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Z. Dha, E. Schaumburg. “The pricing of volatility risk across asset classes,” (University of Notre Dame, 21 November 2011).

Z. Dha, E. Schaumburg. “The pricing of volatility risk across asset classes,” (University of Notre Dame, 21 November 2011).

Abstract: 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. In addition, we propose a novel method for extracting volatility risk factors from the cross-section and find it help to price assets, especially synthetic volatility swaps.