Working Paper: CEPR ID: DP10681
Authors: John Y. Campbell; Stefano W. Giglio; Christopher Polk; Robert Turley
Abstract: This paper studies the pricing of volatility risk using the first-order conditions of a long-term equity investor who is content to hold the aggregate equity market rather than tilting towards value stocks and other equity portfolios that are attractive to short-term investors. We show that a conservative long-term investor will avoid such overweights in order to hedge against two types of deterioration in investment opportunities: declining expected stock returns, and increasing volatility. Empirically, we present novel evidence that low-frequency movements in equity volatility, tied to the default spread, are priced in the cross-section of stock returns.
Keywords: ICAPM; stochastic volatility; time-varying expected returns; value premium
JEL Codes: G12; N22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| conservative long-term investors avoid tilting towards value stocks (G40) | serve as a hedge against declines in expected stock returns (G12) |
| moderate level of risk aversion (around 7) (D81) | prefer holding the market index rather than engaging in value tilts (G11) |
| growth stocks (G31) | provide a hedge against both declining expected returns and rising volatility (G17) |
| low-frequency movements in volatility influenced by financial indicators (C58) | significantly impact the cross-section of stock returns (G41) |
| empirical model of stochastic equity volatility (C58) | reveals the pricing of risk factors associated with future cash flows, discount rates, and volatility (G17) |