Time-varying Equity Premia with a High-VIX Threshold and Sentiment

Abstract

Over the 1990 to 2022 period, we show that time-variation in the return earned from equity-market exposure can be explained well with a simple specification, which predicts: (1) much higher excess returns after the implied volatility from equity-index options exceeds a threshold at around its 80th to 85th percentile; and (2) lower excess returns following a high market sentiment. Our results are robustly evident for 1-, 3-, 6-, and 12-month return horizons, in subperiod analysis, and for both in-sample and out-of-sample evaluations. The predictive R-squared values are substantial at about 20% and 30% for 6-month and 12-month returns, respectively. Furthermore, we find that the VIX-threshold in our specification outperforms other risk explanatory terms suggested by the literature; including the recent high-frequency realized volatility, the equity volatility risk premium, a risk-aversion index measure, stock-market illiquidity, and macroeconomic uncertainty. Our evidence indicate that the VIX-threshold and sentiment capture complementary risk aspects, suggesting an interpretation where VIX largely indicates the level of risk and sentiment is informative about the market’s risk appetite or price of risk.

Keywords: Stock market risk, nonlinear threshold risk-return relation, investor sentiment.

JEL Classification: G11, G12