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

TLDR

The study aims to decompose equity market risk into short‑ and long‑run volatility components. The authors achieve this by decomposing the equity market risk time series into short‑ and long‑run volatility components. Both components exhibit negative, highly significant prices of risk; a three‑factor model incorporating the market return and these two volatility components outperforms benchmark models, with the short‑run component capturing market skewness risk and the long‑run component capturing business‑cycle risk, and the short‑run factor proving more important cross‑sectionally despite a smaller average risk premium.

Abstract

We decompose the time series of equity market risk into short- and long-run volatility components. Both components have negative and highly significant prices of risk in the cross section of equity returns. A three-factor model with the market return and the two volatility components compares favorably to benchmark models. We show that the short-run component captures market skewness risk, while the long-run component captures business cycle risk. Furthermore, short-run volatility is the more important cross-sectional risk factor, even though its average risk premium is smaller than the premium of the long-run component.