On the Stock Market Variance-Return or Price Relations: A Tale Of Two Variances

Conditional Equity Premium and Aggregate Corporate Investment

“…Second, Papanikolaou (2011) proposes a general equilibrium two-factor model in which the price of risk is negative for investment-specific technological (IST) shocks and is positive for disembodied technological (DT) shocks. Incorporating these two types of risks into a variant of the Bansal and Yaron (2004) long-run risk model, Guo, Lin, and Pai (2021) show that conditional equity premium depends positively on DT variance and negatively on IST variance. In the model, the value-weighted aggregate idiosyncratic variance is a proxy for IST variance because stocks with higher loadings on IST variance have lower risk premia and hence higher prices.…”

“…On the other hand, because stock market variance is the sum of IST and DT variances, it is a proxy for DT variance when we control for IV, a proxy for IST variance, in the forecast regression. Using simulated data from the model, Guo, Lin, and Pai (2021) show that conditional equity premium depends positively on MV and negatively on IV. The model provides an intuitive explanation for two noticeable episodes in Figure 3.…”