Return predictability of variance differences : A fractionally cointegrated approach

Li, Z. and Izzeldin, M. and Yao, X. (2020) Return predictability of variance differences : A fractionally cointegrated approach. Journal of Futures Markets, 40 (7). pp. 1072-1089. ISSN 0270-7314

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Abstract

This paper examines the fractional cointegration between downside (upside) components of realized and implied variances. A positive association is found between the strength of their cofractional relation and the return predictability of their differences. That association is established via the common long-memory component of the variances that are fractionally cointegrated, which represents the volatility-of-volatility factor that determines the variance premium. Our results indicate that market fears play a critical role not only in driving the long-run equilibrium relationship between implied-realized variances but also in understanding the return predictability. A simulation study further verifies these claims.