How Does Stochastic Volatility Influence Asset Prices? – A Parameter-Free Approach
32 Pages Posted: 9 Mar 2018
Date Written: February 26, 2018
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
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