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

TLDR

The study investigates how equity market volatility can be priced by separating it into short‑run and long‑run components. The authors model short‑run volatility as market skewness reflecting financial‑constraint tightness, while long‑run volatility is linked to business‑cycle risk. Both volatility components command negative, significant risk premiums, indicating investors pay for insurance against volatility spikes, and a three‑factor model including these components outperforms standard benchmarks.

Abstract

ABSTRACT We 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 to business cycle risk. Furthermore, a three‐factor pricing model with the market return and the two volatility components compares favorably to benchmark models.