Macroeconomic determinants of stock volatility and volatility premiums
How does stock market volatility relate to the business cycle? We develop, and estimate, a no-arbitrage model, and find that (i) the level and fluctuations of stock volatility are largely explained by business cycle factors and (ii) some unobserved factor contributes to nearly 20% to the overall variation in volatility, although not to its ups and downs. Instead, this “volatility of volatility” relates to the business cycle. Finally, volatility risk-premiums are strongly countercyclical, even more than stock volatility, and partially explain the large swings of the VIX index during the 2007–2009 subprime crisis, which our model captures in out-of-sample experiments. âº The level of stock market volatility cannot be explained by macroeconomic factors only. âº However, macroeconomic factors are needed to explain the volatility of volatility. âº Volatility risk-premiums are strongly countercyclical, even more so than stock volatility. âº In our model macro factors and stock volatility are linked through no-arbitrage restrictions.