Volatility Risk Premium, Risk Aversion and the Cross-Section of Stock Returns

42 Pages Posted: 24 Oct 2007 Last revised: 5 Mar 2008

See all articles by Peter M. Nyberg

Peter M. Nyberg

Aalto University

Anders Vilhelmsson

Lund University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: March 3, 2008

Abstract

We test if innovations in investor risk aversion are a priced factor in the stock market as is predicted by models incorporating habit formation in preferences. Our proxy for time-varying risk aversion is based on the volatility risk premium series constructed by Bollerslev et al. (2007). Time-series tests show that a mimicking portfolio tracking innovations in risk aversion partly captures the strong momentum effect in stock returns and produces only two significant alphas for 25 momentum portfolios. Furthermore, using 25 portfolios sorted on book-to-market and size as test assets in Fama-MacBeth regressions, our new factor together with the market factor explains 64% of the variation in average returns compared to 60% for the Fama-French three factor model. The new factor is generally significant with an estimated risk premium close to its time series mean also when industry portfolios and portfolios sorted on previous returns are included among the test assets.

Keywords: asset pricing, volatility risk premium, risk aversion, habit formation, momentum

JEL Classification: G12

Suggested Citation

Nyberg, Peter Mikael and Vilhelmsson, Anders, Volatility Risk Premium, Risk Aversion and the Cross-Section of Stock Returns (March 3, 2008). Available at SSRN: https://ssrn.com/abstract=1024158 or http://dx.doi.org/10.2139/ssrn.1024158

Peter Mikael Nyberg (Contact Author)

Aalto University ( email )

P.O. Box 21210
Helsinki, 00101
Finland

Anders Vilhelmsson

Lund University - Department of Economics ( email )

Lund
Sweden

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