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State-dependent volatility feedback effect in the ICAPM

Author

Listed:
  • Kilic, Osman
  • Nam, Kiseok
  • O'Connor, Matthew L.

Abstract

Considering that risk-averse investors revise their expectations in response to changes in both expected and unexpected volatility, we hypothesize and demonstrate that an unexpectedly high (low) volatility shock causes an increase (decrease) in risk premium. Using a novel approach to endogeneity issues, we utilize a state dependent, ICAPM to measure volatility effects on risk-return relationships. Our empirical results show that the volatility feedback effect strengthens (attenuates) the positive risk-return relation under bad (good) news. Furthermore, the volatility feedback effect under the combined conditions of bad news and a high unexpected volatility causes an extremely heightened level of the risk-return tradeoff.

Suggested Citation

  • Kilic, Osman & Nam, Kiseok & O'Connor, Matthew L., 2024. "State-dependent volatility feedback effect in the ICAPM," Finance Research Letters, Elsevier, vol. 59(C).
    • Handle: RePEc:eee:finlet:v:59:y:2024:i:c:s1544612323010723
    DOI: 10.1016/j.frl.2023.104700
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    More about this item

    Keywords

    Volatility feedback effect; State-dependent ICAPM; Endogeneity issue; Investor sentiment;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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