An Emprical Research On The Relationship Of Stock Market Volatility Risk And The Cross-Section Returns

In this paper we examine the importance of market volatility dynamics for assetpricing of the16size and book-to-market sorted portfolios for1997/7-2011/6. Based on anICAPM model, we shows that the stochstic discount factor is a function of marketvolatility innovations as well as the market return.Firstly, we decompose the market volatity into a short-run compent and a long-runcomponent, and use innovations of the components as explanatory variables and add theminto the classic CAPM model. We use Fama-Macbeth two-pass method to find innovationof the short-run component is significantly positively related to the cross-section returnsand has a positive price of risk. Compared with large-cap stocks, small-cap stocks aremore sensitive to the short-run volatility innovation, which helps explain the sizepremium.In the opposite, the long-run component has an negative relationship with thecross-section returns, but its price of risk is insignificant.When we add innovations of the volatility components into the CAPM model,explanatory power is highly improved. Compared with the classic CAPM model and theFrench-Fama three-factor model, our model is highly favorable, which manifests theimportance of market volatility in Chinese stock market.