Information-Driven Volatility

Abstract

Standard asset pricing models with stochastic volatility predict a robust positive relationship between past realized volatility and future expected returns. Empirical work typically finds this relationship to be negative. We develop an asset pricing model where stock market volatility dynamics are driven by information. We show that under strong generalized risk sensitivity of preferences, information-driven volatility induces a negative correlation between past realized volatility and future expected returns. Using FOMC announcements and stock market jump days to identify information events, we provide empirical evidence for the unique implications of the information-driven volatility channel.

Keywords: Information, Risk-return Trade-off, Return Volatility, FOMC Announcements, Generalized Risk Sensitivity

JEL Classification: D83, D84, G11, G12, G14