Revisiting Fama–French’s asset pricing model with an MCB volatility risk factor

Xiaoying Chen and Nicholas Ray-Wang Gao

Journal of Risk Finance, 2020, vol. 21, issue 3, 233-251

Abstract: Purpose - Since the introduction of VIX to measure the spot volatility in the stock market, VIX and its futures have been widely considered to be the standard of underlying investor sentiment. This study aims to examine how the magnitude of contango or backwardation (MCB volatility risk factor) derived from VIX and VIX3M may affect the pricing of assets. Design/methodology/approach - This paper focuses on the statistical inference of three defined MCB risk factors when cross-examined with Fama–French’s five factors: the market factor Rm–Rf, the size factor SMB (small minus big), the value factor HML (high minus low B/M), the profitability factor RMW (robust minus weak) and the investing factor CMA (conservative minus aggressive). Robustness checks are performed with the revised HML-Dev factor, as well as with daily data sets. Findings - The inclusions of the MCB volatility risk factor, either defined as a spread of monthly VIX3M/VIX and its monthly MA(20), or as a monthly net return of VIX3M/VIX, generally enhance the explanatory power of all factors in the Fama and French’s model, in particular the market factor Rm–Rfand the value factor HML, and the investing factor CMA also displays a significant and positive correlation with the MCB risk factor. When the more in-time adjusted HML-Dev factor, suggested by Asness (2014), replaces the original HML factor, results are generally better and more intuitive, with a higherR2for the market factor and more explanatory power with HML-Dev. Originality/value - This paper introduces the term structure of VIX to Fama–French’s asset pricing model. The MCB risk factor identifies underlying configurations of investor sentiment. The sensitivities to this timing indicator will significantly relate to returns across individual stocks or portfolios.

Keywords: Investor sentiment; VIX; Contango; Backwardation; Market volatility; Asset pricing model (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jrfpps:jrf-07-2019-0130

DOI: 10.1108/JRF-07-2019-0130

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