Financial Markets with Trade on Risk and Return
The Review of Financial Studies, Volume 32, Issue 10
Posted: 25 Sep 2019
Date Written: October 1, 2019
In this paper, I develop a model in which risk-averse investors possess private information regarding both a stock’s expected payoff and its risk. These investors trade in the stock and a derivative whose payoff is driven by the stock’s risk. In equilibrium, the derivative is used to speculate on the stock’s risk and to hedge against adverse fluctuations in the stock’s risk. I analyze the derivative price and variance risk premium that arise in this equilibrium and their predictive power for stock returns. Finally, I examine the relationship between prices and trading volume in the stock and derivative.
JEL Classification: D82, G11, G12, G14
Suggested Citation: Suggested Citation