Residuals from linear factor-based asset pricing models exhibit volatility comovement which cannot be explained by missing factors on the return-structure. Equalizing the market variance and the index variance shows that if a two-factor structure on individual stock variances exists, the common factor besides the market variance factor, the so-called “variance residual (VR) factor”, embeds a negative premium that offsets the variance risk premium spillover of the index on individual stocks, which also explains the fact that the individual variance risk premium is usually smaller than the index variance premium. The difference in the persistence of the two factors suggests an option trading strategy that buys the long term individual straddle with the lowest predicted variance risk premium, and shorts the short term index straddle with the highest variance risk premium. The strategy generates significant positive returns in both in- and out-of sample analysis.

Discussant: Nico Dragt (VU University Amsterdam)