A New Approach to Measuring Riskiness in the Equity Market: Implications for the Risk Premium

Abstract

We propose options' implied and physical measures of riskiness and investigate their performance in predicting future returns on the U.S. equity market. The predictive regressions indicate a positive and significant relation between time-varying riskiness and expected market returns. The significantly positive link between aggregate riskiness and market risk premium remains intact after controlling for the S&P500 index option's implied volatility (VIX), aggregate idiosyncratic volatility, and a large set of macroeconomic and financial variables. We present a theoretical framework that justifies the positive link between aggregate riskiness and equity premium. We also provide alternative explanations for the positive relation by showing that aggregate riskiness is higher during economic downturns characterized by high aggregate risk aversion and high expected returns.