On the relation between the market risk premium and market volatility

Yufeng Han

Applied Financial Economics, 2011, vol. 21, issue 22, 1711-1723

Abstract: The Capital Asset Pricing Model (CAPM) suggests that the market risk premium should be positively related to the market systematic risk as measured by the market variance. However, the empirical evidence is conflicting. While some studies find a significantly positive relation, others find an insignificant or a significantly negative relation. This article attempts to resolve the market risk and return relation puzzle by recognizing that the market volatility is stochastic and should be treated as an important source of systematic risk - volatility risk. Investors demand a risk premium for bearing the market volatility risk in addition to the market systematic risk. As a result, the market risk premium consists of two components, both related to the market volatility. After taking into account the volatility risk premium, we find strong evidence of a significantly positive relation between the market risk premium and the market systematic risk. We also find that the volatility risk premium is negative and significant, which distorts the positive market risk and return relation.

Keywords: market risk premium; market risk-return tradeoff; volatility risk premium; stochastic volatility; EMM (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://www.tandfonline.com/doi/abs/10.1080/09603107.2011.593497 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:apfiec:v:21:y:2011:i:22:p:1711-1723

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RAFE20

DOI: 10.1080/09603107.2011.593497

Access Statistics for this article

Applied Financial Economics is currently edited by Anita Phillips

More articles in Applied Financial Economics from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().