Modeling Common Volatility and Dynamic Risk Premia in European Equity Markets

Abstract

This paper tests the hypothesis that the market portfolio in European equity returns is a dynamic factor in the sense that individual stock return volatilities and risk premia are driven by the dynamics of a common dynamic factor namely, the market portfolio. Support for the hypothesis would suggest that the dynamic Arbitrage Pricing Theory with observed dynamic factors (APT) provides a satisfactory description of the dynamics of European stock return. In addition, this paper examines the role of portfolio size, in the behavior of first and second moment dynamics.

Keywords: Factor-GARCH, European markets, dynamic risk premia, common volatility

JEL Classification: C1