On the relation between the market risk premium and market volatility

The Capital Asset Pricing Model (CAPM) suggests that the market risk premium should be positively related to the market systematic risk as measured by the market variance. However, the empirical evidence is conflicting. While some studies find a significantly positive relation, others find an insignificant or a significantly negative relation. This article attempts to resolve the market risk and return relation puzzle by recognizing that the market volatility is stochastic and should be treated as an important source of systematic risk – volatility risk. Investors demand a risk premium for bearing the market volatility risk in addition to the market systematic risk. As a result, the market risk premium consists of two components, both related to the market volatility. After taking into account the volatility risk premium, we find strong evidence of a significantly positive relation between the market risk premium and the market systematic risk. We also find that the volatility risk premium is negative and significant, which distorts the positive market risk and return relation.