In the Merton (1973) ICAPM, state variables that capture the evolution of the investor’s opportunity set are necessary to explain observed asset prices. We show that augmenting the CAPM by a measure of market-wide volatility innovation yields a two-factor model that performs well in explaining the cross-section of returns on securities in several asset classes. The consistent pricing of volatility risk (with a negative risk premium) suggests that volatility risk indeed acts as a state variable rather than being just another statistical factor.