Staff Reports

Stock Returns and Volatility: Pricing the Short-Run andLong-Run Components of Market Risk

July 2006Number 254
Revised February 2008
JEL classification: G10, G12

Authors: Tobias Adrian and Joshua Rosenberg

We explore the cross-sectional pricing of volatility risk by decomposing equity market volatility into short- and long-run components. Our finding that prices of risk are negative and significant for both volatility components implies that investors pay for insurance against increases in volatility, even if those increases have little persistence. The short-run component captures market skewness risk, which we interpret as a measure of the tightness of financial constraints. The long-run component relates closely to business cycle risk. Furthermore, a three-factor pricing model with the market return and the two volatility components compares favorably to benchmark models.

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For a published version of this report, see Tobias Adrian and Joshua Rosenberg, "Stock Returns and Volatility: Pricing the Short-Run and Long-Run Components of Market Risk," Journal of Finance 63, no. 6 (December 2008): 2997-3030.