On the Relation Between the Market Risk Premium and Market Volatility

Abstract

Intuition derived from the static capital asset pricing theory(CAPM) suggests that the market risk premium should be positively related to the market systematic risk as measured by the market volatility (variance). However, the empirical evidence is conflicting. While some studies find significantly positive relation, others find insignificant or significantly negative relation. This paper attempts to resolve the market risk and return relation puzzle by recognizing that the market volatility is time-varying and should be treated as an important source of systematic risk - volatility risk. Therefore, investors demand a risk premium for bearing the market volatility risk in addition to the market systematic risk. As a result, the market risk premium consists of two components: risk premium on the market systematic risk and risk premium on the market volatility risk. We find strong evidence of a significantly positive relation between the market risk premium and market systematic risk. We also find that the risk premium on the volatility risk, is negative and significant, which distorts the positive market risk and return relationship.