The Pricing of Tail Risk and the Equity Premium: Evidence From International Option Markets

Torben G. Andersena*, Nicola Fusarib & Viktor Todorovca Kellogg School, Northwestern University, Evanston, IL 60208; b The Johns Hopkins University Carey Business School, Baltimore, MD 21202; c Kellogg School, Northwestern University, Evanston, IL 60208Kellogg School, Northwestern University, Evanston, IL 60208 (t-andersen@northwestern.edu)AbstractWe explore the pricing of tail risk as manifest in index options across international equity markets. The risk premium associated with negative tail events displays persistent shifts, unrelated to volatility. This tail risk premium is a potent predictor of future returns for all the indices, while the option-implied volatility only forecasts the future return variation. Hence, compensation for negative jump risk is the primary driver of the equity premium, whereas the reward for pure diffusive variance risk is unrelated to future equity returns. We also document pronounced commonalities, suggesting a high degree of integration among the major global equity markets.