State-dependent volatility feedback effect in the ICAPM

Osman Kilic, Kiseok Nam and Matthew L. O'Connor

Finance Research Letters, 2024, vol. 59, issue C

Abstract: Considering that risk-averse investors revise their expectations in response to changes in both expected and unexpected volatility, we hypothesize and demonstrate that an unexpectedly high (low) volatility shock causes an increase (decrease) in risk premium. Using a novel approach to endogeneity issues, we utilize a state dependent, ICAPM to measure volatility effects on risk-return relationships. Our empirical results show that the volatility feedback effect strengthens (attenuates) the positive risk-return relation under bad (good) news. Furthermore, the volatility feedback effect under the combined conditions of bad news and a high unexpected volatility causes an extremely heightened level of the risk-return tradeoff.

Keywords: Volatility feedback effect; State-dependent ICAPM; Endogeneity issue; Investor sentiment (search for similar items in EconPapers)
JEL-codes: G10 G12 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:59:y:2024:i:c:s1544612323010723

DOI: 10.1016/j.frl.2023.104700

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