A New Look at Market Volatility and Market Risk Premia

The goal of the project is to identify drivers of market volatility and risk premia related to uncertainty about aggregate economic growth, dividends, and discount rates. The model features expected stock market returns which are impacted by a separate "risk premium factor", which is not related to uncertainty about fundamentals like economic growth or corporate payouts. In case one finds such a separate factor of sufficient magnitude, this would have, among other implications, a significant impact on the overall validity of recently proposed estimates for the expected market return based on option prices. The proper identification of expected returns via option prices requires a negative covariance between the return on a security and the product of this return with the pricing kernel (Martin, QJE 2017). In case when the volatility of corporate payouts is an important determinant of market volatility, but is at the same time not priced as an idiosyncratic source of risk, the condition assumed by Martin can be violated.

The approach to the problem we take is to econometrically estimate a present-value model featuring separate processes for economic growth, corporate payouts, and expected equity market returns (an extension featuring a risk-free rate is basically possible). The output of the estimation will then deliver information about the relative importance of the different factors, which is in turn important for our ability to infer expected returns from option prices.