Stochastic Volatility Risk and the Size Anomaly

Investors’concerns about systematic volatility risk explain a large portion of the small …rm premia in the long run. This novel …nding supports the concept of market e¢ ciency and indicates a “‡ight to quality”during recessions: investors shift their preferences away from small …rms, which are considered as being relatively risky. Instead they use large, “quality”stocks, whose returns co-vary positively with innovations in volatility (a recession-and-distress proxy), and therefore pay o¤during times of low market returns. This leads to higher hedging demands for large stocks, higher prices and lower expected returns. Using a sample of monthly returns spanning the period January 1927December 2005, I estimate a statistically signi…cant and negative price for volatility risk. This result is robust to the type of volatility measure used, to the inclusion of traditional risk factors in the model and to di¤erent model speci…cations. Controlling for accounting pro…tability type, I document a signi…cant volatility premium ranging between 3% and 7% per year, for the Fama-French portfolios. JEL Classi…cation: G12