Using Fundamental Factors to Forecast Equity Market Volatility

Abstract

This paper introduces a model for forecasting future volatility using fundamental factors. The fundamental factors include the extent to which the market’s valuation deviates from its predicted value, the losses reported by companies with negative earnings, projected earnings growth rates, and Treasury Bill rates. The main result is that fundamental factors provide significant incremental explanatory for predicting volatility relative to that provided by past volatility realizations alone. In particular, markets in which there is a large difference between current and theoretical values, markets in which there is a high aggregate amount of negative earnings reported by companies with losses, and markets with high shorter-term expected earnings growth rates should all have higher volatility. Markets with higher short-term interest rates have tighter financial conditions, and therefore should also have higher volatility. The explanatory power of fundamental factors is greatest when VIX is at moderate rather than extreme levels, so that there is no expectation of long-term mean reversion for volatility. In addition, the explanatory power of fundamental factors is greatest when the model forecasts an increase in VIX. The overall conclusion is that forecasts of future volatility should incorporate fundamental factors.