Volatility Expectations and Returns

84 Pages Posted: 30 Oct 2019 Last revised: 12 Dec 2020

See all articles by Lars A. Lochstoer

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Tyler Muir

University of California, Los Angeles (UCLA) - Anderson School of Management; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 22, 2019

Abstract

We provide evidence that agents have slow moving beliefs about stock market volatility. This is supported in survey data and is also reflected in firm level option prices. We embed these expectations into an asset pricing model and show that we jointly explain the following stylized facts (some of which are novel to this paper): when volatility increases the equity and variance risk premiums fall or stay flat at short horizons, despite higher future risk; these premiums appear to rise at longer horizons after future volatility has subsided; strategies that time volatility generate alpha; the variance risk premium forecasts stock returns more strongly than either realized variance or risk-neutral variance (VIX); changes in volatility are negatively correlated with contemporaneous returns. Slow moving expectations about volatility lead agents to initially underreact to volatility news followed by a delayed overreaction. This results in a weak, or even negative, risk-return tradeoff at shorter horizons but a stronger tradeoff at longer horizons (beyond where one can strongly forecast volatility). These dynamics are mirrored in the VIX and variance risk premium which reflect investor expectations about volatility.

Suggested Citation

Lochstoer, Lars A. and Muir, Tyler, Volatility Expectations and Returns (October 22, 2019). Available at SSRN: https://ssrn.com/abstract=3473572 or http://dx.doi.org/10.2139/ssrn.3473572

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Tyler Muir (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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