Title of the Article : Aggregate Jump and Volatility Risk in the Cross-Section of Stock Returns
Author Information : David Weinbaum (Whitman School of Management, Syracuse University)
Year of Publication : Journal of Finance (2014)
Summary of Findings : Risk due to aggregate market jumps in stock prices can be priced independently of the normal risk due to random continuous fluctuations in stock prices.
Research Questions : 1. How is the risk of aggregate market jumps factored into stock prices?
2. Is it possible to price this risk separately from other risks?
What we know : Stock price returns are correlated with market risk: the more risky is a stock the larger is the expected stock return, and vice-versa.
Two risks of common concern are: volatility risk, the risk that the market environment may become more uncertain, and jump risk, the risk of sudden large market movements such as stock market crashes.
People have traditionally thought of these two kinds of risks as being similar.
Novel Findings : Both aggregate jump and volatility risk help explain variation in expected returns.
Both these types of risk can be measured and priced separately.
Novel Methodology : The authors separate the two risks from one another are by creating portfolios of options (straddles) that are exposed either to jump risk or to volatility risk, but not both.
Implications for Practice : Stock returns can be predicted more accurately.
Full Citations : Martijn Cremers, Michael Halling, David Weinbaum, “Aggregate Jump and Volatility Risk in the Cross-Section of Stock Returns,” The Journal of Finance, Volume 70, Issue 2, pages 577–614, April 2015.
Abstract : Understanding the relation between risk and return is crucial. This relation is usually thought of as a tradeoff: the more risk you take on, the greater your possible return. Investors more willing to take on risk can expect to be compensated through higher expected returns. Two risks of common concern are: volatility risk due to random but continuous changes stock prices normally undergo, and jump risk due to the possibility of sudden large market movements such as stock market crashes (see Figure 1). People have traditionally thought of these two kinds of risks as being similar. This paper shows this not to be the case: jump and volatility risk can both be measured separately and both are important economically. The authors are able to separate the two risks from one another are by creating portfolios of options (straddles) that are exposed either to jump risk or to volatility risk, but not both. The portfolios allow testing whether investors care about these risks and to estimate the associated risk premia. The main result is that investors care about both jump and volatility risk: they treat these risks separately from one another and expect to be rewarded by earning extra returns whenever exposed to either of these risks.
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Risk due to aggregate market jumps in stock prices can be priced independently of the normal risk due to random continuous fluctuations in stock prices.
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