How Does Stochastic Volatility Influence Asset Prices? – A Parameter-Free Approach

Abstract

We disentangle the risk of time-varying volatility and return in a consumption-based asset pricing model by introducing stochastic volatility of consumption growth to asset prices moving in volatility units instead of moving in time. This time-change approach yields additional insights to risk premia’s composition. We explore stochastic volatility empirically where it eases the risk-free rate puzzle and solves the equity premium puzzle if people are very impatient. As a factor it significantly improves the explanation of returns in the cross-section and is not captured by existing factors. Adding our factor helps to explain the momentum effect among other anomalies.

Keywords: Stochastic volatility, Consumption-based asset pricing, Factor models, Time-change

JEL Classification: G12, E21, C38