Pricing Stock Market Volatility: Does It Matter Whether the Volatility Is Related to the Business Cycle? by

Given two virtually separate literatures on return predictability and the risk-return relation, this paper reconciles the two literatures by investigating the underlying mechanism of the return predictability literature through exploiting the risk-return relation. In developing an empirical model to examine the business cycles-risk-return relationship, we consider the fact that market volatility increases during recessions and other short periods of liquidity crises such as the 1987 stock market crash and the 1998 Russian default. Then, the impacts that expected market volatilities, each due to two different sources, have on expected returns are investigated. Specifically, we decompose stock prices into fundamental and transitory components and then derive a bivariate model of stock returns and output growth within Campbell and Shiller's (1988) log-linear present value framework. Our empirical results show that business cycles-related market volatility has predictive power for expected return movements, while business cycles-unrelated volatility does not. We confirm the underlying mechanism of the return predictability literature, i.e. the business cycles-risk-return relationship. On the other hand, the temporary high variances during liquidity crises are not compensated by higher expected returns. Finally, a few episodes of transitory components are identified, including the 1973-4 OPEC oil shock, the 1987 crash and the 1998 Russian default. These results provide new evidence for the risk-return literature and support for the business cycles-risk-return mechanism.