A new approach to measuring riskiness in the equity market: Implications for the risk premium |
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Affiliation: | 1. School of Business, Management and Economics, University of Sussex, Falmer, East Sussex BN1 9QH, UK;2. Department of Finance, School of Business and Economics, Maastricht University, Tongersestraat 53, 6211 LM Maastricht, The Netherlands;3. Finance Department, Vrije Universiteit Amsterdam and Tinbergen Institute, De Boelelaan 1105, NL-1081 HV Amsterdam, The Netherlands |
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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&P 500 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. |
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Keywords: | Time-varying riskiness Risk-neutral measures Physical measures Expected returns Equity premium G11 G12 G14 G33 |
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