Volatility Pricing in the Stock and Treasury Markets

An asset’s sensitivity to stock market volatility carries a signi…cant risk premium across both equity and …xed income markets. Large-cap and growth stocks have less exposure to volatility risk. Their relatively greater ability to weather volatility surprises, such as those often associated with …nancial crises, accounts for their lower expected returns when compared to small-cap and value stocks. In the Treasury market, Treasury bonds covary positively and signi…cantly with volatility surprises, paying o¤ in times of increased aggregate uncertainty. Therefore, Treasury market models that incorporate stock market volatility risk should provide more accurate models of expected returns for bonds. My novel three-factor model with market return, a volatility surprise factor, and the HML factor dominates the Fama-French three-factor model at estimating the cross-section of expected returns for the universe of assets containing both stocks and U.S. Treasuries. Further, my model also outperforms a model with predictive variables (aggregate dividend yield, term spread, default spread, and one-month Treasury-bill yield). I also document a signi…cant and negative correlation between stock market volatility and shocks to cash ‡ows for small-cap and value …rms, which suggests that the cash ‡ow constraints matter the most for these types of …rms during bad times. This also explains why volatility subsumes the e¤ect of a characteristic-based factor like SMB in asset pricing. JEL Classi…cation : G12