Return Predictability of Variance Differences : a fractionally co-integrated approach

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.