Staff Report, Federal Reserve Bank of New York 706
The illiquidity of long-maturity options has made it difficult to study the term structures of option spanning portfolios. This paper proposes a new estimation and inference framework for these option-implied term structures that addresses long-maturity illiquidity. By building a sieve estimator around the risk-neutral valuation equation, the framework theoretically justifies (fat-tailed) extrapolations beyond truncated strikes and between observed maturities while remaining nonparametric. New confidence intervals quantify the term structure estimation error. The framework is applied to estimating the term structure of the variance risk premium and finds that a short-run component dominates market excess return predictability.
equity risk premium finance options predictability sieve M estimation state-price density term structures variance risk premium VIX