Post by Sapphire Capital on Oct 10, 2008 21:20:48 GMT 4
Equity Risk Premium and Volatility: A Correlation Structure
Yonggan Zhao
Dalhousie University - School of Business Administration
September 15, 2008
Abstract:
This paper investigates the relation between stock market returns and volatility using a bivariate factor model governing the evolution of volatility and the market price of risk. The time-varying risk premiums on a market portfolio are derived from an intertemporal constant correlation structure between a volatility indicator and the market price of risk. The accuracy of a measured volatility is verified by comparing the predictable volatility with the conditional standard deviation of excess stock returns. Using the Standard and Poor's Composite Index and three volatility indicators (option-based implied volatility, historical volatility, and a GARCH(1,1)-predicted volatility), we study a predictive model with the observed market state variables, such as up-to-date excess stock returns, current level of the volatility indicator, aggregate dividend yield, changes in the aggregate consumption, changes in the production output, and stock earnings. Although the time-varying risk premiums follow similar patterns for the three volatility indicators, the GARCH(1,1) indicator provides the most consistent predictability. While a positive relation between the intertemporal risk premium and volatility is plausible, the correlations between unexpected returns and volatility indicators are mixed with different measures of volatility. For the selected sample data, we find both strong leverage and volatility feedback effects. Finally, we discuss a portfolio strategy to show the predictive power of the model.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1268567_code977651.pdf?abstractid=1268567&mirid=2
Yonggan Zhao
Dalhousie University - School of Business Administration
September 15, 2008
Abstract:
This paper investigates the relation between stock market returns and volatility using a bivariate factor model governing the evolution of volatility and the market price of risk. The time-varying risk premiums on a market portfolio are derived from an intertemporal constant correlation structure between a volatility indicator and the market price of risk. The accuracy of a measured volatility is verified by comparing the predictable volatility with the conditional standard deviation of excess stock returns. Using the Standard and Poor's Composite Index and three volatility indicators (option-based implied volatility, historical volatility, and a GARCH(1,1)-predicted volatility), we study a predictive model with the observed market state variables, such as up-to-date excess stock returns, current level of the volatility indicator, aggregate dividend yield, changes in the aggregate consumption, changes in the production output, and stock earnings. Although the time-varying risk premiums follow similar patterns for the three volatility indicators, the GARCH(1,1) indicator provides the most consistent predictability. While a positive relation between the intertemporal risk premium and volatility is plausible, the correlations between unexpected returns and volatility indicators are mixed with different measures of volatility. For the selected sample data, we find both strong leverage and volatility feedback effects. Finally, we discuss a portfolio strategy to show the predictive power of the model.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1268567_code977651.pdf?abstractid=1268567&mirid=2