โ Scribed by Kevin Daly; Vinh Vo
No coin nor oath required. For personal study only.
Recent evidence by Campbell et al. [J.Y. Campbell, M. Lettau B.G. Malkiel, Y. Xu, Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk, The Journal of Finance (February) ( 2001)] shows an increase in firm-level volatility and a decline of the correlation among stock returns in the US. In relation to the Euro-Area stock markets, we find that both aggregate firm-level volatility and average stock market correlation have trended upwards.
We estimate a linear model of the market risk-return relationship nested in an EGARCH(1, 1)-M model for conditional second moments. We then show that traditional estimates of the conditional risk-return relationship, that use ex-post excess-returns as the conditioning information set, lead to joint tests of the theoretical model (usually the ICAPM) and of the Efficient Market Hypothesis in its strong form.
To overcome this problem we propose alternative measures of expected market risk based on implied volatility extracted from traded option prices and we discuss the conditions under which implied volatility depends solely on expected risk. We then regress market excess-returns on lagged market implied variance computed from implied market volatility to estimate the relationship between expected market excess-returns and expected market risk.We investigate whether, as predicted by the ICAPM, the expected market risk is the main factor in explaining the market risk premium and the latter is independent of aggregate idiosyncratic risk.
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