Blackwell Reference Online

Extract

In both the academic and popular press, the subject of volatility risk has been an issue of debate. Evidence that stock volatility is both time varying and stochastic has led researchers to ask whether volatility risk is priced in equity stock and option markets. Volatility risk may be said to be priced if the risk premium determining the expected return on the security is a function of volatility. In the equity stock market, the notion that the expected return is a positive monotonic function of risk suggests that the expected return on the market portfolio should be positively correlated with the market volatility. Although the detailed description of this relationship is not important for pricing individual stocks relative to each other (where one only needs to know the covariance of the stock's return with the market or another posited factor), it is required for understanding the intertemporal changes in prices. There are two questions that have been asked in the literature. First, is there a significant relationship between the expected return and volatility for the market portfolio? Merton (1980) offers some preliminary evidence, noting that the empirical research in examining the relationship between the expected return and volatility is confounded by the fact that the volatility in actual returns is likely to be larger than the volatility in the expected returns. However, ... log in or subscribe to read full text