A general equilibrium approach to pricing volatility risk

Abstract

This paper provides a general equilibrium approach to pricing volatility. Existing models (e.g., ARCH/GARCH, stochastic volatility) take a statistical approach to estimating volatility, volatility indices (e.g., CBOE VIX) use a weighted combination of options, and utility based models assume a specific type of preferences. In contrast we treat volatility as an asset and price it using the general equilibrium state pricing framework. Our results show that the general equilibrium volatility method developed in this paper provides superior forecasting ability for realized volatility and serves as an effective fear gauge. We demonstrate the flexibility and generality of our approach by pricing downside risk and upside opportunity. Finally, we show that the superior forecasting ability of our approach generates significant economic value through volatility timing.