This paper studies the determinants of the variance risk premium and discusses the hedging possibilities offered by variance swaps. We start by showing that the variance risk premium responds to changes in higher order moments of the distribution of market returns. But the uncertainty that determines the variance risk premium – the fear by investors to deviations from normality in returns – is also strongly related to a variety of macroeconomic and financial risks associated with default, employment growth, consumption growth, stock market and market illiquidity risks. We conclude that the variance risk premium reflects the market willingness to pay for hedging against these financial and macroeconomic sources of risk. An out-of-sample asset allocation exercise shows that the inclusion of the variance swap reduces the modified value-at-risk with respect to a portfolio holding exclusively the equity market portfolio.Financial support from the Ministry of Science and Innovation through grant ECO2011-29751 [Belén Nieto], and from the Ministry of Economics and Competitiveness through grants ECO2012-31941 [Alfonso Novales] and ECO2012-34268 [Gonzalo Rubio]. The authors also acknowledge financial support from Generalitat Valenciana grant PROMETEOII/2013/015
