Predicting the Equity Premium with a High-Threshold Risk Level and the Price of Risk 

75 Pages Posted: 18 Jun 2023 Last revised: 7 Jun 2024

See all articles by Naresh Bansal

Naresh Bansal

Saint Louis University - Department of Finance

Chris T. Stivers

University of Louisville

Date Written: June 07, 2024

Abstract

Over 1990 to 2022, we show that excess equity-market returns tend to be much higher after the implied volatility from equity-index options (VIX) exceeds a threshold at around its 80th to 85th percentile and appreciably lower following a high market sentiment. Our findings are robustly evident for predictions at the 1-, 3-, 6-, and 12-month return horizons, in subperiod analysis, and for both in-sample and out-of-sample evaluations. For instance, for the 6-month and 12-month horizons, the predictive adjusted R-squared values are substantial at nearly 20% and 30% for in-sample estimation and at over 15% and 20% for out-of-sample evaluations. Further, we find that the VIX-threshold in our specification outperforms other risk explanatory terms suggested by the literature; including the recent high-frequency realized volatility, the equity volatility risk premium, a risk-aversion index measure, stock-market illiquidity, and macroeconomic uncertainty. Our risk-premium interpretation is that a high-VIX threshold identifies times of economic distress, times with a sharply higher level of risk along with a probable elevated price of risk. Sentiment complements VIX, where high sentiment can be particularly effective in identifying times with a low price of risk.

Keywords: nonlinear threshold risk-return relation, investor sentiment, stock market volatility

JEL Classification: G11, G12

Suggested Citation

Bansal, Naresh and Stivers, Chris T., Predicting the Equity Premium with a High-Threshold Risk Level and the Price of Risk  (June 07, 2024). Available at SSRN: https://ssrn.com/abstract=4477652 or http://dx.doi.org/10.2139/ssrn.4477652

Naresh Bansal

Saint Louis University - Department of Finance ( email )

Richard A. Chaifetz School of Business
St. Louis, MO 63108
United States
314-977-7204 (Phone)

Chris T. Stivers (Contact Author)

University of Louisville ( email )

Finance Dept., College of Business
University of Louisville
Louisville, KY 40292
United States
502-852-4829 (Phone)

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