We show that the highly volatile variance risk premium (VRP) can be theoretically and empirically reconciled with investor sentiment captured by temporary variation in risk aversion. In an effort to understand the poor predictive power of the VRP in non-U.S. markets, we propose a new investor sentiment index, the Variance Sentiment index (VSI), obtained from the trading behavior of individual investors. We show that the VSI predicts local return dynamics, in a similar way to what the VRP does in the US market. Moreover, the VSI does not lose its predictive power even in the presence of the global VRP.​

JEL Code: G12, G13, G15, G41
Keywords: Variance Risk Premium, Investor Sentiment, Variance Sentiment Index, S&P 500, KOSPI, TAIEX​