Are Investors Compensated for Bearing Market Volatility in a Country?

Abstract

We investigate whether market volatility risk is a systematic pricing factor for stocks and market portfolios and whether it is a factor risk or a country-specific characteristic risk to investors in 21 developed countries. We find that local market volatility risk factor negatively prices stock returns in Belgium, Canada, Spain, Norway, the U.K., and the U.S. and that global market volatility risk factor systematically prices 21 market portfolios after controlling for global market, value, and size factors. Idiosyncratic market volatility as a country-specific characteristic risk dominates global market, value, size, and market volatility risk factors in predicting the return of market portfolios. Countries with higher investor protection and accounting standards have higher country-specific market volatility. We interpret this as consistent with the good volatility hypothesis of Bartram, Brown, and Stulz (2012); that market volatility is higher in these countries with good corporate governance because they encourage corporate managers to take higher risks on innovative projects, which can in turn generate higher returns for shareholders and thus benefit economic growth.