spociloo no-aiLiliago moool iolaling lho oynamics of slock volalilily ano
volalilily iisk-piomiums lo Lusinoss cyclo, ano aooilional unoLsoivaLlo, faclois. Wilh lho oxcop-
lion of King, Sonlana ano Waohwani (1004) ano Aoiian ano IosonLoig (2008), who slill havo a
focus oiloionl fiom ouis, lho piooicling iolalions in lho piovious papois, whilo coilainly usoful,
aio slill pail of iooucoo-foim slalislical moools. In oui oul-of-samplo oxpoiimonls of lho suLpiimo
ciisis, wo shall show lhal oui no-aiLiliago fiamowoik is consiooiaLly iichoi lhan lhal Lasoo on
piooiclivo linoai iogiossions. Wo show, foi oxamplo, lhal compaioo lo oui moool`s piooiclions
aLoul slock volalilily ano lho VIX inoox, piooiclions fiom linoai iogiossions aio suLslanlially
lal ovoi lho suLpiimo ciisis.
1ho only anlocooonl lo oui papoi is Lolloislov, 1auchon ano Zhou (2008), who oovolop a
consumplion-Lasoo ialionalo foi lho oxislonco of lho volalilily iisk-piomium, allhough lhon, lho
aulhois uso lhis ialionalo only as a guioanco lo lho oslimalion of iooucoo-foim piooiclaLilily
iogiossions conoilionoo on lho volalilily iisk-piomium. In ioconl inooponoonl woik oiscussoo
Lolow, Diochsloi ano Yaion (2008) invosligalo lho piopoilios of lho volalilily iisk-piomium, im-
plioo Ly a caliLialoo consumplion-Lasoo moool wilh long-iun iisks. 1ho aulhois, howovoi, aio
nol concoinoo wilh lho cioss-oqualion iosliiclions iolaling lho volalilily iisk-piomium lo slalo
vaiiaLlos oiiving low fioquoncy slock maikol luclualions which, insloao, conslilulo lho conlial
lopic of oui papoi.
No-arbitrage regressions In ioconl yoais, lhoio has Loon a signilcanl suigo of inloiosl in
consumplion-Lasoo oxplanalions of aggiogalo slock maikol volalilily (soo, foi oxamplo, CampLoll
ano Cochiano (1000), Lansal ano Yaion (2004), 1auchon (200), Molo (2007), oi lho lwo suivoys
in CampLoll (2008) ano Mohia ano Iioscoll (2008)). 1hoso oxplanalions aio impoilanl Locauso
lhoy highlighl lho main oconomic mochanisms lhiough which maikols ano piofoioncos alocl
oquiliLiium assol piicos ano, honco, slock volalilily. In oui fiamowoik, cioss-oqualions iosliiclions
aiiso lhiough lho woakoi ioquiiomonl of aLsonco of aiLiliago oppoilunilios. In lhis iospocl, oui
appioach is similai in spiiil lo lho no-aiLiliago" vocloi auloiogiossions inliooucoo in lho loim-
sliucluio liloialuio Ly Ang ano Iiazzosi (2008) ano Ang, Iiazzosi ano Woi (2006). Similaily as in
lhoso papois, wo spocify an analylically convonionl piicing koinol alocloo Ly somo maciooconomic
faclois, allhough wo oo nol oiioclly iolalo lhoso lo, say, maikols, piofoioncos oi lochnology.
Oui moool, lhon, woiks quilo simply. Wo oxogonously spocify lho joinl oynamics of a numLoi
of maciooconomic ano unoLsoivaLlo faclois. Wo assumo lhal lho assol payols ano lho iisk-
piomiums ioquiioo Ly agonls lo Lo componsaloo foi lho luclualions of lho faclois, aio ossonlially
amno funclions of lho voiy samo faclois, along lho linos of Duloo (2002). Wo show lhal lho
iosulling no-aiLiliago slock piico is amno in lho faclois.
1
Oui moool ooos nol allow foi jumps
1
Oui noool oilois fion fhoso in !oluoif uno Gionuoioi (2001), Ang uno Liu (2004) oi Munuysly (2002). Foi
4
oi olhoi maikol micio-sliucluio olocls, as oui main focus is lo moool low fioquoncy movomonls
in lho aggiogalo slock volalilily ano volalilily iisk-piomiums, lhiough lho uso of maciooconomic
ano unoLsoivaLlo faclois. Oui oslimalion iosulls, oLlainoo lhiough oala samploo al monlhly
fioquoncy, aio unlikoly lo Lo alocloo Ly moasuiomonl noiso oi jumps, say. In iolaloo woik,
Diochsloi ano Yaion (2008), Caii ano Wu (2000), 1oooiov (2000), ano 1oooiov ano 1auchon
(2000) oo allow foi lho piosonco of jumps, allhough lhoy oo nol analyzo lho iolalions Lolwoon
maciooconomic vaiiaLlos ano aggiogalo volalilily oi volalilily iisk-piomiums, which wo oo hoio.
Estimation strategy, and plan of the paper
In slanoaio slochaslic volalilily moools such as lhal in Hoslon (1008), volalilily is oiivon Ly fac-
lois, which aio nol nocossaiily lho samo as lhoso alocling lho slock piicovolalilily is oxogonous
in lhoso moools. In oui no-aiLiliago moool, volalilily is onoogonous, ano can Lo unooislooo as
lho oulcomo of lwo foicos, which wo nooo lo loll apail fiom oala: (i) lho maikol pailicipanls`
iisk-avoision, ano (ii) lho oynamics of lho funoamonlals. Wo aooioss lhis ioonlilcalion issuo Ly
oxploiling ooiivalivos oala, iolaloo lo vaiianco swaps. 1ho vaiianco swap ialo is, lhooiolically, lho
iisk-aojusloo oxpoclalion of lho fuluio inlogialoo volalilily wilhin ono monlh, ano is calculaloo
oaily sinco 2008, ano io-calculaloo Lack lo 1000, Ly lho CLOL, as lho now VIX inoox.
Wo implomonl a lhioo-slop oslimalion piocoouio lhal iolios on simulalion-Lasoo infoionco
molhoos. In lho lisl slop, wo oslimalo lho paiamolois unooilying lho maciooconomic faclois.
In lho socono slop, wo uso oala on a Lioao slock maikol inoox ano lho maciooconomic faclois,
ano oslimalo iooucoo-foim paiamolois linking lho slock maikol inoox lo lho maciooconomic
faclois ano lho lhiio unoLsoivaLlo facloi, as woll as lho paiamolois unooilying lho oynamics of
lho unoLsoivaLlo facloi. Wo implomonl lhis slop Ly malching momonls iolaloo lo ox-posl slock
maikol ioluins, ioalizoo slock maikol volalilily ano lho maciooconomic faclois. In lho lhiio
slop, wo uso oala on lho now VIX inoox, ano lho maciooconomic faclois, lo oslimalo lho iisk-
piomiums paiamolois, Ly malching lho impulso iosponso funclion of lho moool-Lasoo VIX inoox
lo ils ompiiical counloipail. 1ho limiling oisliiLulion of oui oslimalois is alocloo Ly paiamoloi
oslimalion oiioi, aiising Locauso lho oslimalois as of lho lasl slop oopono on paiamoloi oslimalos
compuloo in piovious slops. Whilo wo oo chaiacloiizo slanoaio oiiois, lhooiolically, lho aclual
compulalion of lhoso oiiois is pioLlomalic, in piaclico. Wo oovolop, ano ulilizo, a lhooiy lo
consislonlly oslimalo lho slanoaio oiiois lhiough Llock-Loolsliap molhoos.
1ho iomainooi of lho papoi is oiganizoo as follows. In Soclion 2 wo oovolop a no-aiLiliago
moool foi lho slock piico, slock volalilily ano volalilily-iolaloo iisk-piomiums. Soclion 8 illus-
oxunplo, wo consiooi u confinuous-fino fiunowoil, which uvoios fhooioficul chullongos poinfoo ouf Ly !oluoif uno
Gionuoioi (2001). Fuifhoinoio, Ang uno Liu (2004) consiooi u oisciofo-fino soffing in which oxpocfoo iofuins
uio oxogonous, whilo in oui noool, oxpocfoo iofuins uio onoogonous. Finully, oui noool woils oiloionfly fion
Munuysly`s Locuuso if onoogonously oofoininos fho piico-oivioono iufio.

lialos lho oslimalion slialogy. Soclion 4 piosonls oui ompiiical iosulls. Soclion concluoos, ano
lho Apponoix piovioos lochnical oolails omilloo fiom lho main loxl.
2 The model
2.1 The macroeconomic environment
Wo assumo lhal a numLoi of faclois alocl lho oovolopmonl of aggiogalo maciooconomic vaiiaLlos.
1hoso faclois foim a vocloi-valuoo piocoss (t), solulion lo a :-oimonsional amno oilusion,
o (t) = :( (t)) ot X ( (t)) oM (t) , (1)
whoio M (t) is a d-oimonsional Liownian molion (: _ d), is a full iank : d maliix, ano X
is a full iank d d oiagonal maliix wilh olomonls,
\ ()
(ii)
=
_
c
i
d
>
i
, i = 1, , d,
foi somo scalais c
i
ano voclois d
i
. Apponoix A ioviows sumcionl conoilions lhal aio known lo
onsuio lhal Lq. (1) has a sliong solulion wilh X ( (t))
(ii)
0 almosl suioly foi all t.
Whilo wo oo nol nocossaiily oLsoivo ovoiy singlo compononl of (t), wo oo oLsoivo ois-
ciololy samploo palhs of maciooconomic vaiiaLlos such as inousliial pioouclion, unomploymonl
oi inlalion. Lol M
)
(t)
t=1,2,
Lo lho oisciololy samploo palh of lho maciooconomic vaiiaLlo
M
)
(t) whoio, foi oxamplo, M
)
(t) can Lo lho inousliial pioouclion inoox availaLlo al limo t, ano
, = 1, ,
M
, whoio
M
is lho numLoi of oLsoivoo maciooconomic faclois.
Wo assumo, wilhoul loss of gonoialily, lhal lhoso oLsoivoo maciooconomic faclois aio sliiclly
posilivo, ano lhal lhoy aio iolaloo lo lho slalo vocloi piocoss in Lq. (1) Ly:
ln(M
)
(t) M
)
(t 12)) = )
)
( (t)) , , = 1, ,
M
, (2)
whoio lho colloclion of funclions )
)
ooloiminos how lho faclois oynamics impingo upon lho
oLsoivoo maciooconomic vaiiaLlos. Wo now luin lo moool assol piicos.
2.2 Risk-premiums and stock market volatility
Wo assumo lhal assol piicos aio iolaloo lo lho vocloi of faclois (t) in Lq. (1), ano lhal somo of
lhoso faclois alocl oovolopmonls in maciooconomic conoilions, lhiough Lq. (2). Wo assumo lhal
assol piicos iospono lo movomonls in lho faclois alocling maciooconomic conoilions.
2
Foimally,
2
Foi unulyficul convonionco, wo iulo ouf fhuf ussof piicos cun fooo Lucl fho ioul oconony, ulfhough wo uc-
lnowloogo fhuf fho piosonco of fiicfions cun nulo cupiful nuilofs uno fho nuciooconony infinufoly iolufoo, us
in fho fnunciul uccoloiufoi hypofhosis ioviowoo Ly !oinunlo, Goifloi uno Gilchiisf (1000), oi in fho sfufic noool
unulyzoo Ly Angolofos, Loionzoni uno Iuvun (200S), whoio foooLucls uiiso ouo fo usynnofiic infoinufion uno
louining Lofwoon ugonfs ucfing wifhin fho ioul uno fho fnunciul sphoio of fho oconony.
6
wo assumo lhal lhoio oxisls a ialional piicing funclion : ( (t)) such lhal lho ioal slock piico al
limo t, : (t) say, is : (t) = : ( (t)). Wo lol lhis piico funclion Lo lwico conlinuously oiloionliaLlo
in . Ly Ilo`s lomma, : (t) salislos,
o: (t)
: (t)
= :( (t) , : (t)) ot
:
j
( (t))
>
X ( (t))
: ( (t))
oM (t) , (8)
whoio :
j
() = [
0
0j
1
: () , ,
0
0j
n
: ()[
>
ano : is a funclion wo shall ooloimino Lolow Ly no-
aiLiliago conoilions. Ly Lq. (8), lho inslanlanoous vaiianco of slock ioluins is
o
2
(t) =
_
_
_
_
_
:
j
( (t))
>
X ( (t))
: ( (t))
_
_
_
_
_
2
. (4)
Noxl, wo moool lho piicing koinol, oi lho Aiiow-DoLiou piico oonsily, in lho oconomy. Lol
F(T) Lo lho sigma-algoLia gonoialoo Ly lho Liownian molion M (t), t _ T, ano 1 Lo lho
physical pioLaLilily unooi which M (t) is oolnoo. 1ho Iaoon-Nikooym ooiivalivo of lho iisk-
noulial pioLaLilily Q wilh iospocl lo 1 on F(T) is,
(T) =
oQ
o1
= oxp
_

_
T
0
(t)
>
oM (t)
1
2
_
T
0
|(t)|
2
ot
_
, ()
foi somo aoaploo iisk-piomium piocoss (t). Wo assumo lhal oach compononl of lho iisk-
piomium process A
i
(t) salislos,
A
i
(t) = A
i
( (t)) , i = 1, , d,
foi somo function A
i
. Wo also assumo lhal lho safo assol is olaslically supplioo such lhal lho
shoil-loim ialo r (say) is conslanl.
3
Unooi lho oquivalonl mailingalo moasuio, lho slock piico is solulion lo,
o: ( (t))
: ( (t))
=
_
r
c ( (t))
: ( (t))
_
ot
:
j
( (t))
>
X ( (t))
: ( (t))
o
^
M (t) , (6)
whoio c () is lho inslanlanoous oivioono ialo, ano
^
M is a Liownian molion oolnoo unooi lho
iisk-noulial pioLaLilily Q.
2.3 No-arbitrage restrictions
1hoio is oLviously no fioooom in moooling iisk-piomiums ano slochaslic volalilily sopaialoly.
Givon a oivioono piocoss, volalilily is uniquoly ooloiminoo, onco wo spocify lho iisk-piomiums.
3
1his ussunpfion cun Lo ioplucoo wifh u wouloi conoifion fhuf fho shoif-foin iufo is un umno funcfion of fho
unooilying sfufo vocfoi. In fhis cuso, Iioposifion 1 Lolow woulo nof holo, which nighf consiooiuLly hinooi fho
ucfuul osfinufion of fho noool.
7
Consiooi, lhon, lho following ossonlially amno" spocilcalion foi lho oynamics of lho faclois in
Lq. (1), ano lho iisk-piomiums. Lol X

() Lo a d d oiagonal maliix wilh olomonls

\

()
(ii)
=
_
1
\ (y)
(..)
if Ii\ ( (t))
(ii)
0 all t = 1
0 olhoiwiso
ano sol,
() = X () X
1
X

() X
2
, (7)
foi somo d-oimonsional vocloi X
1
ano somo d: maliix X
2
. 1ho funclional foim foi is lho samo
as lhal suggosloo Ly Duloo (2002) in lho loim-sliucluio liloialuio. If lho maliix X
2
= 0
oa
,
lhon, collapsos lo lho slanoaio complololy amno" spocilcalion inliooucoo Ly Dumo ano Kan
(1006), in which lho iisk-piomiums aio lioo up lo lho volalilily of lho funoamonlals, X ().
Whilo il is ioasonaLlo lo assumo lhal iisk-piomiums aio iolaloo lo lho volatility of funoamonlals,
lho spocilcalion in Lq. (7) is moio gonoial, as il allows iisk-piomiums lo Lo iolaloo lo lho level
of lho funoamonlals, lhiough lho aooilional loim X
2
.
Finally, wo ooloimino lho no-aiLiliago slock piico. Unooi iogulaiily conoilions (soo Apponoix
A), ano in lho aLsonco of LuLLlos, Lq. (6) implios lhal lho slock piico is,
: () = E
__
1
0
c
vt
c ( (t)) ot

(0) =
_
, (8)
whoio E is lho oxpoclalion lakon unooi lho iisk-noulial pioLaLilily Q. Wo aio only lofl wilh
spocifying how lho inslanlanoous oivioono piocoss iolalos lo lho slalo vocloi . As il luins oul,
lho piovious assumplion on lho piicing koinol ano lho assumplion lhal c () is amno in implios
lhal lho slock piico is also amno in . Iiocisoly, lol
c () = c
0

>
, (0)
foi somo scalai c
0
ano somo vocloi .
4
Wo havo:
Proposition 1: Let the risk-premiums and the instantaneous dividend rate be as in Eqs. (7)
and (9). Then, under a technical regularity condition in Appendix A (condition (A2)), we have
that: (i) Eq. (8) holds; and (ii) the rational stock price function : () is linear in the state vector
, viz
: () =
c
0

>
(Lr1
aa
)
1
c
r

>
(Lr1
aa
)
1
, (10)
4
Lg. (0) nulos fho oivioono sfufionuiy us soon us g (t) is sfufionuiy. Alfoinufivoly, wo nighf ussuno fhuf fho
oivioono us of fino t is c
I
c (g (t)), foi sono consfunf j, whoio c () is us in Lg. (0). In fhis cuso, fho piico funcfion
is givon Ly c
I
c (g), whoio c () is fho piico funcfion in Iioposifion 1, wifh v ioplucoo Ly v j. Such u noio gonoiul
foinulufion wifh u oofoininisfic trend foi fho ioul sfocl piico, woulo nof ulfoi oui iosulfs in fho onpiiicul socfion,
us oui osfinufois oo nof ioly on fho ussunpfion of uLsonco of such u fiono.
8
where
c = :
_
c
1
`
1(1)
c
o
`
1(o)
_
>
(11)
L = :
_
_
`
1(1)
d
>
1
`
1(o)
d
>
o
_
>
1

X
2
_
, (12)
1

is a d d diagonal matrix with elements 1

(ii)
= 1 if Ii\ ( (t))
(ii)
0 all t = 1 and 0
otherwise; and, nally `
1())

o
)=1
are the components of X
1
.
Iioposilion 1 allows us lo singlo oul lho no-aiLiliago iosliiclions Lolwoon slochaslic volalilily
ano iisk-piomiums. Ly Lq. (4), ano lho oxpiossion foi lho slock piico in Lq. (10), wo havo:
o ( (t)) = o (t) =
_
_
_
_
>
(Lr1
aa
)
1
X ( (t))
_
_
_
2
c
0
+

(D+vI
nn
)
1
c
v

>
(Lr1
aa
)
1
(t)
. (18)
1his oxpiossion foi lho slock volalilily claiilos why oui appioach is oislincl fiom lhal in lho
slanoaio slochaslic volalilily liloialuio. In lhis liloialuio, lho assol piico ano, honco, ils volalilily,
is lakon as givon, ano volalilily ano volalilily iisk-piomiums aio moooloo inooponoonlly of oach
olhoi. Foi oxamplo, in lho coloLialoo Hoslon`s (1008) moool, lho slock piico is solulion lo,
_

_
o: (t)
: (t)
= :
1
(t) ot (t) o\
1
(t)
o
2
(t) = i

_
j

2
(t)
_
ot o

(t)
_
jo\
1
(t)
_
1 j
2
o\
2
(t)
_ (14)
foi somo aoaploo piocoss :
1
(t) ano somo conslanls i

, j

, o

, j. In lhis moool, lho volalilily

iisk-piomium is spociloo sopaialoly fiom lho volalilily piocoss. Many ompiiical sluoios havo
followoo lho loao of lhis moool (o.g., Choinov ano Ghysols (2000), Coiiaoi ano Dislaso (2006),
Gaicia, Lowis, Iasloiollo ano Ionaull (2007)). Moioovoi, a ioconl focus in lhis ompiiical liloia-
luio is lo oxamino how lho iisk-componsalion foi slochaslic volalilily is iolaloo lo lho Lusinoss
cyclo (o.g., Lolloislov, GiLson ano Zhou (2004)). Whilo lho ompiiical iosulls in lhoso papois
aio giouno Lioaking, lho Hoslon`s moool ooos nol piooicl lhal lhoio is any iolalion Lolwoon
slochaslic volalilily, volalilily iisk-piomiums ano lho Lusinoss cyclo.
Oui moool woiks oiloionlly, as il placos iosliiclions on lho assol piico piocoss oiioclly, lhiough
oui assumplions aLoul lho funoamonlals of lho oconomy, i.o. lho oivioono piocoss in Lq. (0)
ano lho iisk-piomiums in Lq. (7). In oui moool, il is lho assol piico piocoss lhal ooloiminos,
onoogonously, lho volalilily oynamics. Foi lhis ioason, lho moool piooicls lhal slock volalilily
omLoos infoimalion aLoul iisk-coiioclions lhal agonls ioquiio lo invosl in lho slock maikol, as
Lq. (18) makos cloai. Wo shall mako uso of lhis oLsoivalion in lho ompiiical pail of lho papoi.
Wo now luin lo oosciiLo which moasuio of slock volalilily wo uso lo piocooo wilh such a ciilical
slop of oui analysis.
0
2.4 Arrow-Debreu adjusted volatility
In SoplomLoi 2008, lho Chicago Loaio Oplion Lxchango (CLOL) changoo ils volalilily inoox
VIX lo appioximalo lho vaiianco swap ialo of lho S\I 00 Compounooo inoox. 1ho now inoox
iolocls ioconl aovancos in lho oplion piicing liloialuio. Givon an assol piico piocoss : (t) lhal is
conlinuous in limo (as foi lho assol piico of oui moool in Lq. (10)), ano all availaLlo infoimalion
F(t) al limo t, consiooi lho oconomic valuo of lho fuluio inlogialoo vaiianco on a givon inloival
[t, T[, which is, appioximaloly, lho sum of lho fuluio vaiianco woighloo wilh lho Aiiow-DoLiou
slalo piicos:
1\
t,T
=
_
T
t
E
__
o
ot
vai [ ln: (t)[ F(n)[

t=&
_

F(t)
_
on. (1)
1ho now VIX inoox iolios on lho woik of Dumas (100), Lakshi ano Maoan (2000), Liillon-Jonos
ano NouLoigoi (2000), ano Caii ano Maoan (2001), who showoo lhal lho iisk-noulial oxpoclalion
of lho fuluio inlogialoo vaiianco is a funclional of pul ano call oplions wiillon on lho assol:
E[ 1\
t,T
[ F(t)[ = 2c
v(Tt)
_
_
1(t)
0
1 (t, T, 1)
1
2
o1
_
1
1(t)
C (t, T, 1)
1
2
o1
_
, (16)
whoio 1 (t) = c
v(Tt)
: (t) is lho foiwaio piico, ano C (t, T, 1) ano 1 (t, T, 1) aio lho piicos as of
limo t of a call ano a pul oplion oxpiiing al T ano sliuck al 1. A vaiianco swap is a conliacl
wilh payol piopoilional lo lho oiloionco Lolwoon lho ioalizoo inlogialoo vaiianco, (1), ano
somo sliiko piico, lho vaiianco swap ialo. In lho aLsonco of aiLiliago oppoilunilios, lho vaiianco
swap ialo is givon Ly Lq. (16).
In conliasl, oui moool, which iolios on lho Aiiow-DoLiou slalo piicos in Lq. (), piooicls
lhal lho iisk-noulial oxpoclalion of lho inlogialoo vaiianco is:
E[ 1\
t,T
[ (t) = [ =
_
T
t
E
_
o
2
(n)

(t) =

on, (17)
whoio o
2
(t) is givon in Lq. (18). An impoilanl lask of lhis papoi is lo oslimalo lho moool so
lhal il piooicls a lhooiolical palloin of lho VIX inoox lhal malchos ils ompiiical counloipail,
compuloo Ly lho CLOL lhiough Lq. (16). Finally, nolo lhal oui moool makos piooiclions
aLoul fuluio oxpocloo volalilily unooi Lolh lho iisk-noulial ano lho physical pioLaLilily, 1. Lol,
lhon, 1 oonolo lho oxpoclalion lakon unooi 1. Oui moool allows lo liaco how lho volalilily
iisk-piomium, oolnoo as,
VII( (t)) =
_
1
T t
_
_
E[ 1\
t,T
[ (t) = [
_
1 [ 1\
t,T
[ (t) = [
_
,
changos wilh changos in lho faclois (t) in Lq. (1).
10
2.5 The leading model
Wo foimulalo a fow spocilc assumplions lo mako lho moool amonaLlo lo ompiiical woik. Fiisl,
wo assumo lhal lwo maciooconomic aggiogalos, inlalion ano inousliial pioouclion giowlh, aio
lho only oLsoivaLlo faclois (say j
1
ano j
2
) alocling slock maikol oovolopmonls. Wo oolno lhoso
faclois as follows, ln(M
)
(t) M
)
(t 12)) = lnj
)
(t), , = 1, 2, whoio M
1
(t) is lho consumoi
piico inoox as of monlh t ano M
2
(t) is lho inousliial pioouclion as of monlh t. Honco, in
loims of Lq. (2), lho funclions )
)
() = lnj
)
. In Soclion 4.1, wo oiscuss fuilhoi lho iolo lhoso lwo
maciooconomic faclois havo playoo in assol piicing. Socono, wo assumo lhal a lhiio unoLsoivaLlo
facloi j
3
alocls lho slock piico, Lul nol lho lwo maciooconomic aggiogalos M
1
ano M
2
. 1hiio, wo
consiooi a moool in which lho lwo maciooconomic faclois j
1
ano j
2
oo nol alocl lho unoLsoivaLlo
facloi j
3
, allhough wo allow foi simullanoous foooLack olocls Lolwoon inlalion ano inousliial
pioouclion giowlh. 1hoiofoio, wo sol, in Lq. (1),
: =
_

_
i
1
i
1
0
i
2
i
2
0
0 0 i
3
_

_
,
whoio i
1
ano i
2
aio lho spooo of aojuslmonl of inlalion ano inousliial pioouclion giowlh lowaios
lhoii long iun moans, j
1
ano j
2
, ano i
1
ano i
2
aio lho foooLack paiamolois. Moioovoi, wo lako
= 1
33
ano lho voclois d
i
so as lo mako j
)
solulion lo,
oj
)
(t) =
_
i
)
_
j
)
j
)
(t)
_
i
)
_
j
)
j
)
(t)
_
ot
_
c
)
,
)
j
)
(t)o\
)
(t) , , = 1, 2, 8, (18)
whoio, foi Liovily, wo havo sol j
1
= j
2
, j
1
(t) = j
2
(t), j
2
= j
1
, j
2
(t) = j
1
(t), i
3
= j
3
= j
3
(t) =
0 ano, lnally, ,
)
= ,
))
. Wo assumo lhal, foi oach i, Ii\ ( (t))
(ii)
0 all t = 1, which il ooos
unooi lho conoilions ioviowoo in Apponoix A.
Wo assumo lhal lho iisk-piomium piocoss salislos lho ossonlially amno" spocilcalion in
Lq. (7), whoio wo lako lho maliix X
2
lo Lo oiagonal wilh oiagonal olomonls oqual lo `
2())
= `
2()))
,
, = 1, 2, 8. 1ho implicalion is lhal lho total iisk-piomiums piocoss oolnoo as,
r() = X () () =
_
_
_
c
1
`
1(1)

_
,
1
`
1(1)
`
2(1)
_
j
1
c
2
`
1(2)

_
,
2
`
1(2)
`
2(2)
_
j
2
c
3
`
1(3)

_
,
3
`
1(3)
`
2(3)
_
j
3
_
_
_
(10)
ooponos on lho facloi j
)
nol only lhiough lho channol of lho volalilily of lhoso faclois (i.o.
lhiough lho paiamolois ,
))
), Lul also lhiough lho aooilional iisk-piomiums paiamolois `
2())
.
Finally, lho inslanlanoous oivioono piocoss c (t) in Lq. (0) salislos,
c () = c
0
c
1
j
1
c
2
j
2
c
3
j
3
. (20)
11
Unooi lhoso conoilions, lho assol piico in Iioposilion 1 is givon Ly,
: () = :
0

3

)=1
:
)
j
)
, (21)
whoio
:
0
=
1
r
_
_
c
0

3

)=1
:
)
_
i
)
j
)
i
)
j
)
c
)
`
1())
_
_
_
, (22)
:
)
=
c
)
_
r i
i
`
1(i)
,
i
`
2(i)
_
c
i
i
i

2
I=1
_
r i
I
`
1(I)
,
I
`
2(I)
_
i
1
i
2
, foi ,, i 1, 2 ano i ,= ,, (28)
:
3
=
c
3
r i
3
`
1(3)
,
3
`
2(3)
, (24)
ano whoio i
)
ano j
)
aio as in Lq. (18).
Nolo, lhon, an impoilanl foaluio of lho moool. 1ho paiamolois `
(1)i
ano `
(2)i
ano c
i
cannol Lo
ioonliloo fiom oala on lho assol piico ano lho maciooconomic faclois. Inluilivoly, lho paiamolois
`
(1)i
ano `
(2)i
ooloimino how sonsilivo lho lolal iisk-piomium in Lq. (10) is lo changos in lho slalo
piocoss . Insloao, lho paiamolois c
i
ooloimino how sonsilivo lho oivioono piocoss in Lq. (20) is
lo changos in . 1wo piico piocossos mighl Lo maoo oLsoivalionally oquivalonl lhiough juoicious
choicos of lho iisk-componsalion ioquiioo lo Loai lho assol oi lho payol piocoss piomisoo Ly
lhis assol (lho oivioono). 1ho noxl soclion oxplains how lo oxploil lho Aiiow-DoLiou aojusloo
volalilily inliooucoo in Soclion 2.4 lo ioonlify lhoso paiamolois.
3 Statistical inference
Wo ioly on a lhioo-slop piocoouio. In lho lisl slop, wo oslimalo lho paiamolois of lho piocoss
unooilying lho oynamics of lho lwo maciooconomic faclois,
>
=
_
i
)
, j
)
, c
)
, ,
)
, i
)
, , = 1, 2
_
.
In lho socono slop, wo oslimalo lho iooucoo-foim paiamolois lhal link lho oquiliLiium slock
piico lo lho lhioo faclois in Lq. (21), ano lho paiamolois of lho piocoss foi lho unoLsoivoo
facloi, 0
>
= (i
3
, j
3
, c
3
, ,
3
, :
0
, :
)
, , = 1, 2, 8), whilo imposing lho ioonlilaLilily conoilion lhal
j
3
= 1, as oxplainoo Lolow. In lho lhiio slop, wo oslimalo lho iisk-piomiums paiamolois X
>
=
_
`
1(1)
, `
2(1)
, `
1(2)
, `
2(2)
, `
1(3)
, `
2(3)
_
, iolying on a simulalion-Lasoo appioximalion of lho moool-
implioo VIX, which wo malch lo lho limo soiios Lohavioi of lho VIX inoox. Al oach of lhoso
slops, wo oo nol havo a closoo foim oxpiossion of oilhoi lho likolihooo funclion oi solocloo sols
of momonl conoilions. Foi lhis ioason, wo nooo lo ioly on a simulalion-Lasoo appioach. Oui
oslimalion slialogy, lhon, iolios on an hyLiio of Inoiiocl Infoionco (Gouiioioux, Monfoil ano
Ionaull, 1008) ano lho Simulaloo Gonoializoo Molhoo of Momonls (Dumo ano Singlolon, 1008).
5
5
1ho osfinufois wo oovolop uio nof us omcionf us Muxinun Lilolihooo. Unooi sono conoifions, fho nofhoos
puf foiwuio Ly Gullunf uno 1uuchon (1006), Foinuniun uno Sulunio (2004), Cuiiusco, Choinov, Floions uno Ghysols
12
3.1 Moment conditions for the macroeconomic factors
1o simulalo lho facloi oynamics in Lq. (18), wo ioly on a Milsloin appioximalion schomo, wilh
oisciolo inloival ^, say. Wo simulalo H palhs of longlh T of lho lwo oLsoivaLlo faclois, ano
samplo lhom al lho samo fioquoncy as lho availaLlo oala, oLlaining j

1,t,,I
ano j

2,t,,I
, whoio
j

),t,,I
is lho valuo al limo t lakon Ly lho ,-lh facloi, al lho /-lh simulalion poifoimoo wilh lho
paiamoloi vocloi . 1hon, wo oslimalo lho following auloiogiossivo moools on Lolh hisloiical
ano simulaloo oala, foi i = 1, 2,
j
i,t
= a
j
i


)2f12,24g
/
j
i,1,)
j
1,t)


)2f12,24g
/
j
i,2,)
j
2,t)
c
j
i,t
, (2)
ano
j

i,t,,I
= a
j
i,I


)2f12,24g
/
j
i,1,),I
j

1,t),,I


)2f12,24g
/
j
i,2,),I
j

2,t),,I
c
j
i,t,I
. (26)
Noxl, lol ~
T
=
_
~
1,T
, ~
2,T
, j
1
, j
2
, o
1
, o
2
_
>
whoio ~
1,T
ano ~
2,T
oonolo lho oioinaiy loasl squaios
oslimalois of lho paiamolois in Lq. (2) foi i = 1, 2, ano j
i
ano o
i
aio lho samplo moan
ano slanoaio oovialion of lho maciooconomic faclois. Likowiso, oolno ^
T,,I
() lo Lo lho
simulaloo counloipail lo ~
T
al simulalion /, incluoing lho oioinaiy loasl squaios oslimaloi of
lho paiamolois in Lq. (26), ano lho samplo moans ano slanoaio oovialions of lho maciooconomic
faclois.
1ho oslimaloi of , lho paiamolois of lho piocoss unooilying lho maciooconomic faclois, is:
^

T
= aig min
2
0
_
_
_
_
_
1
H
1

I=1
^
T,,I
() ~
T
_
_
_
_
_
2
, (27)
whoio
0
is a compacl sol of , a paiamoloi sol oolnoo in Apponoix L.1. Naluially, lhis
oslimaloi of , analyzoo in Iioposilion 2 Lolow (as woll as lhoso of 0 ano X in Iioposilions
8 ano 4), ooponos on lho oisciolizalion inloival, ^, allhough wo oo nol mako lhis ooponoonco
oxplicil, lo allovialo nolalion.
Wo havo:
Proposition 2: Under regularity conditions (Assumption B1(i)-(iii) in Appendix B), as T
and ^
_
T 0,
_
T
_
^

T

0
_
o
N(0, X
1
) , X
1
=
_
1
1
H
_
_
L
>
1
L
1
_
1
L
>
1
J
1
L
1
_
L
>
1
L
1
_
1
,
(2007), Aif-Suhuliu (200S), oi Alfissino uno Molo (2000), uio usynpfofic oguivulonf fo Muxinun Lilolihooo. In
oui confoxf, fhoy oolivoi usynpfoficully omcionf osfinufois foi fho puiunofois in fho fisf sfop. Howovoi, hinging
upon fhoso uppiouchos in fho ionuining sfops woulo nulo fho fwo issuos of unoLsoivuLilify of volufilify uno,
ospociully, puiunofoi osfinufion oiioi consiooiuLly Loyono fho scopo of fhis pupoi.
18
where the two matrices L
1
and J
1
are dened in Appendix B.1, and
0
is the minimizer of the
moment conditions in Eq. (27) for T and ^ 0.
3.2 Moment conditions for realized returns and volatility
Dala on maciooconomic faclois ano slock ioluins oo nol allow us lo ioonlify all lho sliucluial
paiamolois of lho moool: lho paiamolois :
)
in Lq. (21) oopono on lho sliucluial paiamolois,
as Lqs. (22)-(24) show. In pailiculai, wo cannol ioonlify lho paiamolois iolaloo lo lho oivioono
piocoss ano lho iisk-piomiums paiamolois: lhoio aio many comLinalions of ano X giving iiso
lo lho samo slock piico. In lhis socono slop, wo oslimalo lho iooucoo-foim paiamolois, :
)
, ano
lho paiamolois of lho piocoss foi lho unoLsoivaLlo facloi j
3
, (i
3
, j
3
, c
3
, ,
3
). 1ho paiamolois X
shall Lo ioonliloo, ano oslimaloo, in a lhiio ano lnal slop, oosciiLoo in lho noxl soclion.
Lvon piocoooing in lhis way, wo aio nol aLlo lo loll apail lho loaoing on lho unoLsoivaLlo
facloi, :
3
, fiom lho paiamolois unooilying lho oynamics of lho voiy samo unoLsoivaLlo piocoss,
(i
3
, j
3
, c
3
, ,
3
), as lhis facloi is inooponoonl of lho oLsoivaLlo onos. 1o aooioss lhis issuo, wo
imposo lho noimalizalion j
3
= 1, ano oolno a now facloi 7(t) = :
3
j
3
(t), which has oynamics:
o7(t) = i
3
(:
3
7(t)) ot
_
1 C7(t)o\
3
(t) ,
whoio 1 = c
3
:
2
3
ano C = ,
3
:
3
. Wo simulalo H palhs of longlh T of lho unoLsoivaLlo facloi 7 (t),
using a Milsloin appioximalion wilh oisciolo inloival ^, ano samplo il al lho samo fioquoncy
as lho oala, oLlaining foi 0
&
= (i
3
, c
3
, ,
3
, :
3
) ano simulalion /, lho soiios 7
0
u
t,,I
. Likowiso, lol
:
0
t,,I
Lo lho simulaloo soiios of lho slock piico, whon lho paiamolois aio lxoo al 0:
:
0
t,,I
= :
0
:
1
j
1,t
:
2
j
2,t
7
0
u
t,,I
, (28)
whoio wo lx lho inloicopl al :
0
= : :
1
j
1
:
2
j
2
:
3
, ano whoio :, j
1
, ano j
2
aio lho samplo
moans of lho oLsoivoo slock piico inoox, o
t
say, ano lho lwo maciooconomic faclois j
1,t
ano j
2,t
.
Nolo, wo simulalo lho slock piico using lho observed samplos of j
1,t
ano j
2,t
, a foaluio of lho
oslimalion slialogy lhal iosulls in impiovoo omcioncy, as oiscussoo Lolow.
Following Molo (2007) ano Foinaii ano Molo (2000), wo moasuio lho volalilily of lho monlhly
conlinuously compounooo piico changos, as:
Vol
t
=
_
6
1
12
12

i=1

ln
_
o
t+1i
o
ti
_

. (20)
Noxl, oolno yoaily ioluins as, 1
t
= ln(o
t
,o
t12
), ano lol 1
0
t,,I
ano Vol
0
t,,I
Lo lho simulaloo
counloipails of 1
t
ano Vol
t
.
Oui oslimaloi iolios on lho following lwo auxiliaiy moools:
1
t
= a
R
/
R
1
j
1,t12
/
R
2
j
2,t12
c
R
t
, (80)
14
ano
Vol
t
= a
V

i2f6,12,18,24,36,48g
/
V
i
Vol
ti


i2f12,24,36,48g
/
V
1,i
j
1,ti


i2f12,24,36,48g
/
V
2,i
j
2,ti
c
V
t
. (81)
Lol
~
u
T
=
_
~
u
1,T
,
~
u
2,T
,

1, Vol
_
>
, whoio

1 ano Vol aio lho samplo moans of ioluins ano
volalilily,
~
u
1,T
is lho oioinaiy loasl squaios oslimalo of lho paiamolois in Lq. (80) ano
~
u
2,T
is
lho oioinaiy loasl squaios oslimalo of lho paiamolois in Lq. (81). Lol
^
u
T,,I
(0) Lo lho simulaloo
counloipail lo
~
u
T
al simulalion /.
1ho oslimaloi of 0, lho vocloi incluoing lho iooucoo-foim paiamolois :
)
ano lho paiamolois
iolaloo lo piocoss of lho unoLsoivaLlo facloi, is:
^
0
T
= aig min
2
0
_
_
_
_
_
1
H
1

I=1
^
u
T,,I
(0)
~
u
T
_
_
_
_
_
2
, (82)
whoio
0
is a compacl sol of , a paiamoloi sol oolnoo in Apponoix L.1.
Wo havo:
Proposition 3: Under regularity conditions (Assumption B1(i)-(iv) in Appendix B), as T
and ^
_
T 0,
_
T
_
^
0
T
0
0
_
o
N(0, X
2
) , X
2
=
_
1
1
H
_
_
L
>
2
L
2
_
1
L
>
2
(J
2
1
2
) L
2
_
L
>
2
L
2
_
1
,
where the three matrices L
2
, J
2
and 1
2
are dened in Appendix B.1, and 0
0
is the minimizer
of the moment conditions in Eq. (32) for T and ^ 0.
Nolo lhal lho sliucluio of lho asymplolic covaiianco maliix is oiloionl fiom lhal in Iiopo-
silion 2. 1ho oiloionco is lho piosonco of lho maliix 1
2
, which capluios lho covaiianco acioss
palhs al oiloionl simulalion ioplicalions, as woll as lho covaiianco Lolwoon aclual ano simulaloo
palhs. Inoooo, wo aio simulaling lho slock piico piocoss, conoilionally upon lho samplo ioaliza-
lions foi lho oLsoivaLlo faclois, lhus poifoiming conoilional simulaloo infoionco. 1his foaluio of
lho molhoo iosulls in a coiiolalion Lolwoon lho auxiliaiy paiamoloi oslimalos oLlainoo ovoi all
lho simulalions. Il is immooialo lo soo lhal lho uso of oLsoivoo valuos of j
1,t
ano j
2,t
in (28),
piovioos an omcioncy impiovomonl ovoi unconoilional (simulaloo) infoionco.
3.3 Estimation of the risk-premium parameters
Samplo oala on lho maciooconomic faclois ano slock piicos oo nol sumco lo ioonlify lho iisk-
piomium paiamolois, X. Wo ioonlify, ano oslimalo, X Ly malching momonls ano impulso iosponso
funclions of lho moool-Lasoo VIX lo lhoso of lho moool fioo VIX inoox.
1
1ho VIX, as oolnoo in Lq. (16), is availaLlo only fiom 1000. Honco, in lhis slago, wo uso a
samplo of T oLsoivalions, wilh T <T. As foi lho lhooiolical counloipail lo lho VIX, consiooi
lho inslanlanoous slock volalilily piooicloo Ly lho moool, as oolnoo in Lq. (18), o ( (t)). 1ho
VIX inoox piooicloo Ly lho moool is,
VIX( (t)) =
_
1
T t
_
T
t
E[o
2
( (n)) [ (t) = [on, (88)
whoio T t oquals ono monlh, ano E is lho oxpoclalion unooi lho iisk-noulial pioLaLilily.
Allhough VIX() is nol known in closoo-foim, il can Lo accuialoly appioximaloo lhiough sim-
ulalions. Apponoix L.1 piovioos oolails on lhoso simulalions, upon which wo Laso lho pioofs
of Iioposilion 4 Lolow. Nolo, also, lhal in lho aclual compulalion of Lq. (88), wo ioplaco lho
unknown paiamolois :
0
, :
)
, i
)
, c
)
, ,
)
, = 1, 2, 8 ano i
i
, j
i
, i = 1, 2 wilh lhoii oslimaloo counloi-
pails compuloo in lho piovious lwo slops:
^
0
T
ano
^

T
. 1his loaos lo paiamoloi oslimalion oiioi,
which wo shall havo lo lako inlo accounl. As in lho piovious slago of lho oslimalion, wo mako
uso of lho oLsoivoo samplos foi lho maciooconomic faclois j
1,t
, j
2,t
, ano simulalo samplos foi lho
lalonl facloi only. Nolo, lnally, lhal givon 0 ano , wo can now ioonlify X fiom c ano L.
In lho soquol, wo ioly on lho following auxiliaiy moool:
VIX
t
= a
VIX
/
VIX
VIX
t1


i2f36,48g
/
VIX
1,i
j
1,ti


i2f36,48g
/
VIX
2,i
j
2,ti
c
VIX
t
. (84)
Dolno,
~
)
T
=
_
~
)
1,T
, VIX, o
VIX
_
>
, whoio
~
)
1,T
is lho oioinaiy loasl squaios oslimaloi of lho
paiamolois in Lq. (84), ano VIX ano o
VIX
aio lho samplo moan ano slanoaio oovialion of lho
VIX inoox. Likowiso, oolno
^
)
T ,,I
(
^
0
T
,
^

T
, X), lho simulaloo counloipail lo
~
)
T
al simulalion
/, oLlainoo lhiough simulalions of lho moool-implioo inoox VIX
t,,I
(
^
0
T
,
^

T
, X), whoio lho lwo
maciooconomic faclois, j
1,t
ano j
2,t
, aio lxoo al lhoii samplo valuos.
1ho oslimaloi of X, lho paiamolois unooilying lho iisk-piomium piocoss, is:
^
X
T
= aig min
2
0
_
_
_
_
_
1
H
1

I=1
^
)
T ,,I
(
^

T
,
^
0
T
, X)
~
)
T
_
_
_
_
_
2
, (8)
foi somo compacl sol
0
.
Wo havo:
Proposition 4: Under regularity conditions (Assumption B1 in Appendix B), if for some
(0, 1), T, T , ^
_
T 0, ^T , ano T ,T , then:
_
T
_
^
X
T
X
0
_
o
N(0, X
3
) , X
3
=
_
L
>
3
L
3
_
1
L
>
3
__
1
1
H
_
(J
3
1
3
) 1
3
_
L
3
_
L
>
3
L
3
_
1
,
16
where the four matrices L
3
, J
3
, 1
3
and 1
3
are dened in Appendix B.1, and X
0
is the minimizer
of the moment conditions in Eq. (35) for ^
_
T 0, ^T .
Nolo lhal lho maliix 1
3
capluios lho conliiLulion of paiamoloi oslimalion oiioi. 1ho osli-
malion oiioi aiisos Locauso lho moool-implioo VIX inoox, VIX
t,,I
(
^
0
T
,
^

T
, X), is simulaloo using
paiamolois oslimaloo in lho piovious lwo slagos,
^

T
ano
^
0
T
.
3.4 Bootstrap Standard Errors
1ho limiling vaiianco-covaiianco maliicos in lho piovious Iioposilions 2, 8 ano 4, X
1
, X
2
, ano
X
3
, aio oimcull lo oslimalo, as lhoy ioquiio lho compulalion of sovoial numoiical ooiivalivos.
Moioovoi, X
3
iolocls lho conliiLulion of paiamoloi oslimalion oiioi. As a viaLlo ioulo lo
copo wilh lhis lack of a closoo-foim oxpiossion foi lho slanoaio oiiois, wo oovolop Loolsliap
slanoaio oiiois consislonl foi X
1
, X
2
, ano X
3
. Nolo lhal oui oslimalion piocoouio is an hyLiio
Lolwoon Inoiiocl Infoionco ano Simulaloo GMM, which loaos lo lochnical issuos, aiising Locauso
lho auxiliaiy moools wo uso aio polonlially oynamically misspociloo, ano likoly havo a scoio
lhal is nol nocossaiily a mailingalo oiloionco soquonco. A naluial solulion is lo appoal lo lho
Llock-Loolsliap," oosciiLoo succinclly in Apponoix L.2. 1ho Llock-Loolsliap molhoo lakos inlo
accounl a possiLlo coiiolalion of lho scoio of lho auxiliaiy moools. In Apponoix L.2, wo oovolop
lhioo iosulls (Iioposilions L1, L2 ano L8), which allow us lo mako uso of lhis molhoo wilhin
lho simulalion-Lasoo oslimalion piocoouio of lhis soclion.
4 Empirical analysis
4.1 Data
Oui socuiily oala incluoo lho S\I 00 Compounooo inoox ano lho VIX inoox, as puLlishoo Ly
lho Chicago Loaio of Lxchango. Dala foi lho VIX inoox aio availaLlo oaily, Lul only foi lho
poiioo following Januaiy 1000. Oui maciooconomic vaiiaLlos incluoo lho consumoi piico inoox
(CII) ano lho inoox of inousliial pioouclion (II) foi lho US. Infoimalion iolaloo lo lho CII ano
lho II inoox is maoo availaLlo lo lho maikol Lolwoon lho 10-lh ano lho 28-lh of ovoiy monlh.
1o possiLly avoio ovoiioaclion lo ioloasos of infoimalion, wo samplo lho S\I Compounooo inoox
ano lho VIX inoox ovoiy 2-lh of lho monlh. Wo compulo lho ioal slock piico as lho ialio
Lolwoon lho S\I inoox ano lho CII. Oui oalasol, lhon, incluoos (i) monlhly oLsoivalions of
lho VIX inoox, fiom Januaiy 1000 lo DocomLoi 2006, foi a lolal of 204 oLsoivalions; ano (ii)
monlhly oLsoivalions of lho ioal slock piico, lho CII ano lho inoox of II, fiom Januaiy 100 lo
DocomLoi 2006, foi a lolal of 672 oLsoivalions.
Wo uso lhis samplo lo oslimalo lho moool. Wo ulilizo aooilional oala, fiom Januaiy 2007
17
lo Maich 2000, lo implomonl a slioss losl of how lho pioviously oslimaloo moool woulo havo
poifoimoo ovoi a pailiculaily ciilical poiioo. Such oul-of-samplo poiioo is ciilical foi al loasl lhioo
ioasons: lisl, lho NLLI ooloiminoo lhal lho US oconomy onloioo in a iocossion in DocomLoi
2007, which is lho lhiio NLLI-oaloo iocossion sinco lho cioalion of lho now VIX inoox; socono,
lhis poiioo incluoos lho ovonls of lho suLpiimo ciisis, which aio quilo uniquo in lnancial hisloiy
ano, of couiso, oxliomoly iolovanl lo lho puiposos of oui papoi; lhiio, Lolh ioalizoo slock maikol
volalilily ano lho VIX inoox ioachoo iocoio highs, as oiscussoo Lolow, ano possiLly poso soiious
challongos lo ialional moools of assol piicos. As wo shall oxplain, oui oul-of-samplo oxpoiimonls
aio nol inlonooo lo foiocasl lho maikol, slock maikol volalilily, ano lho lovol of lho VIX inoox.
Ialhoi, wo fooo lho moool oslimaloo up lo DocomLoi 2006, wilh lho maciooconomic oala (lho
CII ano lho inoox of II) availaLlo fiom Januaiy 2007, ano compaio lho piooiclions of lho moool
wilh lho aclual movomonls in lho maikol, slock maikol volalilily ano lho VIX inoox.
1o cioalo lho lwo maciooconomic faclois fiom lho CII ano lho inoox of II, wo compulo gioss
inlalion ano gioss inousliial pioouclion giowlh, Lolh al a yoaily lovol,
j
1,t
= CII
t
,CII
t12
ano j
2,t
= II
t
,II
t12
,
whoio CII
t
is lho consumoi piico inoox ano II
t
is lho soasonally aojusloo inousliial pioouclion
inoox, as of monlh t. As wo oxplain in lho Inlioouclion, many lhooiolical oxplanalions of assol
piico movomonls, ano in facl, lho ompiiical ovioonco, woulo loao us lo oxpocl lhal assol piicos
aio inoooo iolaloo lo vaiiaLlos liacking lho Lusinoss cyclo conoilions (soo, o.g., Cochiano (200)),
such as lho CII ano lho II giowlh. Foi oxamplo, in lhoii sominal ailiclo iolaling slock ioluins lo
lho maciooconomy, Chon, Ioll ano Ioss (1086) lno lhal inousliial pioouclion ano inlalion aio
among lho mosl piominonl piicoo faclois. 1hooiolically, in slanoaio lhooiios of oxloinal haLil
foimalion, lho piicing koinol volalilily is oiivon Ly lho suiplus consumplion ialio, oolnoo as
lho poiconlago oovialion of cuiionl consumplion, C, fiom somo haLil lovol, H, i.o. (C H) ,C,
which highly coiiolalos wilh piocyclical vaiiaLlos such as inousliial pioouclion giowlh. Likowiso,
slanoaio assol piicing moools piooicl lhal componsalion foi inlalion iisk iolalos lo vaiiaLlos lhal
aio highly coiiolaloo wilh inlalion (o.g., Lakshi ano Chon (1006), Luiaschi ano Jillsov (200)).
Mainly foi compulalional ioasons, wo iofiain fiom consiooiing aooilional faclois lo moool lho
linkagos of lho piicing koinol lo lho Lusinoss cyclo.
Figuio 1 oopicls lho lwo soiios j
1,t
ano j
2,t
, along wilh NLLI-oaloo iocossion ovonls. Gioss
inlalion is piocyclical, allhough il poakoo up ouiing lho 107 ano lho 1080 iocossions, as a
iosull of lho goopolilical oiivon oil ciisos lhal occuiioo in 1078 ano 1070. Ils volalilily ouiing
lho 1070s was laigo unlil lho Monolaiy oxpoiimonl of lho oaily 1080s, allhough il oiamalically
oioppoo ouiing lho poiioo following lho oxpoiimonl, usually iofoiioo lo as lho Gioal Moooialion
(o.g., Loinanko (2004)). Al lho samo limo, inlalion is poisislonl: a Dickoy-Fulloi losl iojocls lho
null hypolhosis of a unil iool in j
1,t
, allhough lho iojoclion is al lho maiginal 0/ lovol. 1ho
18
assol piicing implicalions of lhis piopoily aio lhon piomising: allhough inlalion has Locomo loss
volalilo, ils poisislonco makos il a canoioalo foi Loing a iisk foi lho long iun. 1ho inclusion of
inlalion as a ooloiminanl of lho piicing koinol oisplays ono aooilional alliaclivo foaluio. An
olo ooLalo oxisls upon wholhoi slocks piovioo a hoogo againsl inlalion (soo, o.g., Danlhino ano
Donaloson (1086)). Whilo oui no-aiLiliago moool is silonl aLoul lho gonoial oquiliLiium foicos
unooilying inlalion-hoogo piopoilios of assol piicos, ils oala-oiivon sliucluio allows us lo assoss
quilo oiioclly lho iolalions Lolwoon inlalion ano lho slock piico, ioluins, volalilily ano volalilily
iisk-piomiums.
Figuio 1 also shows lhal whilo lho volalilily of gioss inousliial pioouclion giowlh oioppoo
ouiing lho Gioal Moooialion, giowlh is slill poisislonl, allhough loss so lhan gioss inlalion: hoio,
a Dickoy-Fulloi losl iojocls lho null hypolhosis of a unil iool in j
2,t
al any convonlional lovol.
Finally, lho piopoilios of gioss inlalion ano gioss inousliial pioouclion ovoi oui oul-of-samplo
poiioo, fiom Januaiy 2007 lo Maich 2000, aio oiscussoo in Soclion 4.2.4.
4.2 Estimation results
4.2.1 Macroeconomic drivers
1aLlo 1 iopoils paiamoloi oslimalos foi lho joinl piocoss of lho lwo maciooconomic vaiiaLlos,
j
1,t
ano j
2,t
. 1ho oslimalos aio oLlainoo lhiough lho lisl slop of lho piocoouio sol foilh in
Soclion 8.1. In paionlhosis, wo iopoil lho slanoaio oiiois compuloo lhiough lho Llock-Loolsliap
piocoouio oovolopoo in Apponoix L.2. 1hoso oslimalos, which aio all laigoly signilcanl, conlim
oui piovious oiscussion of Figuio 1: inlalion is moio poisislonl lhan II giowlh, as Lolh ils spooo
of aojuslmonl in lho aLsonco of foooLacks, i
1
, ano ils foooLack paiamoloi, i
1
, aio much lowoi lhan
lho counloipails foi II giowlh, i
2
ano i
2
. Moioovoi, lho sign ano valuo of lhoso paiamolois aio
lhoso wo nooo lo malch lho impulso-iosponso funclions foi j
1,t
ano j
2,t
in lho oala (nol iopoiloo
hoio, foi spaco ioasons). 1hoso foooLack olocls oo havo assol piicing implicalions, as wo shall
oiscuss Lolow. Finally, nolo lhal lho oslimalos of ,
1
ano ,
2
aio Lolh nogalivo, implying lhal lho
volalilily of lhoso lwo maciooconomic vaiiaLlos aio counloicyclical, anolhoi inloiosling piopoily,
fiom an assol piicing poispoclivo.
4.2.2 Aggregate stock returns and volatility
1aLlo 2 iopoils paiamoloi oslimalos ano slanoaio oiiois foi (i) lho paiamolois linking lho lwo
maciooconomic faclois, j
1,t
ano j
2,t
, ano lho unoLsoivaLlo facloi, j
3,t
, lo lho ioal slock piico
inoox, o
t
; ano (ii) lho paiamolois foi lho unoLsoivaLlo facloi piocoss. Iaiamoloi oslimalos aio
oLlainoo lhiough lho socono slop of oui oslimalion slialogy, oxplainoo in Soclion 8.2. Slanoaio
oiiois aio compuloo lhiough lho Llock-Loolsliap piocoouio oovolopoo in Apponoix L.2. 1ho
paiamoloi oslimalos aio all laigoly signilcanl. 1hoy poinl lo lwo main conclusions. Fiisl, lho
10
slock piico is posilivoly iolaloo lo Lolh inlalion ano II giowlh, allhough lho link wilh II giowlh
sooms lo Lo of paiamounl impoilanco. Socono, lho unoLsoivaLlo facloi is laigoly poisislonl, ano
oisplays a laigo volalilily, as lho oslimalo of lho spooo iovoision coomcionl, i
3
is low. Nolo,
lho liloialuio on long iun iisks slailoo Ly Lansal ano Yaion (2004) omphasizos lho assol piicing
implicalions of long iun iisks alocling lho oxpocloo consumplion giowlh ialo. Inloioslingly, lho
piosonco of a poisislonl facloi alocling slock ioluins ano volalilily omoigos quilo noally fiom
oui oslimalion.
Finally, lho conoilional volalilily of lho lhiio facloi, ovalualoo al lho long iun moan, j
3
= 1,
i.o.
_
c
3
,
3
j
3

j
3
=1
, is aLoul 8. 1his lguio implios a piico impacl of a volalilily shock
in lho lhiio facloi oqual lo :
3

_
c
3
,
3
j
3

j
3
=1
= 0.88, al lho oslimaloo paiamolois. In
compaiison, lhoso piico impacls oqual :
1

_
c
1
,
1
j
1

j
1
=j
1
= 1.48 10
3
, foi inlalion, ano
:
2

_
c
2
,
2
j
2

j
2
=j
2
= 0.11, foi inousliial pioouclion giowlh, al lho oslimaloo paiamolois.
Honco, in oui moool, lho piico impacl of a shock in lho volalilily of lho II giowlh, is aLoul lhioo
limos smalloi lhan lhal iosulling fiom lho volalilily of lho unoLsoivaLlo facloi. Wo shall oiscuss
Lolow lho iolo inlalion plays in lho conloxl of oui oslimaloo moool.
Figuio 2 shows lho oynamics of slock ioluins ano volalilily piooicloo Ly lho moool, along
wilh lhoii samplo counloipails, calculaloo as oosciiLoo in Soclion 8.2. 1hoso piooiclions aio
oLlainoo Ly foooing lho moool wilh samplo oala foi lho lwo maciooconomic faclois, j
1,t
ano j
2,t
,
in conjunclion wilh simulalions of lho lhiio unoLsoivaLlo facloi. Foi oach simulalion i, lho slock
piico is compuloo lhiough Lq. (28), using all lho oslimaloo paiamolois, lho samplo palhs of lho
lwo maciooconomic faclois, j
1,t
ano j
2,t
, ano lho simulaloo palh of lho lhiio facloi. Givon lho
simulaloo slock piico, wo compulo slock ioluins ano volalilily, foi oach simulalion. Finally, foi
oach poinl in limo, wo avoiago ovoi lho cioss-soclion of 1000 simulalions, ano iopoil ioluins (in
lho lop panol of Figuio 2) ano volalilily (in lho Lollom panol). Ioluins aio compuloo as wo oo
wilh lho oala, ano volalilily is oLlainoo lhiough Lq. (18).
1ho moool appoais lo capluio lho piocyclical naluio of slock ioluins ano lho counloicyclical
Lohavioi of slock volalilily. Il gonoialos all lho slock maikol oiops occuiioo ouiing lho NLLI
iocossions, ano all lho volalilily upwaio swings occuiioo ouiing lho NLLI iocossions, incluoing
lho oiamalic spiko of lho 107 iocossion. In lho oala, avoiago slock volalilily is aLoul 11/, wilh
a slanoaio oovialion of aLoul 8.8/. 1ho moool piooicls an avoiago volalilily of aLoul 18/, wilh
a slanoaio oovialion of aLoul 1.8/.
How much of lho vaiialion in volalilily can Lo alliiLulaLlo lo maciooconomic faclois Il is
a naluial quoslion, as lho koy innovalion of oui moool is lho inlioouclion of lhoso faclois foi
lho puiposo of oxplaining volalilily, on lop of a slanoaio unoLsoivaLlo facloi. Naluially, lho
cyclical piopoilios of slock ioluins ano volalilily lhal wo soo in Figuio 2 can only aiiso ouo lo lho
luclualion of lho maciooconomic faclois. 1o quanlilalivoly assoss lhoso piopoilios, wo poifoim
lho following oxpoiimonl. Wo fioozo lho palh of oach facloi j
),t
al ils oslimaloo long iun moan,
20
j
)
, simulalo lho moool, ano compulo lho avoiago slock maikol ioluins, slock volalilily ano lho
slanoaio oovialion of slock volalilily, ovoi lho simulalions. Naluially, in lhis oxoiciso, wo cannol
compulo volalilily lhiough Lq. (18), which is Lasoo on lho assumplions lhal lho lhioo faclois
aio inoooo slochaslic, ano alocl lho assol piico. Insloao, wo calculalo lho slock volalilily of lho
moool, lhiough lho samo foimulao lhal wo uso lo compulo slock volalilily fiom lho oala.
Figuios 8 ano 4, ano lho following laLlo, iopoil lho iosulls of lhis numoiical oxpoiimonl.
Whon wo shul oown lho gioss inlalion channol, wo oo nol achiovo any nolicoaLlo poiconlago
ioouclion in lho moool-implioo avoiago volalilily ano ils slanoaio oovialion. 1hoiofoio, gioss
inlalion sooms lo play a maiginal iolo as a ooloiminanl of slock maikol volalilily, ano ils cyclical
piopoilios. Al lho samo limo, lho moool piooicls lhal inlalion links lo assol ioluins ano volalilily
in a mannoi compaiaLlo lo lhal in lho oala. Foi oxamplo, il is woll-known sinco al loasl Fama
(1081) lhal ioal slock ioluins aio nogalivoly coiiolaloo wilh inlalion, a piopoily lhal hinoois
lho aLilily of slocks lo hoogo againsl inlalion. In oui samplo, lhis coiiolalion is -42/, whilo lho
coiiolalion oui moool gonoialos is -22/.
6
Finally, lho coiiolalion Lolwoon slock volalilily ano
inlalion is 28/ in lho oala, whilo lhal implioo Ly lho moool is 24/.
Ioiconlago ioouclion in slock volalilily
ano lho volalilily of slock volalilily
volalilily vol of vol
wilhoul j
1
- 0 - 0
wilhoul j
2
11/ 77/
wilhoul j
3
60/ 0/
Insloao, inousliial pioouclion giowlh plays a quilo impoilanl iolo. Fixing j
2,t
al ils long
iun moan loaos lo aLoul a 10/ ioouclion in lho avoiago lovol of volalilily, allhough lho lhiio
unoLsoivaLlo facloi is koy in oxplaining lho level of slock volalilily: whon wo lx j
3,t
= j
3
, lhus
laking lho vaiiaLilily of j
3,t
oul of lho picluio, lho avoiago lovol of volalilily oiops Ly noaily 70/.
Al lho samo limo, inousliial pioouclion is nooooo lo oxplain lho cyclical swings of slock volalilily
lhal wo havo in lho oala. Whon j
2,t
is fiozon al j
2
, lho slanoaio oovialion of lho moool-implioo
slock volalilily oiops oiamalically Ly 77/.
Whon, insloao, j
3,t
is fiozon al j
3
, wo ovon oLsoivo an increase in lho vaiiaLilily of slock
volalilily, of aLoul 0/. 1his lnoing is oasily oxplainoo. As shown in Figuio 1, gioss inousliial
pioouclion was voiy volalilo ouiing lho 100s, which lianslalos inlo a similai piopoily foi lho
aggiogalo maikol ioluins. Inoooo, Figuio 8 shows lhal whon j
3,t
is fiozon al j
3
, lho moool piooicls
6
In oui noool, fho ioul sfocl piico is posifivoly iolufoo fo Lofh inufion uno giowfh, Luf fho coiiolufion Lofwoon
inufion uno giowfh is uLouf -24%, which oxpluins fho nogufivo fguio oui noool piooicfs foi fho coiiolufion Lofwoon
ioul iofuins uno inufion.
21
lhal lho lovol of slock volalilily is quilo high unlil lho iocossion occuiioo in 1060, allhough il
lhon piogiossivoly lowois. Il is lhis chango in lovol occuiiing ouiing lho 1060s, which makos
lho slanoaio oovialion of slock volalilily ovon highoi lhan whon lho unoLsoivaLlo facloi is nol
fiozon (as in Figuio 2). If wo conoilion on suLsamplos lhal only incluoo lho Gioal Moooialion
oia (o.g., fiom Januaiy 108), wo lno lhal lho slanoaio oovialion of slock volalilily is Lack lo
appioximaloly 1.8/. In olhoi woios, lho piosonco of an unoLsoivaLlo facloi has viilually no
olocl on lho vaiiaLilily of slock volalilily, ouiing lho Gioal Moooialion.
In facl, lho main challongo of lho moool is lo oxplain why wo havo oLsoivoo a suslainoo
slock maikol volalilily, in spilo of lho Gioal Moooialion. Oui oslimalion iosulls loao lo a quilo
cloai conclusion: lho lovol of slock volalilily cannol Lo oxplainoo Ly maciooconomic vaiiaLlos
only. Insloao, somo unoLsoivaLlo facloi is nooooo, which accounls foi aLoul lwo lhiios of lho
luclualions in slock volalilily (piocisoly, 60/). Al lho samo limo, lho samo unoLsoivaLlo facloi
cannol oxplain lho vaiiaLilily in slock volalilily. As Figuio 4 iovoals, whon wo fioozo lho lwo
maciooconomic faclois al lhoii unconoilional moans, j
1
ano j
2
, lho slock volalilily piooicloo Ly
lho moool is jusl lho avoiago of ils ompiiical counloipail, wilh viilually no luclualions al all.
7
All in all, oui ompiiical iosulls suggosl lhal lho volalilily of slock volalilily is alliiLulaLlo lo
lho cyclical vaiialions in slock volalilily, which oui moool capluios lhiough lho iolalion Lolwoon
assol ioluins ano inousliial pioouclion giowlh. Of couiso, lhoso swings aio ampliloo Ly lho
piosonco of lho lhiio unoLsoivaLlo facloi.
4.2.3 Volatility risk-premiums and the dynamics of the VIX index
1aLlo 8 iopoils paiamoloi oslimalos ano slanoaio oiiois foi lho vocloi of lho iisk-piomiums
coomcionls X in lho iisk-piomium piocoss of Lq. (10). 1ho oslimalos, which aio all signilcanl,
aio oLlainoo lhiough lho lhiio, ano lnal slop, of lho oslimalion piocoouio, oosciiLoo in Soclion
8.8. Slanoaio oiiois aio compuloo lhiough lho Llock-Loolsliap piocoouio oovolopoo in Apponoix
L.2.
1ho oslimalos imply lhal lho iisk-piomiums piocossos aio all posilivo, ano quilo laigo. Moio-
ovoi, lho iisk componsalion foi gioss inlalion incioasos wilh inlalion ano lhal foi inousliial
pioouclion is counloicyclical, givon lho sign of lho oslimaloo valuos foi lho loaoings of inlalion,
_
,
1
`
1(1)
`
2(1)
_
(posilivo), ano inousliial pioouclion,
_
,
2
`
1(2)
`
2(2)
_
(nogalivo), in lho iisk-
piomium piocoss of Lq. (10). Whilo gioss inlalion ooos iocoivo componsalion, ano holps oxplain
lho oynamics of lho volalilily iisk-piomium, as wo oxplain Lolow, lho counloicyclical Lohavioi of
lho iisk-piomium foi inousliial pioouclion giowlh is ovon moio ciilical, al loasl ovoi lho poiioo
7
In Figuio 4, sfocl volufilify ucfuufos Lofwoon uiouno 11% uno 12%, uno yof sfocl iofuins uio guifo snoofh.
1ho iouson is fhuf sfocl iofuins uio conpufoo youily, whilo sfocl volufilify is osfinufoo wifh ono-nonfh iofuins,
which fho noool piooicfs fo Lo guifo volufilo (piocisoly, uLouf 12%, unnuulizoo, on uvoiugo), ovon in fho uLsonco
of nucioocononic fucfois.
22
fiom 1000 lo 2006. Oui oslimaloo moool piooicls inoooo lhal in Lao limos, lho iisk-piomium
foi inousliial pioouclion giowlh goos up, ano fuluio oxpocloo oconomic conoilions ovon woison,
unooi lho iisk-noulial pioLaLilily, which Loosls fuluio oxpocloo volalilily, unooi lho samo iisk-
noulial pioLaLilily. In pail Locauso of lhoso olocls, lho VIX inoox piooicloo Ly lho moool is
counloicyclical. 1his ioasoning is quanlilalivoly souno. Figuio (lop panol) oopicls lho VIX in-
oox, along wilh lho VIX inoox piooicloo Ly lho moool ano lho (squaio iool of lho) moool-implioo
oxpocloo inlogialoo vaiianco. 1ho moool appoais lo iopioouco woll lho laigo swings in lho VIX
inoox lhal wo havo oLsoivoo ouiing lho 1001 ano lho 2001 iocossion opisooos.
1ho lop panol of Figuio also shows lho oynamics of oxpocloo fuluio volalilily, unooi lho
physical pioLaLilily. 1his oxpocloo volalilily is coilainly counloicyclical, allhough il ooos nol
oisplay lho laigo vaiialions lho moool piooicls foi ils iisk-noulial counloipail, lho VIX inoox. 1ho
VIX inoox piooicloo Ly lho moool is counloicyclical Locauso lho iisk-piomiums ioquiioo lo Loai
lho luclualions of lho maciooconomic faclois aio (i) posilivo ano (ii) counloicyclical, as aiguoo
aLovo, ano, also, Locauso (iii) cuiionl volalilily is counloicyclical. Lxpocloo fuluio volalilily is
counloicyclical, unooi lho physical pioLaLilily, only Locauso of lho lhiio olocl. Figuio 6 iovoals
lho lill" in lho fuluio palhs of inousliial pioouclion giowlh lhal wo nooo, in oiooi lo mako oui
moool malch lho oala on lho VIX inoox. 1ho lofl panol of lhis picluio oopicls samplo palhs
ovoi ono monlh, unooi lho physical pioLaLilily. 1ho iighl panol oopicls samplo palhs unooi lho
iisk-noulial pioLaLilily. In woios, movomonls in lho volalilily iisk-piomiums accounl foi lho
vaiialion of lho VIX inoox sonsiLly moio lhan movomonls in lho fuluio oxpocloo volalilily unooi
lho physical pioLaLilily, as cloaily summaiizoo Ly Figuio .
1ho suLslanlial woogo Lolwoon oxpocloo volalilily unooi lho lwo pioLaLililios is aclually
ioinfoicoo Ly lho foooLack Lolwoon inlalion ano inousliial pioouclion giowlh. 1ho mochanism
is lho following. Gioss inlalion ioquiios a laigo ano posilivo iisk-piomium, as alioaoy monlionoo.
1his piomium is aclually so laigo, lo mako oxpocloo inlalion always oocioaso fiom ils cuiionl
lovols, unooi lho iisk-noulial pioLaLilily. (1ochnically, lho inlalion iisk-piomium is such lhal lho
oiifl of inlalion is nogalivo unooi lho iisk-noulial pioLaLilily.) Sinco lho foooLack paiamoloi,
i
2
, is posilivo ano laigo in valuo, lho iisk-noulial oxpoclalion of inousliial pioouclion woisons
ovon moio lhan in lho aLsonco of foooLack olocls, ouo piocisoly lo lho inlalion iisk-piomium. In
olhoi woios, inlalion alocls lho VIX inoox lhiough a suLllo channol, lho componsalion foi lho
iisk of coiiolalion Lolwoon inlalion ano giowlh, aiising ouo lo sizoaLlo valuos of (i) lho foooLack
Lolwoon inlalion ano giowlh, as summaiizoo Ly i
2
, (ii) lho inlalion iisk-piomium. Inloioslingly,
Slock ano Walson (2008) lno lhal lho linkagos of assol piicos lo giowlh aio sliongoi lhan foi
inlalion. Oui iosulls fuilhoi qualify lhis lnoing: whilo oui piovious lnoings suggosl lhal inlalion
ooos nol alocl loo much lho oynamics of slock ioluins ano volalilily, lho piosonco of signilcanl
foooLacks Lolwoon inlalion ano inousliial pioouclion giowlh, in conjunclion wilh componsalion
foi inlalion iisk, iovoal lhal inlalion ooos alocl fuluio oxpocloo volalilily, unooi lho iisk-noulial
28
pioLaLilily.
Finally, lho Lollom panol in Figuio plols lho volalilily iisk-piomium, oolnoo as lho oif-
foionco Lolwoon lho (squaio iools of lho) moool-implioo oxpocloo inlogialoo vaiianco unooi lho
iisk-noulial pioLaLilily ano lho moool-implioo oxpocloo inlogialoo vaiianco unooi lho physical
pioLaLilily. 1his iisk-piomium is counloicyclical, ano lhis piopoily aiisos foi oxaclly lho samo
ioasons wo pul foiwaio lo oxplain lho laigo swings of lho VIX inoox piooicloo Ly lho moool: posi-
livo componsalion foi iisk, counloicyclical vaiialion of lho iisk-piomiums ioquiioo lo componsalo
foi lho iisk in luclualions of lho maciooconomic faclois, ano foooLack olocls Lolwoon lho lwo
maciooconomic faclois. Inloioslingly, lho lwo iocossions, in 1001 ano 2001, soom lo Lo anlici-
paloo Ly a suigo in lho volalilily iisk-piomium. Figuio 7 piovioos scalloiplols of lho volalilily
iisk-piomium againsl inlalion ano inousliial pioouclion. 1ho lop panol iovoals lhal lho volalilily
iisk-piomium ooos nol oisplay a noal iolalion wilh inlalion, allhough wo havo oxplainoo lhal lho
inlalion iisk-piomium is an impoilanl ooloiminanl of il, as il magnilos lho inousliial pioouclion
giowlh channol, lhiough a foooLack olocl. Insloao, lho Lollom panol iovoals a noal ano invoiso
iolalion Lolwoon lho volalilily iisk-piomium ano inousliial pioouclion giowlh, ano suggosls an
inloiosling convoxily" piopoily: in gooo limos, lho volalilily iisk-piomium ooos nol movo loo
much in iosponso of movomonls in lho inousliial pioouclion giowlh, allhough il incioasos quickly
ano Ly a sizoaLlo amounl as soon as Lusinoss cyclo conoilions ooloiioialo.
4.2.4 Out-of-sample predictions of the model, and the subprime crisis
Wo unooilako oul-of-samplo oxpoiimonls lo invosligalo lho moool`s piooiclions ovoi a quilo ox-
coplional poiioo, lhal fiom Januaiy 2007 lo Maich 2000. 1his samplo covois lho suLpiimo
luimoil, ano foaluios unpiocooonloo ovonls, Lolh foi lho sovoiily of capilal maikols uncoilainly
ano lho poifoimanco of lho US oconomy. 1ho maikol wilnossoo a spoclaculai oiop accompanioo
Ly an oxliaoioinaiy suigo in volalilily. In Maich 2000, yoaily ioluins plummoloo lo -8.80/,
a poifoimanco ovon woiso lhan lhal oxpoiioncoo in OcloLoi 1074 (-8.10/). Fuilhoimoio, ac-
coioing lo oui oslimalos, oLlainoo lhiough Lq. (20), aggiogalo slock volalilily ioachoo 28.20/
in Maich 2000, lho highosl lovol ovoi oxpoiioncoo in oui samplo. Finally, lho VIX inoox hil ils
highosl valuo in oui samplo in NovomLoi 2008 (72.67/), ano iomainoo sluLLoinly high foi sovoial
monlhs. 1ho limo soiios Lohavioi of slock ioluins, slock volalilily ano lho VIX inoox ouiing oui
oul-of-samplo poiioo aio oopicloo ovoi lho shaooo aioas in Figuios 2 ano .
Maciooconomic oovolopmonls ovoi oui oul-of-samplo poiioo woio oqually oxliomo, wilh yoaily
inlalion ialos achioving nogalivo valuos in 2000, ano yoaily inousliial pioouclion giowlh Loing
as low as -18/, in Maich 2000. 1ho shaooo aioa in Figuio 1 covois lho oul-of-samplo Lohavioi
of gioss inlalion ano giowlh.
Unooi such maciooconomic conoilions, wo oxpocl oui moool lo pioouco lho following piooic-
lions: (i) slock ioluins oiop, (ii) slock volalilily iisos, (iii) lho VIX inoox iisos, ano moio lhan
24
slock volalilily. 1ho mochanism is, Ly now, cloai. Assol piicos ano, honco, ioluins, plummol,
as lhoy aio posilivoly iolaloo lo inlalion ano giowlh, which Lolh ciashoo. Moioovoi, volalilily
incioasos, wilh lho VIX inoox incioasing ovon moio, ouo lo oui piovious lnoing of (i) sizoaLlo
maciooconomic iisk-piomiums ano (ii) sliong counloicyclical vaiialion in lhoso piomiums. Wo
now fooo lho moool wilh lho maciooconomic faclois oLsoivoo fiom Januaiy 2007 lo Maich 2000,
lo oLlain quanlilalivo piooiclions aLoul slock ioluins, slock volalilily ano lho VIX inoox.
Figuios 2 ano conlim oui ioasoning, ano iovoal lhal lho moool is aLlo lo liaco oul lho
oynamics of slock ioluins ano volalilily (Figuio 2), ano lho VIX inoox (Figuio ), ovoi lho oul-
of-samplo poiioo. 1ho maikol liloially ciashos, as in lho oala, allhough only loss lhan a half as
much as in lho oala: lho lowosl valuo foi yoaily slock ioluins lho moool piooicls, oul-of-samplo,
is -28.28/, which is lho socono lowosl lguio oui moool piooucos, ovoiall. (1ho lowosl lovol lho
moool piooicls is -28.64/, foi Juno 104, whon Lolh inlalion ano inousliial pioouclion giowlh
woio quilo low.) Insloao, lho moool piooicls lhal slock volalilily ano lho VIX inoox suigo ovon
moio lhan in lho oala, ioaching iocoio highs of 82.48/ (volalilily) ano 78.67/ (VIX).
Figuio 8 piovioo aooilional oolails aLoul lho poiioo fiom Januaiy 2000 lo Maich 2000. Il
compaios slock volalilily ano lho VIX inoox wilh lho piooiclions of lho moool ano lhoso of a OLS
iogiossion. 1ho OLS foi volalilily is lhal in Lq. (81), oxcluoing lho lag foi six monlhs, iolaloo
lo lho auloiogiossivo loim. 1ho OLS foi lho VIX inoox is lhal in Lq. (84). OLS piooiclions
aio oLlainoo Ly foooing lho OLS piooiclivo pail wilh ils iogiossois, using paiamoloi oslimalos
oLlainoo wilh oala up lo DocomLoi 2006. 1ho following laLlo iopoils Iool Moan Squaioo Liiois
(IMSL) foi Lolh oui moool ano OLS, calculaloo foi lho oul-of-samplo poiioo.
IMSL foi lho moool ano OLS
Moool OLS
Volalilily 0.008 0.0700
VIX Inoox 0.121 0.1810
Ovoiall, OLS piooiclions oo nol soom lo capluio lho counloicyclical Lohavioi of slock volalil-
ily. As foi lho VIX inoox, lho OLS moool (in facl, Ly Lq. (84), an auloiogiossivo, oisliiLuloo
lag moool) piooucos piooiclions lhal aio nol as accuialo as lho moool, ano gonoialo ovoill. 1ho
moool, insloao, iopiooucos lho hugo swings wo soo in lho oala, in Lolh lho lasl lwo iocossion
opisooos. Il also sooms lo anlicipalo luining poinls, in lhal il iaisos Lofoio ano oiops al lho ono
of a iocossion. 1ho IMSLs cloaily favoui lho moool againsl OLS, allhough il appoais lo oo so
moio wilh volalilily lhan foi lho VIX, as Figuio 8 infoimally iovoals.
2
5 Conclusion
How piocisoly ooos aggiogalo slock maikol volalilily iolalo lo lho Lusinoss cyclo 1his olo quoslion
has Loon foimulaloo al loasl sinco Omcoi (1078) ano Schwoil (1080a,L). Wo loainl fiom ioconl
lhooiolical oxplanalions lhal lho counloicyclical Lohavioi of slock volalilily can Lo unooislooo as
lho iosull of a ialional valualion piocoss. Howovoi, how much of lhis counloicyclical Lohavioi is
iosponsiLlo foi lho suslainoo lovol aggiogalo volalilily has oxpoiioncoo foi conluiios 1his papoi
shows lhal appioximaloly ono lhiio of lhis lovol can Lo oxplainoo Ly maciooconomic faclois,
ano lhal somo unoLsoivoo compononl is nooooo inoooo lo mako slock volalilily consislonl wilh
ialional assol valualion. Moioovoi, wo show lhal a Lusinoss cyclo facloi is nooooo lo oxplain lho
inovilaLlo luclualions of slock volalilily aiouno ils avoiago.
Wo show lhal iisk-piomiums aiising fiom luclualions in lhis volalilily aio sliongly coun-
loicyclical, coilainly moio so lhan slock volalilily alono. In facl, lho iisk-componsalion foi lho
luclualion in lho maciooconomic faclois is laigo ano counloicyclical, ano oxplains lho laigo
swings in lho VIX inoox lhal wo oLsoivo ouiing iocossions. Wo unooilako oul-of-samplo oxpoi-
imonls lhal covoi lho 2007-2000 suLpiimo ciisis, whon lho VIX ioachoo a iocoio high of moio
lhan 70/, which oui moool succossfully iopiooucos, lhiough a counloicyclical vaiialion in lho
volalilily iisk-piomiums. Finally, wo piovioo ovioonco lhal lho samo volalilily iisk-piomiums
mighl holp piooicl oovolopmonls in lho Lusinoss cyclo in Lao limoslho ono of a iocossion.
Which maciooconomic facloi mallois Wo lno lhal inousliial pioouclion giowlh is laigoly
iosponsiLlo foi lho ianoom luclualions of slock volalilily aiouno ils lovol, ano lhal inlalion plays,
insloao, a quilo limiloo iolo in lhis conloxl. Al lho samo limo, inlalion plays an impoilanl iolo
as a ooloiminanl of lho VIX inoox, lhiough lwo channols: (i) ono, oiiocl, channol, iolaloo lo lho
inlalion iisk-piomium, ano (ii) an inoiiocl channol, aiising fiom lho Lusinoss cyclo piopagalion
mochanism, lhiough which inlalion ano inousliial pioouclion giowlh aio coiiolaloo. 1ho socono
channol is suLllo, as il givos iiso lo a coiiolalion iisk lhal wo show il is signilcanlly piicoo Ly
lho maikol.
1ho koy aspocl of oui moool is lhal lho iolalions among lho maikol, slock volalilily, volalilily
iisk-piomiums ano lho maciooconomic faclois, aio consislonl wilh no-aiLiliago. In pailiculai,
volalilily is onoogonous in oui fiamowoik: lho samo vaiiaLlos oiiving lho payol piocoss ano lho
volalilily of lho piicing koinol, ano honco, lho assol piico, aio lhoso lhal oiivo slock volalilily
ano volalilily-iolaloo iisk-piomiums. A quoslion foi fuluio iosoaich is lo oxploio wholhoi lho
no-aiLiliago fiamowoik in lhis papoi can Lo usoo lo impiovo foiocasls of ioal oconomic aclivily.
In facl, slock volalilily ano volalilily iisk-piomiums aio oiivon Ly Lusinoss cyclo faclois, as lhis
papoi cloaily oomonslialos. An ovon moio challonging ano funoamonlal quoslion is lo oxploio
lho oxlonl lo which Lusinoss cyclo, slock volalilily ano volalilily iisk-piomiums oo onoogonously
oovolop.
26
Appendix
A. Proofs for Section 2
Existence of a strong solution to Eq. (1) and Eq. (18).
Consiooi fho following conoifions: foi ull i,
(i) Foi ull g : \ (g)
(..)
= 0, d

.
(rg r)
1
2
d

.
XX

d
.
(ii) Foi ull ), if
_
d

.
X
_

,= 0, fhon \
..
= \

.
1hon, Ly Dumo uno Kun (1006) (unnunLoioo fhooion, p. 8SS), fhoio oxisfs u uniguo sfiong solufion fo Lg.
(1) foi which \ (g (t))
(..)
0 foi ull t ulnosf suioly.
Wo upply fhoso conoifions fo fho oilusion in Lg. (1S). Conoifion (i) collupsos fo,
Foi ull
.
: c
.
,
.

.
= 0, ,
.

r
.
(j
.

.
) r
.
_
j

__

1
2
,
2
.
, i ,= ),
wifh r
3
= 0. 1huf is, iuling ouf fho fiiviul cuso ,
.
= 0,
r
.
(j
.
,
.
c
.
) r
.
,
.
_
j

_

1
2
,
2
.
, i ,= ). (A1)
Proof of Proposition 1
1ho fochnicul conoifion in Iioposifion 1 is,
1
_
_
T
I
_
_
_
_

XV (g (t))

g (t)
A(t)

_
_
_
_
2
ot
_
< o, (A2)
foi sono consfunfs uno in Lg. (A10) Lolow.
Noxf, oofno fho Aiiow-DoLiou uojusfoo ussof piico piocoss us, c

(t) = c
rI
(t) c (g (t)), t 0. !y Ifo`s
lonnu, if sufisfos,
oc

(t)
c

(t)
= Di (g (t)) ot
_
Q(g (t))

A(g (t))

_
oV (t) , (A8)
whoio
Di (g) = v
/c (g)
c (g)
Q(g)

A(g) ,
/c (g) = c

(g)

r( g)
1
2
1i
_
[XV (g)[ [XV (g)[

(g)
_
, Q(g)

=
c

(g)

XV (g)
c (g)
,
uno c

uno c

oonofo fho giuoionf uno fho Hossiun of c wifh iospocf fo g. !y uLsonco of uiLifiugo oppoifunifios,
foi uny T < o,
c

(t) = 1
__
T
I
c

(I) oI

F(t)
_
1[c

(T) [ F(t)[, (A4)

whoio c

(t) is fho cuiionf Aiiow-DoLiou vuluo of fho oivioono fo Lo puio ol uf fino t, viz c

(t) = c
rI
(t) c (t).
!olow, wo show fhuf fho following fiunsvoisulify conoifion holos,
lin
Tc
1[c

(T) [ F(t)[ = 0, (A)

fion which Lg. (S) in fho nuin foxf follows, onco wo show fhuf
_
c
I
1[c

(I)[oI < o.
Noxf, Ly Lg. (A4),
0 =
o
ot
1[c

(t) [ F(t)[

:=I
c

(t) . (A6)
!olow, wo show fhuf
1[c

(T) [ F(t)[ = c

(t)
_
T
I
D(g (I)) c

(I) oI. (A7)

27
1hoiofoio, Ly fho ussunpfions on A, Lg. (A6) cun Lo iouiiungoo fo yiolo fho following oioinuiy oiloionfiul
oguufion,
Foi ull g, c

(g)

(c 1g)
1
2
1i
_
[XV (g)[ [XV (g)[

(g)
_
c (g) vc (g) = 0, (AS)
whoio c uno 1 uio oofnoo in fho pioposifion.
Assuno fhuf fho piico funcfion is umno in g,
c (g) =

g, (A0)
foi sono scului uno sono vocfoi . !y plugging fhis guoss Lucl info Lg. (AS) wo oLfuin,
Foi ull g,

c c
0
v
_

(1vJ
nn
)

_
g = 0.
1huf is,

c c
0
v = 0 uno
_

(1vJ
nn
)

_
= 0
1n
.
1ho solufion fo fhis sysfon is,
=
c
0

c
v
uno

(1vJ
nn
)
1
. (A10)
Wo uio loff fo show fhuf Lg. (A) uno (A7) holo fiuo.
As foi Lg. (A), wo huvo:
lin
Tc
1[c

(T) [ F(t)[ = lin

Tc
1[c
r(TI)
(T) c (g (T)) [ F(t)[
= lin
Tc
c
r(TI)
1[ (T) [ F(t)[ lin
Tc
c
r(TI)
1[ (T)

g (T) [ F(t)[
= (t) lin
Tc
c
r(TI)
E[

g (T) [ F(t)[,
whoio fho socono lino follows Ly Lg. (A0), uno fho fhiio lino holos Locuuso 1[ (T) [ F(t)[ = 1 foi ull T, uno Ly u
chungo of nousuio. Lg. (A) follows Locuuso g is sfufionuiy noun-iovoifing unooi fho iisl-noufiul pioLuLilify.
1o show fhuf Lg. (A7) holos, wo nooo fo show fhuf fho oilusion puif of c

in Lg. (A8) is u nuifingulo, nof

only u locul nuifingulo, which if ooos whonovoi foi ull T,
1
__
T
I
_
_
_Q(g (t))

A(t)

_
_
_
2
ot
_
< o,
which is fho conoifion in (A2).
B. Proofs for Section 3
Henarks on notatIon: Hoiouffoi, wo lof Avui uno Acov oonofo fho pioLuLilify linifs of fho vuiiunco uno
covuiiunco opoiufois, iospocfivoly. Lof u Lo u n1 vocfoi, whoio ouch olononf ooponos on sono i1 puiunofoi
vocfoi 0. Wo oofno: fho i n nufiix \
0
u =
Ou
>
O
; |u|

=
_
_
u

u
_

, foi sono scului j 0; uno [u[

2
= uu

,
fho oufoi piooucf of u. Finully, foi uny n i nufiix , wo sof [[ =

n
.=1

r
=1
[o
.,
[.
B.1. Proofs of Propositions 2, 3 and 4
1ho sofs 4 uno G in Socfions 8.1 uno 8.2 uio oofnoo us:
4 = | : 1ho inoguulify in (A1) holos, r
.
0, uno r
.
r

r
.
r

0, i, ) = 1, 2 uno i ,= ) ,
uno
G = |0 : 1ho inoguulify in (A1) holos foi i = 8, uno r
3
0 .
Fuifhoinoio, wo lof
0
uno 0
0
Lo fho solufions fo fho fwo linif pioLlons,

0
= uig nin

0
plin
Tc,0
_
_
_
_
_
1
1
1

I=1

T,,I
()
T
_
_
_
_
_
2
,
28
uno
0
0
= uig nin

0
plin
Tc,0
_
_
_
_
_
1
1
1

I=1

u
T,,I
(0)

u
T
_
_
_
_
_
2
,
whoio 4
0
uno G
0
uio conpucf sofs of 4 uno G, iospocfivoly. Finully, wo oofno fho linif pioLlon foi fho osfinufoi
of fho iisl-pioniun puiunofois,
X
0
= uig nin

0
plin
7 c,0
_
_
_
_
_
1
1
1

I=1

)
7 ,,I
(

T
,

0
T
, X)

)
7
_
_
_
_
_
2
.
Wo uio now iouoy fo piovo fho pioposifions in Socfion 8. 1ho following ussunpfion sunnuiizos fho piopoifios
of fho oufu gonoiufing nochunisn wo ioly on.
AssuntIon H1: (i) Conoifions (i) uno (ii) in Apponoix A holo foi i = 1, 2, 8; (ii) 1ho sunplo oLsoivufions foi
fho nucioocononic fucfois
1
(t),
2
(t) uio gonoiufoo Ly Lg. (1S) foi ) = 1, 2; (iii) As foi Lg. (1S), foi i, ) = 1, 2
i ,= ), r
.
r

r
.
r

0 uno foi ull i = 1, 2, 8 r

.
0; (iv) 1ho sunplo oLsoivufions foi fho sfocl nuilof inoox c(t)
uio gonoiufoo Ly Lg. (21); (v) 1ho iisl-pioniun vocfoi r(g) uno fho oivioono vocfoi c (g) uio oofnoo us in Lgs.
(10) uno (20).
Proof of Proposition 2
!y fho conoifions in Assunpfions !1(i) uno !1(ii), (
1
(t),
2
(t)) uonifs u uniguo sfiong solufion, uno hus u posifivo-
oofnifo covuiiunco nufiix wifh pioLuLilify ono. Assunpfion !1(iii) onsuios fhuf (
1
(t),
2
(t)) is goonofiicully
oigooic uno fho slolofon (
1,I
,
2,I
) is goonofiicully ,-nixing. Fuifhoi, Ly Glussoinun uno Kin (200S), fho
sfufionuiy oisfiiLufion of (
1
(t),
2
(t)) uno (
1,I
,
2,I
) hus oxpononfiul fuils, which onsuios fhuf fhoio uio onough
fnifo nononfs foi fho unifoin luw of luigo nunLois uno fho confiul linif fhooion fo upply. !y fho suno uigunonf,
foi uny 4
0
, fho sinulufoo slolofon (

1,I,,I
,

2,I,,I
) is ulso goonofiicully ,-nixing, wifh sfufionuiy oisfiiLufion
huving oxpononfiul fuils. Finully, givon Lg. (1S), (

1,I,,I
,

2,I,,I
) is uf lousf fwico confinuously oiloionfiuLlo in
uny opon noighLoihooo of
0
.
Wo cluin fhuf

0
= o

(1), which follows Ly fho usuul uigunonfs iolying on uniguo ioonfifuLilify (onsuioo
Ly fho piovious piopoifios of fho oilusion in Lg. (1S) uno ifs sinulufoo slolofon), uno fho unifoin luw of luigo
nunLois. Noxf, Ly fho fisf oiooi conoifions uno u noun-vuluo oxpunsion uiouno
0
,
0 = \

_
1
1

1
I=1

T,,I
(

T
)
_

_
1
1

1
I=1

T,,I
(

T
)
T
_
= \

_
1
1

1
I=1

T,,I
(

T
)
_

_
1
1

1
I=1

T,,I
(
0
)
T
_
\

_
1
1

1
I=1

T,,I
(

T
)
_

_
1
1

1
I=1

T,,I
(

T
)
__

T

0
_
,
whoio

T
is sono convox conLinufion of

T
uno
0
. Lof
1
1
(
0
) = 1
1
= plin \

_
1
1

1
I=1

T,,I
(
0
)
_
.
!y fho unifoin luw of luigo nunLois, sup

_
1
1

1
I=1

T,,I
()
_
1
1
()

= o

(1), uno us

T

0
=
o

(1), \

_
1
1

1
I=1

T,,I
(

T
)
_
1
1
= o

(1). Honco,
_
T
_

T

0
_
=
_
1

1
1
1
_
1
1

1
_
_
T
_
1
1

1
I=1

T,,I
(
0
)
0
_

_
T (
T

0
)
_
o

(1).
Lof
T,I
(
0
) Lo fho unfousiLlo osfinufoi, oLfuinoo Ly sinulufing confinuous pufhs foi

(t), i.o.

0
,I,I
, ) = 1, 2.
Wo cluin fhuf foi I = 1, , 1,
_
T
_

T,,I
(
0
)
T,I
(
0
)
_
= o

(1).
Lof 1

0
I,,I
Lo fho vocfoi confuining ull fho iogiossois in Lg. (26), uno lof
1,T,,I
(
0
) Lo fho puiunofoi osfinufoi
of fho OLS iogiossion of

0
1,I,,I
on 1

0
I,,I
. Wo huvo:
_
T
_

1,T,,I
(
0
)
1,T,I
(
0
)
_
20
=
_
1
T
T

I=25
1

0
I,I
1

I,I
_
1
_
T
_
1
T
T

I=25
_
1

0
I,,I

0
1,I,,I
1

0
I,I

0
1,I,I
_
_

_
T
_
_
_
1
T
T

I=25
1

0
I,,I
1

I,,I
_
1

_
1
T
T

I=25
1

0
I,I
1

I,I
_
1
_
_
_
1
T
T

I=25
1

0
I,,I

0
1,I,,I
_
. (!1)
As foi fho fisf foin on fho HHS of (!1),
_
1
T

T
I=25
1

0
I,I
1

I,I
_
1
= O

(1), uno Ly 1hooion 2.8 in Iuiooux uno

1uluy (10S), wo huvo, foi - 0 uno
_
T. 0,
Ii
_

1
_
T
T

I=25
_
1

0
I,,I

0
1,I,,I
1

0
I,I

0
1,I,I
_

-
_
<
1
-
_
TL
_

0
I,,I

0
1,I,,I
1

0
I,I

0
1,I,I

_
=
_
TO(.) = o(1).
1ho socono foin on fho iighf huno sioo of Lg. (!1) cun Lo ooulf wifh siniluily. 1hus, wo huvo:
Avui
_
_
T
_

T

0
__
=
_
1

1
1
1
_
1
1

1
Avui
_
_
T
_
1
1

1
I=1

T,I
(
0
)
0
_

_
T (
T

0
)
_
1
1
_
1

1
1
1
_
1
,
whoio,
Avui
_
_
T
_
1
1

1
I=1

T,I
(
0
)
0
_

_
T (
T

0
)
_
= Avui
_
_
T
_
1
1

1
I=1

T,I
(
0
)
0
__
Avui
_
_
T (
T

0
)
_
2Acov
_
_
T
_
1
1

1
I=1

T,I
(
0
)
0
_
,
_
T (
T

0
)
_
.
1ho lusf foin of fho iighf huno sioo of fhis oguulify is zoio, Locuuso fho sinulufoo pufhs uio inooponoonf of fho
sunplo pufhs. Moioovoi, fho sinulufoo pufhs uio inooponoonf uno ioonficully oisfiiLufoo ucioss ull sinulufion
ioplicufions uno, honco,
Avui
_
_
T
_
1
1

1
I=1

T,I
(
0
)
0
__
=
1
1
2
1

I=1
Avui
_
_
T
_

T,I
(
0
)
0
_
_

1
1
2
1

I=1
1

I
0
,=I
Acov
_
_
T
_

T,I
(
0
)
0
_
,
_
T
_

T,I
0 (
0
)
0
_
_
=
1
1
Avui
_
_
T
_

T,I
(
0
)
0
_
_
, foi ull I.
Finully, givon Assunpfion !1(ii),
J
1
= Avui
_
_
T (
T

0
)
_
= Avui
_
_
T
_

T,,I
(
0
)
0
_
_
, foi ull I,
uno so
Avui
_
_
T
_

T

0
__
=
_
1
1
1
_
_
1

1
1
1
_
1
1

1
J
1
1
1
_
1

1
1
1
_
1
.
1ho pioposifion follows Ly fho confiul linif fhooion foi goonofiicully sfiong nixing piocossos.
Proof of Proposition 3
!y fho suno uigunonfs ufilizoo in fho pioof of Iioposifion 2,
_
T
_

0
T
0
0
_
=
_
1

2
1
2
_
1
1

2
_
_
T
_
1
1

1
I=1

u
T,,I
(0
0
) u
0
_

_
T
_

u
T
u
0
__
o

(1),
whoio
1
2
= plin \
0
_
1
1

1
I=1

u
T,,I
(0
0
)
_
.
1hoiofoio:
Avui
_
_
T
_

0
T
0
0
__
=
_
1

2
1
2
_
1
1

2
J
0
1
2
_
1

2
1
2
_
1
,
80
whoio
J
0
= Avui
_
_
T
_
1
1

1
I=1

u
T,,I
(0
0
) u
0
__
Avui
_
_
T
_

u
T
u
0
__
2Acov
_
_
T
_
1
1

1
I=1

u
T,,I
(0
0
) u
0
_
,
_
T
_

u
T
u
0
__
.
Lof

u
T,I
(0
0
) Lo fho fho unfousiLlo osfinufoi, oLfuinoo Ly sinulufing confinuous pufhs foi fho unoLsoivuLlo fucfoi
Z (t). !y fho suno uigunonfs us fhoso in fho pioof of Iioposifion 2,
Avui
_
_
T
_
1
1

1
I=1

u
T,,I
(0
0
) u
0
__
= Avui
_
_
T
_
1
1

1
I=1

u
T,I
(0
0
) u
0
__
.
Iufhs foi fho noool-Lusoo sfocl piico uio oLfuinoo fhiough fho sunplo pufhs foi fho oLsoivuLlo fucfois
1,I
,
2,I
.
1hoiofoio, sinulufoo pufhs uio nof inooponoonf ucioss sinulufions, uno uio nof inooponoonf of fho ucfuul sunplo
pufhs of sfocl piico uno volufilify. Wo huvo:
Avui
_
_
T
_
1
1

1
I=1

u
T,I
(0
0
) u
0
__
=
1
1
Avui
_
_
T
_

u
T,1
(0
0
) u
0
__

1
1
2
1

I=1
1

I
0
=1,I
0
,=I
Acov
_
_
T
_

u
T,I
(0
0
) u
0
_
,
_
T
_

u
T,I
0 (0
0
) u
0
__
=
1
1
J
2

1(1 1)
1
2
1
2
,
whoio
J
2
= Avui
_
_
T
_

u
T
u
0
__
= Avui
_
_
T
_

u
T,,I
(0
0
) u
0
__
, foi ull I,
uno
1
2
=
1
1 (1 1)
1

I=1
1

I
0
=1,I
0
,=I
Acov
_
_
T
_

u
T,I
(0
0
) u
0
_
,
_
T
_

u
T,I
0 (0
0
) u
0
__
= Acov
_
_
T
_

u
T,1
(0
0
) u
0
_
,
_
T
_

u
T,2
(0
0
) u
0
_

_
.
1hoiofoio, using fho fucf fhuf Avui
_
_
T
_

u
T
u
0
__
= Avui
_
_
T
_

u
T,1
(0
0
) u
0
__
= J
2
, uno oxploifing fho
oxpiossion foi J
0
, wo oLfuin:
J
0
=
1
1
J
2

1(1 1)
1
2
1
2
J
2
21
2
=
_
1
1
1
_
(J
2
1
2
) ,
uno, honco:
Avui
_
_
T
_

0
T
0
0
__
=
_
1
1
1
_
_
1

2
1
2
_
1
1

2
(J
2
1
2
) 1
2
_
1

2
1
2
_
1
.
Details on the simulations of the VIX index predicted by the model
Wo consfiucf u sinulufoo soiios of longfh T foi fho \IX inoox, uf u nonfhly fioguoncy. Sinco wo oo nof huvo
u closoo-foin foinulu foi fho \IX inoox, wo nooo fo iosoif fo nunoiicul nofhoos uining fo uppioxinufo if. Wo
uooioss fhis issuo Ly sinulufing fho fhioo fucfois uf u ouily fioguoncy, which wo fhon uso fo nunoiicully infogiufo
fho ouily volufilifios. Foi ouch sinulufion oiuw I = 1, , 1, wo inifiulizo ouch nonfhly pufh uf fho vuluos fulon
Ly fho oLsoivuLlo nucioocononic fucfois, i.o. uf
1,I
,
2,I
, t = T T , , T 1, uno uf fho nonfhly unconoifionul
noun of fho unoLsoivuLlo fucfoi. Foi i = 1, 2, 8, I = 1, , 1, I = 0, ,

.
1
1, lof
A
.,I+I
^
,I
Lo fho vuluo of fho
i-fh fucfoi, uf fino t I

., foi fho I-fh sinulufion unooi fho iisl-noufiul pioLuLilify, poifoinoo wifh puiunofoi
X A
0
uno ionuining puiunofois fxoo uf fhoii osfinufos oLfuinoo in fho fisf uno socono sfop of oui osfinufion
piocoouio.

. will Lo oofnoo in u nononf. Sinulufions uio oLfuinoo fhiough u Milsfoin uppioxinufion fo fho
iisl-noufiul voision of Lg. (1S),
o
.
(t) = [r
.
(j
.

.
(t)) r
.
( j
.

.
(t)) (
.
)[ ot
_
c
.
,
.

.
(t)o
`
W
.
(t) , i = 1, 2, 8,
81
whoio (
.
) oonofos fho i-fh olononf of fho vocfoi r(g) in Lg. (10), uno
`
W
.
is u sfunouio !iowniun nofion unooi
fho iisl-noufiul pioLuLilify. Wo uso fho oisciofizufion sfop

. = .22, whoio . is fho oisciofizufion sfop usoo in
fho fisf uno fho socono sfop of oui osfinufion piocoouio Givon Lgs. (21)-(24), fho noool-Lusoo volufilify unooi
fho iisl-noufiul nousuio, uf fho )-fh sinulufion, is:
o
2
I+I
^
,I
(

0
T
,

T
, X) =

3
.=1
c
2
.,T
_
c
.,T


,
.,T

A
.,I+I
^
,I
_
` c
2
I+I
^
,I
(

0
T
,

T
, X)
, (!2)
whoio
` c
I+I
^
,I
(

0
T
,

T
, X) = c
0,T

3

.=1
c
.,T

A
.,I+I
^
,I
, (!8)
uno c
I,T
| = 0, , 8 uio fho iooucoo-foin puiunofois oLfuinoo in sfop 2 of fho osfinufion piocoouio. Finully,
wo conpufo fho sinulufoo vuluo of fho noool-Lusoo \IX, \IX
I,
^
,I
(

0
T
,

T
, X), Ly infogiufing volufilify ovoi ouch
nonfh, us follows:
\IX
I,
^
,I
(

0
T
,

T
, X) =

_
1

.
^

1
1

I=0
o
2
I+(I+1)
^
,I
(

0
T
,

T
, X). (!4)
!y iopoufing fho suno piocoouio ouflinoo uLovo 1 finos, wo cun fhon gonoiufo 1 pufhs of longfh T . Fion now
on, wo sinplify nofufion uno inoox ull puiunofoi osfinufois uno sinulufoo fucfois Ly ., iufhoi fhun

..
Proof of Proposition 4
Givon Assunpfions !1(i) uno !1(iii), foi uny X in u conpucf sof A
0
,
A
.,I+(I+1),I
, i = 1, 2, 8, I = 1, , 1, is
goonofiicully ,-nixing, uno hus u sfufionuiy oisfiiLufion wifh oxpononfiul fuils. 1hus, Ly Lgs. (!2), (!8) uno
(!4), \IX
I,,I
(0
0
,
0
, X
0
) is ulso goonofiicully ,-nixing wifh oxpononfiul fuils. 1hoiofoio, \IX
I,,I
(0
0
,
0
, X
0
)
hus onough fnifo nononfs fo sufisfy sumcionf conoifions foi fho luw of luigo nunLois uno fho confiul linif fhooion
fo upply. Noxf, nofo fhuf \IX
I,,I
(0, , X) is confinuously oiloionfiuLlo in fho infoiioi of 4
0
G
0
A
0
uno,
honco, fho unifoin luw of luigo nunLois ulso upplios. Wo nuy now piocooo wifh u pioof fhuf follows fho gonoiul
linos of Iioposifions 2 uno 8, pioviooo wo fulo info uccounf fho confiiLufion of puiunofoi osfinufion oiioi, uiising
Locuuso fho iisl-noufiul pufhs of fho fucfois uio gonoiufoo using

T
uno

0
T
, nof fho unlnown
0
uno 0
0
.
Givon fho fisf oiooi conoifions, uno u noun vuluo oxpunsion uiouno X
0
,
_
T
_

X
7
X
0
_
=
_
\
A
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
,

X
7
)
_

\
A
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
,

X
7
)
_
_
1
\
A
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
,

X
7
)
_
_
T
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
, X
0
)

)
7
_
,
whoio

X
7
is sono convox conLinufion of

X
7
uno X
0
. Lof
1
3
(
0
, 0
0
, X
0
) = 1
3
= plin
7 c
\
A
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
)
_
.
Givon Iioposifions 2 uno 8, Ly fho unifoin luw of luigo nunLois, wo huvo fhuf

X
7
X
0
= o

(1) uno, ulso,

sup

0
,
0
,
0

\
A
_
1
1

1
I=1

)
7 ,,I
(, 0, X)
_
1
3
(, 0, X)

= o

(1). 1hoiofoio, wo huvo fhuf

\
A
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
,

X
T
)
_
1
3
= o

(1), uno, honco,

_
T
_

X
7
X
0
_
=
_
1

3
1
3
_
1
1

3
_
_
T
_
1
1

1
I=1

)
7 ,I
(

T
,

0
T
, X
0
) )
0
_

_
T
_

)
7
)
0
__
o

(1).
Wo huvo,
_
T
_
1
1
1

I=1

)
7 ,,I
(

T
,

0
T
, X
0
) )
0
_
82
=
_
T
_
1
1
1

I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_

_
T
_
1
1
1

I=1
_

)
7 ,,I
(

T
,

0
T
, X
0
)

)
7 ,,I
(

T
, 0
0
, X
0
)
_
_

_
T
_
1
1
1

I=1
_

)
7 ,,I
(

T
, 0
0
, X
0
)

)
7 ,,I
(
0
, 0
0
, X
0
)
_
_
=
_
T
_
1
1
1

I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
\
0
_
1
1
1

I=1

)
7 ,,I
(

T
,

0
T
, X
0
)
_
_
T
_

0
T
0
0
_
\

_
1
1
1

I=1

)
7 ,,I
_

T
, 0
0
, X
0
_
_
_
T
_

T

0
_
=
_
T
_
1
1
1

I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_

_
1

0
0
_
T
_

0
T
0
0
_

_
1

0
_
T
_

T

0
_
o

(1),
whoio = lin
T,7 c
T T,

0
T
uno

T
uio convox conLinufions of

0
T
, 0
0
, uno

T
,
0
, iospocfivoly, uno:
1

0
0
= plin
T,7 c
\
0
_
1
1

1
I=1

)
7 ,,I
(

T
,

0
T
, X
0
)
_
uno 1

0
= plin
T,7 c
\

_
1
1

1
I=1

)
7 ,,I
(

T
, 0
0
, X
0
)
_
.
1hoiofoio, wo huvo:
Avui
_
_
T
_

X
7
X
0
__
=
_
1

3
1
3
_
1
1

3
J
00
1
3
_
1

3
1
3
_
1
,
whoio
J
00
= Avui
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
__
Avui
_
_
T
_

)
7
)
0
__
2Acov
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
,
_
T
_

)
7
)
0
__
1

0
0
Avui
_
_
T
_

0
T
0
0
__
1
0
0
1

0
Avui
_
_
T
_

T

0
__
1

0
2Acov
_
1

0
_
T
_

T

0
_
, 1

0
0
_
T
_

0
T
0
0
__
2
_
Acov
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
, 1

0
_
T
_

T

0
__
2
_
Acov
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
, 1

0
0
_
T
_

0
T
0
0
__
2
_
Acov
_
_
T
_

)
7
)
0
_
, 1

0
_
T
_

T

0
__
2
_
Acov
_
_
T
_

)
7
)
0
_
, 1

0
0
_
T
_

0
T
0
0
__
.
Lof

)
7 ,I
(

T
,

0
T
, X
0
) Lo fho osfinufoi oLfuinoo in fho cuso wo conpufoo fho noool-Lusoo \IX using sinulufoo
pufhs foi fho unoLsoivuLlo fucfoi Z
0
u
I,,I
. !y un uigunonf sinilui fo fhuf in Iioposifion 2,
Avui
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
__
= Avui
_
_
T
_
1
1

1
I=1

)
7 ,I
(
0
, 0
0
, X
0
) )
0
__
.
!y fho suno uigunonf us in Iioposifion 8,
Avui
_
_
T
_
1
1

1
I=1

)
7 ,I
(
0
, 0
0
, X
0
) )
0
__
Avui
_
_
T
_

)
7
)
0
__
2Acov
_
_
T
_
1
1

1
I=1

)
7 ,I
(
0
, 0
0
, X
0
) )
0
_
,
_
T
_

)
7
)
0
__
=
_
1
1
1
_
(J
3
1
3
) ,
whoio
J
3
= Avui
_
_
T
_

)
7
)
0
__
= Avui
_
_
T
_

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
__
, foi ull I,
uno
1
3
= Acov
_
_
T
_

)
7 ,1
(
0
, 0
0
, X
0
) )
0
_
,
_
T
_

)
7 ,2
(
0
, 0
0
, X
0
) )
0
_

_
.
88
Honco, givon Iioposifions 2 uno 8,
Avui
_
_
T
_

X
T
X
0
__
=
_
1

3
1
3
_
1
1

3
__
1
1
1
_
(J
3
1
3
) 1
3
_
1
3
_
1

3
1
3
_
1
,
whoio
1
3
= 1

0
0
Avui
_
_
T
_

0
T
0
0
__
1
0
0
1

0
Avui
_
_
T
_

T

0
__
1

0
2Acov
_
1

0
_
T
_

T

0
_
, 1

0
0
_
T
_

0
T
0
0
__
2
_
Acov
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
, 1

0
_
T
_

T

0
__
2
_
Acov
_
_
T
_
1
1

1
I=1

)
7 ,,I
(
0
, 0
0
, X
0
) )
0
_
, 1

0
0
_
T
_

0
T
0
0
__
2
_
Acov
_
_
T
_

)
7
)
0
_
, 1

0
_
T
_

T

0
__
2
_
Acov
_
_
T
_

)
7
)
0
_
, 1

0
0
_
T
_

0
T
0
0
__
.
B.2. Bootstrap estimates of the standard errors
Wo oiuw 1 ovoilupping Llocls of longfh |, wifh T = 1|, of
^
I
= (
1,I
, ,
1,II
1
,
2,I
, ,
2,II
2
,
o
I
, , o
II
3
),
whoio I
1
, I
2
, I
3
oopono on fho lugs wo uso in fho uuxiliuiy noools. 1ho io-sunploo oLsoivufions uio:
^
+
I
= (
+
1,I
, ,
+
1,II
1
,
+
2,I
, ,
+
2,II
2
,
o
+
I
, , o
+
II
3
).
Lof 1
+
Lo fho pioLuLilify nousuio govoining fho io-sunploo soiios, ^
+
I
, uno lof L
+
, vui
+
oonofo fho noun uno fho
vuiiunco fulon wifh iospocf fo 1
+
, iospocfivoly. Fuifhoi O
+

(1) uno o
+

(1) oonofo, iospocfivoly, u foin Lounooo in

pioLuLilify, uno convoiging fo zoio in pioLuLilify, unooi 1
+
, conoifionul on fho sunplo uno foi ull sunplos Luf u
sof of pioLuLilify nousuio uppiouching zoio.
Bootstrap Standard Errors for
1ho sinulufoo sunplos foi
1,I
uno
2,I
uio inooponoonf of fho ucfuul sunplos uno uio ulso inooponoonf ucioss
sinulufion ioplicufions. Also, us sfufoo in Iioposifion 2, fho osfinufois of fho uuxiliuiy noool puiunofois, Lusoo
on ucfuul uno sinulufoo sunplos, huvo fho suno usynpfofic vuiiunco. Honco, fhoio is no nooo fo io-sunplo fho
sinulufoo soiios.
Givon fhuf fho nunLoi of uuxiliuiy noool puiunofois uno nononf conoifions is luigoi fhun fho nunLoi of
puiunofois fo Lo osfinufoo, wo nooo fo uso un uppiopiiufo io-confoiing foin. In fho ovoi-ioonfifoo cuso, ovon if
fho populufion nononf conoifions huvo noun zoio, fho Loofsfiup nononf conoifions oo nof huvo noun zoio, uno
u honco piopoi io-confoiing foin is nocossuiy (soo, o.g., Hull uno Hoiowifz (1006)).
Lof
+
T,.
Lo fho Loofsfiup unulog fo
T
uf oiuw i, uno oofno:

+
T,.
= uig nin

0
_
_
_
_
_
_
1
1
1

I=1
_

T,,I
()
T,,I
(

T
)
_

_

+
T,.

T
_
__
_
_
_
_
2
, i = 1, , 1.
Wo conpufo fho Loofsfiup covuiiunco nufiix, us follows:

V
1,T,T
=
T
1
T

.=1

+
T,.

1
1
T

.=1

+
T,.

2
.
1ho noxf pioposifion shows fhuf
_
1
1
1
_

V
1,T,T
, is u consisfonf osfinufoi of V
1
, fhoioLy ullowing fo conpufo
usynpfoficully vulio Loofsfiup sfunouio oiiois.
ProosItIon H1: Under the same assumptions of Proposition 2, if |T
12
0 as T, 1, | o, then for all - 0,
Ii
_
. : 1
+
_

_
1
1
1
_

V
1,T,T
V
1

-
__
0.
84
Proof: !y fho fisf oiooi conoifions uno u noun vuluo oxpunsion uiouno

T
,
0 = \

_
1
1

1
I=1

T,,I
(

+
T
)
_

_
1
1

1
I=1
_

T,,I
(

+
T
)
T,,I
(

T
)
_
(
+
T

T
)
_
= \

_
1
1

1
I=1

T,,I
(

+
T
)
_

(
T

+
T
) \

_
1
1

1
I=1

T,,I
(

+
T
)
_

_
1
1

1
I=1

T,,I
(

+
T
)
__

+
T

T
_
,
whoio

+
T
is sono convox conLinufion of

+
T
uno

T
. Honco,
_
T
_

+
T

T
_
=
_
\

_
1
1

1
I=1

T,I
(

+
T
)
_

_
1
1

1
I=1

T,I
(

+
T
)
_
_
1
\

_
1
1

1
I=1

T,I
(

+
T
)
_
_
T (
+
T

T
) .
1ho Iioposifion follows, onco wo show fhuf:
L
+
_
_
T (
+
T

T
)
_
= o

(1), (!)
vui
+
_
_
T (
+
T

T
)
_
= vui
_
_
T (
T

0
)
_
O

(|
_
T), (!6)
uno foi - 0,
L
+
_
_
_
T |
+
T

T
|
_
2+s
_
= O

(1). (!7)
Inoooo, unooi conoifions (!)-(!6), wo huvo fhuf Ly fho unifoin luw of luigo nunLois,

_
1
1

1
I=1

T,I
(

+
T
)
_
1
1

= o
+

(1). Honco,
_
T
_

+
T

T
_
=
_
1

1
1
1
_
1
1

1
_
T (
T

+
T
) o
+

(1).
uno, givon (!6), uno ioculling fhuf |
_
T 0,
vui
+
_
_
T (
+
T

T
)
_
= Avui
_
_
T (
T

0
)
_
o

(1).
Givon (!7), fho sfufononf follows Ly 1hooion 1 in Gonculvos uno Whifo (200).
Lof us show (!), (!6) uno (!7). Wo huvo,
_
T (
+
T

T
) =
_
T
__

+
1,T

1,T
_
,
_

+
2,T

2,T
_
, (
+
1

1
) , (
+
2

2
) ,
_
o
+2
1
o
2
1
_
,
_
o
+2
2
o
2
2
__

.
Sinco ouch conpononf of
_
T (
+
T

T
) cun Lo ooulf wifh in fho suno wuy, wo only consiooi
_
T
_

+
1,T

1,T
_
. Lof 1
I
Lo fho vocfoi confuining ull fho iogiossois in Lg. (2), uno 1
+
I
Lo ifs Loofsfiup
counfoipuif. !y fho fisf oiooi conoifions,
_
T
_

+
1,T

1,T
_
=
_
1
T
T

I=25
1
+
I
1
+
I
_
1
1
_
T
T

I=25
1
+
I
_

+
1,I
1
+
I

1,T
_
=
_
L(1
I
1

I
)
_
1
1
_
T
T

I=25
1
+
I
_

+
1,I
1
+
I

1,T
_
o
+

(1),
us
1
T

T
I=25
1
+
I
1
+
I
L
+
_
1
T

T
I=25
1
+
I
1
+
I
_
= o
+

(1), uno L
+
_
1
T

T
I=25
1
+
I
1
+
I
_
=
1
T

T
I=25
1
I
1

I
O

(|T) =
L
_
1
I
1

I
_
o

(1). Wo huvo,
L
+
_
_
T
_

+
1,T

1,T
_
_
= L(1
I
1

I
)
1
T
T

I=25
1
I
_

1,I
1

I

1,T
_
O

(|
_
T) = o

(1).
1his piovos (!). Noxf,
vui
+
_
_
T
_

+
1,T

1,T
_
_
8
=
_
L
+
(1
I
1

I
)
_
1
vui
+
_
1
T
T

I=25
1
+
I
_

+
1,I
1
+
I

1,T
_
_
_
L
+
(1
I
1

I
)
_
1
o

(1)
=
_
L(1
I
1

I
)
_
1
_
_
1
T
I

=I
TI

I=25+I
1
I
1

I
`c
1,I
`c
1,I
_
_
_
L(1
I
1

I
)
_
1
o

(1)
= Avui
_
_
T
_

1,T

1,0
_
_
o

(1),
whoio `c
1,I
=
1,I
1

I

1,T
. 1his piovos (!6). Finully, us
1
T

T
I=25
1
I
1

I
is full iunl, Ly fho suno uigunonf usoo
uLovo, foi u gonoiic consfunf C, uno - 0,
L
+
_
_
_
T |
+
T
|
_
2+s
_
C
_
_
_
_
_
1
_
T
T

I=25
1
I
_

1,I
1

I

1,T
_
_
_
_
_
_
2+s
= O

(1).
1his piovos (!7).
Bootstrap Standard Errors for 0
1ho noool-Lusoo sfocl piico soiios is sinulufoo using fho ucfuul sunplos of fho oLsoivuLlo fucfois, uno sinulufoo
sunplos foi fho unoLsoivuLlo fucfoi. 1hus, wo nooo fo fulo info uccounf fho confiiLufion of 1
2
, fho covuiiunco
Lofwoon sinulufoo uno sunplo pufhs, us woll us unong pufhs uf oiloionf sinulufion ioplicufions.
Consfiucf fho io-sunploo sinulufoo sfocl piico soiios us:
c
0,+
I,,I
= c
0
c
1

+
1,I
c
2

+
2,I
Z
0
u
,+
I,,I
, (!S)
whoio Z
0
u
,+
I,,I
is io-sunploo fion fho sinulufoo unoLsoivuLlo piocoss Z
0
u
I,,I
, uno uso c
0,+
I,,I
fo consfiucf 1
+
I,,I
(0)
uno \ol
+
I,,I
(0). Dofno,

u
+
T
=
_

u
+
1,T
,

u
+
2,T
,

1
+
, \ol
+
_

,
whoio

u
+
1,T
,

u
+
2,T
uio fho osfinufois of fho uuxiliuiy noools oLfuinoo using io-sunploo oLsoivufions, uno 1
+
, \ol
+
uio fho sunplo nouns of 1
+
I
= ln(o
+
I
o
+
I12
) uno \ol
+
I
=
_
6
1
12

12
.=1
[ln (o
+
I+1.
o
+
I.
)[, wifh o
+
I
Loing fho
io-sunploo soiios of fho oLsoivuLlo sfocl piico piocoss o
I
, uno

u
+
T,,I
(0) =
_

u
+
1,T,,I
(0) ,

u
+
2,T,,I
(0) ,

1
+
,I
(0), \ol
+
,I
(0)
_

,
whoio

u
+
1,T,,I
(0) uno

u
+
2,T,,I
(0) uio fho puiunofois of fho uuxiliuiy noools osfinufoo using io-sunploo sinulufoo
oLsoivufions, uno 1
+
,I
(0), \ol
+
,I
(0) uio fho sunplo nouns of 1
+
I,,I
(0) uno \ol
+
I,,I
(0). Dofno:

0
+
T,.
= uig nin

0
_
_
_
_
_
1
1
1

I=1
_

u
+
T,,I,.
(0)

T,I
(

0
T
)
_

u
+
T,.

u
T
_
_
_
_
_
_
2
, i = 1, , 1,
whoio

u
+
T,,I,.
(0) uno

u
+
T,.
oonofo fho vuluos of

u
+
T,,I
(0) uno

u
+
T
u f fho i-fh Loofsfiup ioplicufion. 1ho
Loofsfiup covuiiunco nufiix is:

V
2,T,T
=
T
1
T

.=1

0
+
T,.

1
1
T

.=1

0
+
T,.

2
.
1ho noxf pioposifion shows fhuf
_
1
1
1
_

V
2,T,T
is u consisfonf osfinufoi of V
2
, uno cun fhon Lo usoo fo
oLfuin usynpfoficully vulio Loofsfiup sfunouio oiiois.
ProosItIon H2: Under the same assumptions of Proposition 3, if |T
12
0 as T, 1, | o, then, for all
- 0,
Ii
_
. : 1
+
_

_
1
1
1
_

V
2,T,T
V
2

-
__
0.
Proof: !y fho fisf oiooi conoifions uno u noun vuluo oxpunsion uiouno

0
T
,
0 = \
0
_
1
1

1
I=1

u
+
T,,I
(

0
+
T
)
_

_
1
1

1
I=1
_

u
+
T,,I
(

0
+
T
)

u
T,,I
(

0
T
)
_

u
+
T

u
T
__
86
= \
0
_
1
1

1
I=1

u
+
T,,I
(

0
+
T
)
_

_
1
1

1
I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
_

u
+
T

u
T
__
\
0
_
1
1

1
I=1

u
+
T,,I
(

0
+
T
)
_

\
0
_
1
1

1
I=1

u
+
T,,I
_

0
+
T
_
__

0
+
T

0
T
_
,
whoio

0
+
T
is u convox conLinufion of (

0
+
T
,

0
T
). Honco,
_
T
_

0
+
T

0
T
_
=
_
\
0
_
1
1

1
I=1

u
+
T,,I
(

0
+
T
)
_

\
0
_
1
1

1
I=1

u
+
T,,I
_

0
+
T
_
_
_
1
\
0
_
1
1

1
I=1

u
+
T,,I
(

0
+
T
)
_
_
T
_
1
1

1
I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
_

u
+
T

u
T
__
.
Wo nooo fo show fhuf:
L
+
_
_
T
_
1
1

1
I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
___
= o

(1), (!0)
vui
+
_
_
T
_
1
1

1
I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
___
= vui
_
_
T
_
1
1

1
I=1
_

u
T,,I
(

0
T
) (0
0
)
___
o

(1), (!10)
uno foi ull - 0,
L
+
_
_
_
_
_
T
_
1
1

1
I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
___
_
_
2+s
_
< o. (!11)
1ho sfufononf in fho Iioposifion follows Ly fho suno uigunonf us fhuf in fho pioof of Iioposifion !2. Nofo fhuf,
_
T
_
1
1
1

I=1
_

u
+
T,,I
(

0
T
)

u
T,,I
(

0
T
)
_
_
=
_
_
_
_
_
_
_
_
_
T
_
1
1

1
I=1
_

u
+
1,T,,I
(

0
T
)

u
1,T,,I
(

0
T
)
__
_
T
_
1
1

1
I=1
_

u
+
2,T,,I
(

0
T
)

u
2,T,,I
(

0
T
)
__
_
T
_

1
+
,I
(

0
T
)

1
,I
(

0
T
)
_
_
T
_
\ol
+
,I
(

0
T
) \ol
,I
(

0
T
)
_
_
_
_
_
_
_
_
_
.
Wo only consiooi
_
T
_
1
1

1
I=1
_

u
+
2,T,,I
(

0
T
)

u
2,T,,I
(

0
T
)
__
, us fho ionuining foins cun Lo ooulf wifh in fho
suno nunnoi. Lof L
I,,I
(

0
T
) Lo fho vocfoi confuining ull fho sinulufoo iogiossois in Lg. (81). 1his vocfoi
ooponos on

0
T
Locuuso if incluoos fho sinulufoo volufilify, oLfuinoo wifh puiunofoi vocfoi 0 fxoo uf ifs osfinufo,

0
T
. Lilowiso, lof L
+
I,,I
(

0
T
) Lo fho vocfoi confuining fho Loofsfiup vuluos of ull fho sinulufoo iogiossois in Lg.
(81). 1his vocfoi ooponos on

0
T
Locuuso if incluoos fho Loofsfiuppoo vuluo of fho sinulufoo volufilify in Lg. (81),
which wo oonofo wifh \ol
+
I,,I
(

0
T
). !y fho fisf oiooi conoifions,
L
+
_
_
T
_
1
1

1
I=1
_

u
+
2,T,,I
(

0
T
)

u
2,T,,I
(

0
T
)
___
=
1
1
1

I=1
L
+
_
_
1
T

T
I=13
L
+
I,,I
(

0
T
)L
+
I,,I
(

0
T
)

_
1
1
_
T

T
I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
_
=
1
1
1

I=1
_
1
T

T
I=13
L
I,,I
(

0
T
)L
I,,I
(

0
T
)

_
1
L
+
_
1
_
T

T
I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
__

1
1
1

I=1
L
+
_
_
1
T

T
I=13
L
+
I,,I
(

0
T
)L
+
I,,I
(

0
T
)

_
1

_
1
T

T
I=13
L
I,,I
(

0
T
)L
I,,I
(

0
T
)

_
1
_

_
1
_
T

T
I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
___
= L
+
_
1
+
T,I
_
L
+
_
11
+
T,I
_
,
Wo huvo,
L
+
_
1
+
T,I
_
=
1
1
1

I=1
_
1
T

T
I=13
L
I,,I
(

0
T
)L
I,,I
(

0
T
)

_
1
L
+
_
1
_
T

T
I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
__
87
= O

_
|
_
T
_
= o

(1),
uno us 11
+
T,I
is of snulloi oiooi fhuf 1
+
T,I
, L
+
(11
+
T,I
) = o

(1). 1his piovos (!0). Noxf, wo huvo fhuf foi I = 1, , 1,

L
+
_
_
_
1
T
T

I=13
L
+
I,,I
(

0
T
)L
+
I,,I
(

0
T
)

_
1
_
_
=
_
1
T
T

I=13
L
I,,I
(

0
T
)L
I,,I
(

0
T
)

_
1
o

(1)
=
_
L
_
L
I,,I
(0
0
) L
I,,I
(0
0
)

__
1
o

(1).
1hoiofoio, wo nooo fo show fhuf
vui
+
_
1
1
1

I=1
_
1
_
T
T

I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
__
= Avui
_
1
1
1

I=1
_
1
_
T
T

I=13
L
I,,I
(

0
T
)
_
\ol
I,,I
(

0
T
) L
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
__
o

(1).
!ocuuso fho Llocls uio ull inooponoonf,
vui
+
_
1
1
1

I=1
_
1
_
T
T

I=13
L
+
I,,I
(

0
T
)
_
\ol
+
I,,I
(

0
T
) L
+
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
__
=
1
T
1
1
2
1

I=1
1

I
0
=1
I

=13I
TI

I=13+I
c
I,,I
c
I+,,I
0 L
I,,I
(

0
T
)L
I+,,I
0 (

0
T
)

(1)
= Avui
_
1
1
1

I=1
_
1
_
T
T

I=13
L
I,,I
(0
0
)
_
\ol
I,,I
(0
0
) L
I,,I
(0
0
)

u
2,0
(0
0
)
_
__
o

(1),
whoio c
I,,I
= \ol
I,,I
(

0
T
) L
I,,I
(

0
T
)

u
2,T,,I
(

0
T
). 1his piovos Lg. (!10). Finully, unooi fho puiunofoi
iosfiicfions in Assunpfions !1(i) uno !1(iii),
L
+
_
_
_
_
_
_
_
_
T
_
1
1
1

I=1
_

u
+
2,T,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
__
_
_
_
_
2+s
_
_
=
_
_
_
_
_
1
1
1

I=1
_
1
_
T
T

I=13
L
I,,I
(

0
T
)
_
\ol
I,,I
(

0
T
) L
I,,I
(

0
T
)

u
2,T,,I
(

0
T
)
_
__
_
_
_
_
2+s
= O

(1).
Bootstrap Standard Errors for X
As nonfionoo in fho nuin foxf, fho noool fioo \IX inoox soiios is uvuiluLlo only fion 1000 uno so in fho fhiio
sfop wo huvo u sunplo of longfh T , insfouo of longfh T. 1hus, wo nooo fo io-sunplo
1,I
,
2,I
, o
I
uno \IX
I
fion
fho shoifoi sunplo, using Lloclsizo | uno nunLoi of Llocls 1, so fhuf |1 = T . Also, wo nooo fo io-sunplo fho
unoLsoivuLlo fucfoi fion u sunplo of longfh T , uf fho puiunofoi osfinufo of 0
u
oLfuinoo in fho piovious sfop,

Z
0
u
I,,I
suy. Lof \IX
+
I,,I
(g
+
I
;

+
T
,

0
+
T
, X) Lo fho noool-Lusoo \IX inoox consfiucfoo using
+
1,I
,
+
2,I
uno fho unoLsoivuLlo
fucfoi io-sunploo uf fho Loofsfiup osfinufois

+
T
uno

0
+
T
,

Z
0
u
,+
I,,I
suy. Finully, lof

)
+
7
=
_

)
+
1,7
, \IX
+
, o
+
VIX
_

,
whoio

)
+
1,7
uio fho uuxiliuiy noool puiunofois osfinufoo using
+
1,I
,
+
2,I
, uno \IX
+
I
, wifh \IX
+
I
Loing fho io-sunploo
soiios of fho noool-fioo \IX, uno \IX
+
, o
+
VIX
uio fho sunplo noun uno sfunouio ooviufion of \IX
+
I
, uno:

)
+
7 ,,I
(

0
+
T
,

+
T
, X) =
_

)
+
1,7 ,,I
(

0
+
T
,

+
T
, X), \IX
+
,I
(

0
+
T
,

+
T
, X), ` o
+
,I,VIX
(

0
+
T
,

+
T
, X)
_

,
88
whoio

)
+
1,7 ,,I
(

+
T
,

0
+
T
, X) uio fho uuxiliuiy noool puiunofois osfinufoo using
+
1,I
,
+
2,I
, uno
\IX
+
,I
(

0
+
T
,

+
T
, X) uno ` o
+
,I,VIX
(

0
+
T
,

+
T
, X) uio fho sunplo noun uno sfunouio ooviufion of
\IX
+
I,,I
(

+
T
,

0
+
T
, X). Dofno,

X
+
7
= uig nin

0
_
_
_
_
_
_
1
1
1

I=1
_

)
+
7 ,,I
(

+
T
,

0
+
T
, X)

)
7 ,,I
(

T
,

0
T
,

X
7
)
_

)
+
7


)
7
_
__
_
_
_
_
2
.
Consfiucf fho Loofsfiup covuiiunco nufiix, us

V
3,7 ,T
=
T
1
T

.=1

X
+
7 ,.

1
1
T

.=1

X
+
7 ,.

2
,
whoio

X
+
7 ,.
oonofos fho vuluo of

X
+
7
uf fho i-fh Loofsfiup ioplicufion.
1ho noxf pioposifion is fho counfoipuif fo Iioposifions !1 uno !2. If shows fhuf
_
1
1
1
_

V
3,7 ,T
is u
consisfonf osfinufoi of V
3
, uno cun fhon piovioo usynpfoficully vulio Loofsfiup sfunouio oiiois.
ProosItIon H3: Under the same assumptions of Proposition 4, if |T
12
0 as T, T , 1, | o, then, for all
- 0,
Ii
_
. : 1
+
_

_
1
1
1
_

V
3,7 ,T
V
3

-
__
0.
Proof: Wo oiop fho suLsciipf ., sinco foi .
_
T 0,
_
T
_

)
+
7 ,,I
(, 0, X)

)
+
7 ,I
(, 0, X)
_
= o
+

(1). !y fho
fisf oiooi conoifions uno u noun vuluo oxpunsion uiouno

X
7
,
0 = \
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_

_
1
1

1
I=1
_

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)

)
7 ,I
(

T
,

0
T
,

X
7
)
_

)
+
7


)
7
__
= \
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_

_
1
1

1
I=1
_

)
+
7 ,I
(

+
T
,

0
+
T
,

X
7
)

)
7 ,I
(

T
,

0
T
,

X
7
)
_

)
+
7


)
7
__

_
\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_

\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_
_
_

X
+
7

X
7
_
,
whoio

X
+
7
is sono convox conLinufion of

X
+
7
uno

X
7
. Wo huvo:
_
T
_

X
+
7

X
7
_
=
_
\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_

\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_
_
1
\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_
_
T
_
1
1

1
I=1
_

)
+
7 ,I
(

+
T
,

0
+
T
,

X
7
)

)
7 ,I
(

T
,

0
T
,

X
7
)
_

)
+
7


)
7
__
.
!y fho suno uigunonfs usoo fo show Iioposifions !1 uno !2, uno fho conoifion fhuf T T (0, 1),
_
T
_

+
T

0
_
=
_
T
_

+
T

T
_

_
T
_

T

0
_
= O
+

(1),
uno
_
T
_

0
+
T
0
0
_
=
_
T
_

0
+
T

0
T
_

_
T
_

0
T
0
0
_
= O
+

(1).
1hoiofoio, Ly fho unifoin luw of luigo nunLois,

X
+
7
X
0
=
_

X
+
7

X
7
_

X
7
X
0
_
= o
+

(1) o

(1) = o
+

(1)
uno, honco,
\
A
_
1
1

1
I=1

)
+
7 ,I
(

+
T
,

0
+
T
,

X
+
7
)
_
1
3
= o
+

(1).
!y un uigunonf sinilui fo fhuf in fho pioof of Iioposifion !2,
_
T
_
1
1
1

I=1
_

)
+
7 ,I
(

+
T
,

0
+
T
,

X
7
)

)
7 ,I
(

T
,

0
T
,

X
7
)
_
_
80
=
_
T
_
1
1
1

I=1
_

)
+
7 ,I
(

T
,

0
T
,

X
7
)

)
7 ,I
(

T
,

0
T
,

X
7
)
_
_

1
1
1

I=1
\

)
+
7 ,I
(

+
T
,

0
+
T
,

X
7
)
_
_
T
_

+
T

T
_

1
1
1

I=1
\
0
_

)
+
7 ,I
(

T
,

0
+
T
,

X
7
)
_
_
T
_

0
+
T

0
T
_
o
+

(1)
=
_
T
_
1
1
1

I=1
_

)
+
7 ,I
(
0
, 0
0
, X
0
)

)
7 ,I
(
0
, 0
0
, X
0
)
_
_

_
T 1

0
_

+
T

T
_

_
T 1

0
0
_

0
+
T

0
T
_
o
+

(1).
1hoiofoio, Ly fho suno uigunonf usoo in fho pioof of Iioposifions !1 uno !2, wo cun show fhuf
L
+
_
_
T
_

X
+
7

X
7
__
= o

(1),
uno
vui
+
_
_
T
_

X
+
7

X
7
__
= vui
+
_
_
T
_
1
1

1
I=1
_

)
+
7 ,I
(
0
, 0
0
, X
0
)

)
7 ,I
(
0
, 0
0
, X
0
)
__

_
T 1

0
_

+
T

T
_

_
T 1

0
0
_

0
+
T

0
T
_

)
+
7


)
7
__
= Avui
_
_
T
_
1
1

1
I=1
_

)
7 ,I
(
0
, 0
0
, X
0
) )
0
(
0
, 0
0
, X
0
)
__

_
T 1

0
_

T

0
_

_
T 1

0
0
_

0
T
0
0
_

)
7
)
0
__
o

(1).
uno Ly Minlowsli`s inoguulify, L
+
_
_
_
_
_
T
_

X
+
7

X
7
__
_
_
2+s
_
= O
+

(1), foi sono - 0.

40
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48
Tables
Table 1
Iaiamoloi oslimalos ano Llock-Loolsliap slanoaio oiiois foi lho joinl piocoss of lho lwo
maciooconomic faclois, gioss inlalion, j
1;t
= CII
t
CII
t12
= j
1
(t) ano gioss inousliial
pioouclion giowlh, j
2;t
= II
t
II
t12
= j
2
(t), whoio CII
t
is lho Consumoi piico inoox as of
monlh t, II
t
is lho ioal, soasonally aojusloo inousliial pioouclion inoox as of monlh t, ano:
_
o
1
(t)
o
2
(t)
_
=
_
r
1
r
1
r
2
r
2
_ _
j
1

1
(t)
j
2

2
(t)
_
ot
_ _
c
1
,
1

1
(t) 0
0
_
c
2
,
2

2
(t)
_ _
oW
1
(t)
oW
2
(t)
_
,
whoio \
j
(t), , = 1, 2, aio lwo inooponoonl Liownian molions, ano lho paiamoloi vocloi is

>
=
_
i
j
, j
j
, c
j
, ,
j
, i
j
, , = 1, 2
_
. Iaiamoloi oslimalos aio oLlainoo lhiough lho lisl slop of
lho oslimalion piocoouio sol foilh in Soclion 8.1, iolying on Inoiiocl Infoionco ano Simulaloo
Molhoo of Momonls. Malching conoilions iolalo lo (i) paiamoloi oslimalos foi lho auxiliaiy
Vocloi Auloiogiossivo moools in Lq. (2), ano (ii) lho samplo moan ano slanoaio oovialion
of j
1;t
ano j
2;t
. 1ho Llock-Loolsliap piocoouio foi lho slanoaio oiiois of lho oslimalos is
oovolopoo in Apponoix L.2. 1ho samplo covois monlhly oala foi lho poiioo fiom Januaiy
100 lo DocomLoi 2006.
Lslimalo Slo oiioi
i
1
0.0881 8.468010
4
j
1
1.0870 8.4810
3
c
1
2.220610
4
2.760710
6
,
1
0.610710
7
1.000010
8
i
2
0.844 7.448210
3
j
2
1.041 4.002610
3
c
2
0.040 8.28810
4
,
2
0.0407 8.808010
4
i
1
0.2002 4.80410
3
i
2
1.2878 1.800110
2
44
Table 2
Iaiamoloi oslimalos ano Llock-Loolsliap slanoaio oiiois foi lho slock piico ano lho unoL-
soivaLlo facloi:
: (t) = :
0

3

i=1
:
i
j
i
(t) ,
whoio : (t) is lho ioal slock piico, oLlainoo as lho ialio Lolwoon lho S\I Compounooo inoox
ano lho Consumoi Iiico Inoox; j
1
(t) ano j
2
(t) aio lho oLsoivoo gioss inlalion ano gioss
inousliial pioouclion giowlh, as oolnoo in 1aLlo 1; lnally, j
3
(t) is an unoLsoivoo facloi,
wilh lho following oynamics:
oj
3
(t) = i
3
(j
3
j
3
(t)) ot
_
c
3
,
3
j
3
(t)o\
3
(t) ,
whoio \
3
(t) is a slanoaio Liownian molion, ano is inooponoonl of lho Liownian molions
oiiving lho luclualions of lho lwo maciooconomic faclois j
1
(t) ano j
2
(t). 1ho paiamoloi
vocloi is 0
>
= (i
3
, j
3
, c
3
, ,
3
, :
0
, :
j
, , = 1, 2, 8), whoio lho long iun moan foi lho unoLsoivaLlo
facloi, j
3
, is sol oqual lo ono foi lho puiposo of moool`s ioonlilcalion. Iaiamoloi oslimalos
aio oLlainoo lhiough lho socono slop of lho oslimalion piocoouio sol foilh in Soclion 8.2,
iolying on Inoiiocl Infoionco ano Simulaloo Molhoo of Momonls. Malching conoilions iolalo
lo (i) paiamoloi oslimalos foi lho auxiliaiy moool foi slock ioluins, Lq. (80), ano foi lho
auxiliaiy moool foi slock volalilily, Lq. (81), ano (ii) lho samplo moan ano slanoaio oovialion
of slock ioluins ano volalilily. 1ho Llock-Loolsliap piocoouio foi lho slanoaio oiiois of lho
oslimalos is oovolopoo in Apponoix L.2. 1ho samplo covois monlhly oala foi lho poiioo fiom
Januaiy 100 lo DocomLoi 2006.
Lslimalo Slo oiioi
:
0
0.1270 6.806210
2
:
1
0.0008 4.07010
2
:
2
2.108 1.66810
1
:
3
0.0100 4.61810
3
i
3
0.0002 2.808010
3
j
3
1 iosliicloo
c
3
0.44810
2
8.287710
2
,
3
4.168 2.088
4
Table 3
Iaiamoloi oslimalos ano Llock-Loolsliap slanoaio oiiois foi lho iisk-piomium paiamolois of
lho lolal iisk-piomium piocoss in Lq. (10):

1
(j
1
(t)) = c
1
`
1(1)

_
,
1
`
1(1)
`
2(1)
_
j
1
(t) (inlalion)

2
(j
2
(t)) = c
2
`
1(2)

_
,
2
`
1(2)
`
2(2)
_
j
2
(t) (inousliial pioouclion)

3
(j
3
(t)) = c
3
`
1(3)

_
,
3
`
1(3)
`
2(3)
_
j
3
(t) (unoLsoivaLlo facloi)
whoio j
1
(t) ano j
2
(t) aio lho oLsoivoo gioss inlalion ano gioss inousliial pioouclion giowlh,
as oolnoo in 1aLlo 1, ano j
3
(t) is lho unoLsoivoo facloi. 1ho paiamoloi vocloi is X
>
=
_
`
1(1)
, `
2(1)
, `
1(2)
, `
2(2)
, `
1(3)
, `
2(3)
_
. Iaiamoloi oslimalos aio oLlainoo lhiough lho lhiio slop
of lho oslimalion piocoouio sol foilh in Soclion 8.8, iolying on Inoiiocl Infoionco ano Simulaloo
Molhoo of Momonls. Malching conoilions iolalo lo (i) paiamoloi oslimalos foi lho auxiliaiy
moool foi lho VIX inoox, Lq. (84), ano (ii) lho samplo moan ano slanoaio oovialion of
lho VIX inoox. 1ho Llock-Loolsliap piocoouio foi lho slanoaio oiiois of lho oslimalos is
oovolopoo in Apponoix L.2. 1ho samplo covois monlhly oala foi lho poiioo fiom Januaiy
1000 lo DocomLoi 2006.
Lslimalo Slo oiioi
Inlalion
`
1(1)
`
2(1)
24.640110
2
86.06
81.41010
4.8017
Ino. Iioo.
`
1(2)
`
2(2)
47.088810
1.110
24.0107
0.1677
UnoLs.
`
1(3)
`
2(3)
0.2078
27.718710
0.0274
8.688
46
Figures
Figure 1 Industrial production growth and ination, with NBER dated re-
cession periods. This gure plots the one-year, monthly gross ination, dened as j
1;t

CPI
t
/ CPI
t12
, and the one-year, monthly gross industrial production growth, dened as
j
2;t
IP
t
/ IP
t12
, where CPI
t
is the Consumer price index as of month t, and IP
t
is the real,
seasonally adjusted industrial production index as of month t. The sample covers monthly
data for the period from January 1950 to December 2006. Vertical solid lines (in black) track
the beginning of NBER-dated recessions, and vertical dashed lines (in red) indicate the end
of NBER-dated recessions. The shaded area (in yellow) covers the out-of-sample period, from
January 2007 to March 2009, which we use to formulate models predictions.
47
Figure 2 Stock returns and volatility along with the model predictions, with
NBER dated recession periods, and out-of-sample predictions. This gure plots
one-year ex-post price changes and one-year return volatility, along with their counterparts
predicted by the model. The top panel depicts continuously compounded price changes,
dened as 1
t
ln( :
t
/ :
t12
), where :
t
is the real stock price as of month t. The bottom
panel depicts smoothed return volatility, dened as Vol
t

p
6 12
1
P
12
i=1
jln(:
t+1i
,:
ti
)j,
along with the instantaneous standard deviation predicted by the model, obtained through
Eq. (12). Each prediction at each point in time is obtained by feeding the model with the
two macroeconomic factors depicted in Figure 1 (ination and growth) and by averaging
over the cross-section of 1000 dynamic simulations of the unobserved factor. The sample
covers monthly data for the period from January 1950 to December 2006. Vertical solid
lines (in black) track the beginning of NBER-dated recessions, and vertical dashed lines (in
red) indicate the end of NBER-dated recessions. The shaded area (in yellow) covers the
out-of-sample period, from January 2007 to March 2009, which we use to formulate models
predictions.
48
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
-0.5
0
0.5
price changes
observed
predicted by t he model
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0
0. 05
0.1
0. 15
0.2
0. 25
stock market volatility
estimated
predicted by t he model
Figure 3 Stock returns and volatility along with the model predictions in the
absence of an unobservable factor, with NBER dated recession periods. This gure
plots one-year price changes and one-year return volatility, along with their counterparts
predicited by the model, when the model is driven by the macroeconomic factors only. The
top panel depicts continuously compounded price changes, dened as 1
t
ln( :
t
/ :
t12
),
where :
t
is the real stock price as of month t. The bottom panel depicts smoothed return
volatility, dened as Vol
t

p
6 12
1
P
12
i=1
jln(:
t+1i
,:
ti
)j, along with the instantaneous
standard deviation predicted by the model, estimated in the same way as for the data. Each
prediction at each point in time is obtained by feeding the model with the two macroeconomic
factors depicted in Figure 1 (ination and growth) and by freezing the unobserved factor at
its long run mean, j
3
= 1. The sample covers monthly data for the period from January
1950 to December 2006. Vertical solid lines (in black) track the beginning of NBER-dated
recessions, and vertical dashed lines (in red) indicate the end of NBER-dated recessions.
49
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
-0.5
0
0.5
price changes
observed
predicted by the model
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0
0.05
0.1
0.15
0.2
0.25
stock market volatility
estimated
predicted by the model
Figure 4 Stock returns and volatility along with the model predictions in the
absence of macroeconomic factors, with NBER dated recession periods. This gure
plots one-year price changes and one-year return volatility, along with their counterparts
predicited by the model, when the model is driven by the unobservable factor only. The top
panel depicts continuously compounded price changes, dened as 1
t
ln( :
t
/ :
t12
), where
:
t
is the real stock price as of month t. The bottom panel depicts smoothed return volatility,
dened as Vol
t

p
6 12
1
P
12
i=1
jln(:
t+1i
,:
ti
)j, along with the instantaneous standard
deviation predicted by the model, estimated in the same way as for the data. Each prediction
at each point in time is obtained by freezing the two macroeconomic factors at their long
run means, j
1
and j
2
, and by averaging over the cross-section 1000 dynamic simulations of
the unobserved factor. The sample covers monthly data for the period from January 1950 to
December 2006. Vertical solid lines (in black) track the beginning of NBER-dated recessions,
and vertical dashed lines (in red) indicate the end of NBER-dated recessions.
50
Figure 5 The VIX Index and volatility risk-premia, with NBER dated recession
periods, and out-of-sample predictions. This gure plots the VIX index along with
models predictions. The top panel depicts (i) the VIX index, (ii) the VIX index predicted
by the model, and (iii) the VIX index predicted by the model in an economy without risk-
aversion, i.e. the expected integrated volatility under the physical probability. The bottom
panel depicts the volatility risk-premium predicted by the model, dened as the dierence
between the model-generated expected integrated volatility under the risk-neutral and the
physical probability,
VRP(y (t))
r
1
T t

r
E

R
T
t
o
2
(y (n)) dn

y (t)

r
1

R
T
t
o
2
(y (n)) dn

y (t)

!
,
where T t = 12
1
, E is the conditional expectation under the risk-neutral probability, 1 is
the conditional expectation under the true probability, o
2
(y) is the instantaneous variance
predicted by the model, obtained through Eq. (12), and y is the vector of three factors: the
two macroeconomic factors depicted in Figure 1 (ination and growth) and one unobservable
factor. Each prediction at each point in time is obtained by feeding the model with the
two macroeconomic factors depicted in Figure 1 (ination and growth) and by averaging
over the cross-section of 1000 dynamic simulations of the unobserved factor. The sample
covers monthly data for the period from January 1990 to December 2006. Vertical solid
lines (in black) track the beginning of NBER-dated recessions, and vertical dashed lines (in
red) indicate the end of NBER-dated recessions. The shaded area (in yellow) covers the
out-of-sample period, from January 2007 to March 2009, which we use to formulate models
predictions.
51
0 0.2 0.4 0.6 0.8 1
0.99
1
1.01
1.02
1.03
1.04
1.05
1.06
1.07
1.08
1.09
IP growth: time path under P (one month)
0 0.2 0.4 0.6 0.8 1
0.55
0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
1.05
IP growth: time path under Q (one month)
Figure 6 Sample paths of industrial production growth: under the objective
probability, and implied by the VIX index. This gure plots 1000 simulations of one
month paths of the gross industral production growth, with starting values xed at 1.03 (gross
ination) and 0.96 (gross industrial production growth). The left panel displays the sample
paths under 1, the physical probability. The right panel depicts the sample paths under Q,
the risk-neutral probability, obtained by matching the model to the VIX index.
52
1 . 0 1 1 . 0 2 1 . 0 3 1 . 0 4 1 . 0 5 1 . 0 6 1 . 0 7 1 . 0 8
0
0 . 1
0 . 2
0 . 3
0 . 4
V o l a t i l i t y r i s k -p r e m i u m a n d i n f l a t i o n
G r o s s in f la t io n
V
o
l
a
t
i
l
i
t
y

r
i
s
k
-
p
r
s
e
m
i
u
m
0 . 9 4 0 . 9 6 0 . 9 8 1 1 . 0 2 1 . 0 4 1 . 0 6 1 . 0 8 1 . 1 1 . 1 2
0
0 . 1
0 . 2
0 . 3
0 . 4
V o l a t i li t y r i s k -p r e m i u m a n d i n d u s t r i a l p r o d u c t io n g r o wt h
G r o s s in d u s t ri a l p r o d u c t i o n g r o wt h
V
o
l
a
t
i
l
i
t
y

r
i
s
k
-
p
r
e
m
i
u
m
Figure 7 Volatility risk-premium against ination and industrial production
growth. This gure provides scatterplots of the volatility risk-premium predicted by the
model, depicted in Figure 3 (bottom panel), against the two macroeconomic factors depicted
in Figure 1 (ination and growth). Each prediction at each point in time is obtained by feeding
the model with the two macroeconomic and by averaging over 1000 dynamic simulations of
the unobserved factor. The sample covers monthly data for the period from January 1990 to
December 2006. Vertical solid lines (in black) track the beginning of NBER-dated recessions,
and vertical dashed lines (in red) indicate the end of NBER-dated recessions.
53
Figure 8 Out of sample predictions and the subprime crisis. This gure plots
one-year return volatility and the VIX index, along with its counterparts predicted by the
model and by an OLS regression. The left panel depicts smoothed return volatility, dened as
Vol
t

p
6 12
1
P
12
i=1
jln(:
t+1i
,:
ti
)j, where :
t
is the real stock price as of month t, along
with the instantaneous standard deviation predicted by (i) the model, through Eq. (12), and
(ii) the predictive part of an OLS regression of Vol
t
on to past values of Vol
t
, ination and
industrial production growth. The right panel depicts the VIX index, along with the VIX
index predicted by (i) the model; and (ii) the predictive part of an OLS regression of the VIX
index on to past values of the VIX index, ination and industrial production growth. Each
prediction is obtained by feeding the model and the predictive part of the OLS regression
with the two macroeconomic factors depicted in Figure 1 (ination and growth) and, for the
model, by averaging over the cross-section of 1000 dynamic simulations of the unobserved
factor. The sample depicted in the gure spans the period from January 2000 to March
2009. The estimation of both the model and the OLS regressions relates to the period from
January 1950 to December 2006. Vertical solid lines (in black) track the beginning of NBER-
dated recessions, and the vertical dashed line (in red) indicates the end of the NBER-dated
recession, occurred in November 2001. The shaded area (in yellow) covers the out-of-sample
period, from January 2007 to March 2009, which includes the NBER recession announced to
have occurred in December 2007, and the subprime crisis, which started in June 2007.
54