Fear and the Fama‐French Factors

Abstract

Investors’ expectations of market volatility, captured by the VIX (the Chicago Board Options Exchange's volatility index, also known as the “investor fear gauge”), affects the expected returns of US equities. Changes in the VIX drive variations in the expected returns of the factors included in the Fama and French three‐factor model augmented with a momentum factor. The market risk premium (Rm– Rf) and the value premium (HML) are especially sensitive to changes in the VIX. An increase in expected volatility is associated with flights to quality and increases in estimated required returns.

The risk–return tradeoff: A COGARCH analysis of Merton's hypothesis

“…Any increase in expected risk will increase the discount rate and, hence, reduce the price. 3 French et al, however, find a negative relationship of unexpected changes in volatility to returns which is supported by Durand, Lim and Zumwalt (2007). 4 Campbell and Hentschel argue that volatility only matters when it is relatively high.…”

“…Perhaps, as argued by Jorion and Goetzmann 1 From the end of June 2007, when two of Bear Sterns' hedge funds suffered heavy losses due to their exposure to the sub-prime market, to the end of 2008, the S&P500 fell approximately 40%. 2 Other research has avoided the problem of the joint endogeneity of returns and risk by using an exogenous proxy such as the Chicago Board Options Exchange Volatility Index (the VIX) (see, for example, Ang et al, 2006;Durand, Lim and Zumwalt, 2007). Durand et al (2007) argue that a negative correlation between market returns and unexpected changes in volatility is associated with a repricing of risk.…”

“…2 Other research has avoided the problem of the joint endogeneity of returns and risk by using an exogenous proxy such as the Chicago Board Options Exchange Volatility Index (the VIX) (see, for example, Ang et al, 2006;Durand, Lim and Zumwalt, 2007). Durand et al (2007) argue that a negative correlation between market returns and unexpected changes in volatility is associated with a repricing of risk. Such an interpretation is natural if prices in securities markets are thought of as the present value of future cash flows where the present value is calculated using a risk-adjusted discount rate.…”

Conditional beta: Evidence from Asian emerging markets

“…The model with the greatest claim to be the CAPM's successor, Fama and French's three-factor model (Fama & French, 1993), has been established empirically and, despite its success, there is still debate about why the factors work. The recent interest we have noted in PSM's model might be influenced by a desire to "save" a theoretically appealing model when the debate about Fama and French's factors is far from being resolved (see Durand, Lim, & Zumwalt, 2011, for a discussion of the variety of views on why the factors work). Fama and French (1992) provide evidence that factors other than beta itself explain returns; such a finding is sufficient grounds to reject the CAPM.…”

Re-examining risk premiums in the Fama–French model: The role of investor sentiment

“…Whaley (2000) indicates that VIX is referred to as the investor fear gauge because high levels of VIX have coincided with high degrees of market turmoil in the US. Other studies evaluate the ability of implied volatility to predict future market returns (e.g., Diavatopoulos, Doran, & Peterson, 2008;Durand, Lim, & Zumwalt, 2011). For example, Fleming, Ostdiek, and Whaley (1995) find evidence that VIX index and stock index return has negative contemporaneous relationship.…”