A New Approach to Measuring Riskiness in the Equity Market: Implications for the Risk Premium
Fisher College of Business Working Paper No. 2012-03-009
Charles A. Dice Center Working Paper No. 2012-9
61 Pages Posted: 10 May 2012 Last revised: 6 Sep 2013
There are 2 versions of this paper
A New Approach to Measuring Riskiness in the Equity Market: Implications for the Risk Premium
A New Approach to Measuring Riskiness in the Equity Market: Implications for the Risk Premium
Date Written: September 5, 2013
Abstract
We introduce a new approach to measuring riskiness in the equity market. We propose option implied and physical measures of riskiness and investigate their performance in predicting future market returns. The predictive regressions indicate a positive and significant relation between time-varying riskiness and expected market returns. The significantly positive link between aggregate riskiness and market risk premium remains intact after controlling for the S&P500 index option implied volatility (VIX), aggregate idiosyncratic volatility, and a large set of macroeconomic variables. We also provide alternative explanations for the positive relation by showing that aggregate riskiness is higher during economic downturns characterized by high aggregate risk aversion and high expected returns.
Keywords: Time-varying riskiness, risk-neutral measures, physical measures, expected returns, equity premium
JEL Classification: G11, G12, G14, G33
Suggested Citation: Suggested Citation