Forthcoming in The Review of Financial Studies
I analyze a model in which risk-averse investors trade on signals regarding both a stock’s expected payoffs and its risk. These investors may trade in the stock and a derivative whose payoffs depends upon the stock’s risk. I study the role played by the derivative, finding that it is used to speculate on the stockís risk and hedge against fluctuations in this risk. I then analyze how trade among investors influences the derivative price and variance risk premium and their predictive power for stock returns. Finally, I examine the relationship between prices and trading volume in the stock and derivative.