Abstract
We examine the relationship between risk premium and conditional volatility of the stock market using a decomposition of the volatility into a permanent and a transitory component. We find that the conditional permanent volatility has a significant positive relationship with the market risk premium, but the conditional transitory volatility is negatively related to the market risk premium. The strength of this negative relationship is time varying and depends on the market conditions being closely correlated with extreme movements in the stock market. The relationship between risk premium and conditional volatility in extreme movement periods is much different from that in ordinary movement periods. In the highly volatile market, the conditional transitory volatility is negatively priced in market risk premium even though the conditional permanent volatility still has a positive one. Also, the results of the paper show that the negative extreme events such as the stock market crash in October 1987 can be a good candidate for explaining the puzzling negative relationship between risk premium and conditional transitory volatility.
| Original language | English |
|---|---|
| Pages (from-to) | 139-176 |
| Number of pages | 38 |
| Journal | Asia-Pacific Journal of Financial Studies |
| Volume | 35 |
| Issue number | 2 |
| State | Published - 2006 |
Keywords
- Extreme movements
- Risk premium permanent volatility
- Rolling window estimator
- Transitory volatility