Stock Returns and Volatility: Pricing the Short-Run and Long-Run Components of Market Risk

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractWe explore the cross-sectional pricing of volatility risk by decomposing equity market volatility into short-and long-run components. Our finding that prices of risk are negative and significant for both volatility components implies that investors pay for insurance against increases in volatility, even if those increases have little persistence. The short-run component captures market skewness risk, which we interpret as a measure of the tightness of financial constraints. The long-run component relates closely to business cycle risk. Furthermore, a three-factor pricing model with the market return and the two volatility components compares favorably to benchmark models. 1When market volatility is stochastic, intertemporal models predict that asset risk premia are not only determined by covariation of returns with the market return, but also covariation with the state variables that govern market volatility. To study this prediction, we model the log-volatility of the market portfolio as the sum of a short-and a long-run volatility component. This approach parsimoniously captures shocks to systematic risk at different horizons.Market volatility is a significant cross sectional asset pricing factor as shown by Ang et al. (2006).1 Their two-factor model with the market return and market volatility does reduce pricing errors compared to the capital asset pricing model (CAPM), though not by as much as the Fama-French model. In contrast, our benchmark asset pricing model with the market return and the two volatility components as cross sectional pricing factors achieves lower pricing errors than the Fama and French (1993) model for size and book-to-market sorted portfolios. Our finding that the short-and long-run volatility components have negative, highly significant prices of risk is robust across sets of portfolios, sub-periods, and volatility model specifications.Consistent with previous research, we also find that the average compensation for volatility risk is positive. This is because the prices of risk of both volatility components are negative, and average sensitivities to the volatility components are also negative. Our two-factor decomposition shows that the average risk premium for short-run volatility is 0.17% monthly versus 0.23% monthly for long-run volatility.Across individual portfolios, we see a wide dispersion in sensitivity to the volatility components, which generates cross sectional varia...

Volatility Decomposition and Correlation in International Securitized Real Estate Markets

“…Their analysis of the US and Japanese stock return volatility supports the decomposition and makes valuable contribution to the literature of persistent stock return volatility. In addition, other studies such as Adrian and Rosenburg (2006), Guo and Neely (2007) and Zhu (2007) find that the two-component volatility specification outperforms one-factor GARCH model for market return volatility. For example, Guo and Neely (2007) investigate the risk-return relation in international stock markets.…”

Foreign exchange volatility and stock returns

“…They find that the market risk (beta) of multinational firms increases with the increase in foreign exchange volatility when a longerhorizon (5 years) is focused upon. The second study is Adrian and Rosenberg (2008). The authors find differential effects of the long-run and short-run components of stock market volatility on expected returns of stocks.…”

“…Therefore, it should be a priced factor for equity returns. Bartov et al (1996) and Adrian and Rosenberg (2008) imply that it might be the long-term component of foreign exchange volatility that affects systematic risk of firms. Therefore, future research may decompose foreign exchange volatility into different components and examine their differential effects on the time-series and the cross-section of stock returns.…”

“…We find that foreign exchange volatility has no power to explain either the time-series or the cross-section of stock returns, which calls for more research on foreign exchange risk. Bartov et al (1996) and Adrian and Rosenberg (2008) suggest an alternative and maybe promising direction. …”

Linking the interest rate swap markets to the macroeconomic risk: The UK and us evidence

“…In regards to the benefits of using low-frequency volatility, Engle and Lee (1999), Adrian and Rosenberg (2008), Engle and Rangel (2008) and Azad et al (2011) show that the low-frequency component represents the slow moving trend that varies systematically with fundamental economic variables. They find that the use of the low-frequency component indicates a stronger relationship between macroeconomic risk and the volatility of the financial market.…”