Stochastic Volatility in General Equilibrium
Abstract
The connections between stock market volatility and returns are studied within the context of a general equilibrium framework. The framework rules out a priori any purely statistical relationship between volatility and returns by imposing uncorrelated innovations. The main model generates a two-factor structure for stock market volatility along with time-varying risk premiums on consumption and volatility risk. It also generates endogenously a dynamic leverage effect (volatility asymmetry), the sign of which depends upon the magnitudes of the risk aversion and the intertemporal elasticity of substitution parameters.
Prepared for presentation at the "Conference on Financial Econometrics" in honor of Rob Engle's Nobel Prize and presented at several meetings and conferences. The paper reflects an effort to understand better the underlying economics of stochastic volatility, risk, return, time varying risk premiums, and the volatility risk premium. I have benefitted from many, helpful discussions with Ravi Bansal, and I am also grateful to Ivan Shaliastovich and Kenneth Singleton for helpful comments. Earlier versions of the manuscript circulated on the web, and extensions are part of (Bollerslev et al., 2009) and (Bollerslev et al., 2012).
