Aggregate Volatility Expectations and Threshold CAPM1

Yakup Eser Arısoy* Aslıhan Altay-Salih** Levent Akdeniz***

This version: 24 July 2015

Abstract

We propose a volatility-based capital asset pricing model (V-CAPM) in which asset betas
change discretely with respect to changes in investors’ expectations regarding near-term
aggregate volatility. Using a novel measure to proxy uncertainty about expected changes in
aggregate volatility, i.e. monthly range of the VIX index (RVIX), we find that portfolio betas
change significantly when uncertainty about aggregate volatility expectations is beyond a certain
threshold level. Due to changes in their market betas, small and value stocks are perceived as
riskier than their big and growth counterparts in bad times, when uncertainty about aggregate
volatility expectations is high. The proposed model yields a positive and significant market risk
premium during periods when investors do not expect significant uncertainty in near-term
aggregate volatility. Our findings support a volatility-based time-varying risk explanation.

JEL Classification: C13; G12

Keywords: Aggregate volatility; Threshold regression; Conditional CAPM; Range; VIX

* Université Paris-Dauphine, DRM Finance, 75775, Paris Cedex 16, France. Tel: +33 (0)1 44 05
43 60, email: eser.arisoy@dauphine.fr
** Bilkent University Faculty of Business Administration, 06533, Ankara, Turkey, Tel: +90 312
290 2047 email: asalih@bilkent.edu.tr
*** Bilkent University Faculty of Business Administration, 06533, Ankara, Turkey, Tel:
+90 312 290 2202 email: akdeniz@bilkent.edu.tr

1
We would like to thank to seminar participants and discussants at Grenoble Ecole de Management, Lancaster
University Management School, Manchester Business School, Université Paris Dauphine, Université Picardie Jules
Verne, AFFI 2012 Strasbourg Meetings and FMA 2012 Atlanta Meetings.

Electronic copy available at: http://ssrn.com/abstract=1847670

1. Introduction

The capital asset pricing model (CAPM) assumes that a firm's riskiness, which is

captured by its beta, is constant through time. However, changes in business conditions,

technology, and taste might induce shifts in the investment opportunity set and investors'

associated risk-return tradeoffs (Jagannathan and Wang, 1996). Many studies model the variation

in betas using continuous approximation and the theoretical framework of the conditional

CAPM.2 Yet, despite a strong theory and considerable evidence on time variation in betas, there

is no consensus on how this variation should be modelled.

In this paper, we model asset betas neither as static nor as a continuous approximation

implied by conditional models, instead we assume that asset betas change discretely in time.3

Our approach follows the spirit of regime-switching models, which have been extensively used

in modelling financial time-series.4 More particularly, we posit that investors re-assess firms’

systematic risk with respect to expected changes in aggregate risk conditions based on their

expectations regarding uncertainty about future aggregate volatility. There are several reasons

why we assume betas should change with respect to uncertainty about aggregate volatility

expectations. First, it is well documented that both equity and aggregate volatility is time-

varying.5 Therefore, an asset pricing model that incorporates time-variation in aggregate

2
See Harvey (1989), Ferson and Harvey (1991, 1993, 1999), Ferson and Korajczyk (1995), Jagannathan and Wang
(1996), and Petkovan and Zhang (2005).
3
The intuition behind discrete changes in betas with respect to two different regimes similar to downside-upside
beta approach in Ang, Cheng, and Xing (2006) who show that asset betas change during downside and upside
markets and downside risk is priced. Methodologically, our approach is also related to Markov chain regime
switching models as in Guidolin and Timmermann (2008), and Chen, Gerlach, and Lin (2011), and optimal
changepoint approach as in Bollen and Whaley (2009), and Patten and Ramadorai (2013).
4
See Hamilton (1989), Hamilton and Lin (2002), Ang and Bekaert (2002), Guidolin and Timmermann (2012), Ho,
Shi, and Zhang (2013), Chuang, Huang, and Lin (2013), Zheng and Zuo (2013), and Bailliu et al. (2014) for details
and applications of regime-switching models in different settings
5
For theoretical background and empirical evidence on stochastic volatility of equity and stock market returns, see
Engle and Bollerslev (1986), French, Schwert, and Stambaugh (1987), Schwert (1989), Engle and Ng (1993),
Canina and Figlewski (1993), Duffee (1995), Braun, Nelson, and Sunier (1995), Andersen (1996), Bollerslev and
Mikkelsen (1999), and Bekaert and Wu (2000).

Electronic copy available at: http://ssrn.com/abstract=1847670

volatility would naturally imply that asset betas also change accordingly.6,7 Second, time-varying

risk literature suggests that stocks have different exposures to market risk during recessions and

expansions (Lettau and Ludvigson, 2001; Petkova and Zhang, 2005). Given the fact that change

in aggregate volatility is tightly linked to business cycles, our model is able to capture this link

by conditioning changes in asset betas on changes in aggregate volatility expectations.8 Driven

by the fact that option-implied volatility measures are good forecasts of future volatility, we

condition time variation in betas based on an option-implied measure, which summarizes

investors’ expectations with respect to changes in near-term aggregate volatility.9 Rather than

using macro variables as in previous studies, our approach contributes to the literature by

proposing a novel conditioning variable, which has a forward-looking feature by construction

and which models time variation in an asset’s riskiness in a parsimonious way.10, 11

Covri , rm 
i 
Var rm  , any uncertainty in investors’ aggregate volatility expectations
6
Given the definition of beta, i.e.
(i.e. the denominator) is expected to affect returns in the cross-section through betas on the market portfolio. Hence,
our approach is different from Ang et al. (2006) who condition expected returns directly on aggregate volatility and
who model aggregate volatility as a separate risk factor. Our approach is also different from Wang and Ma (2014)
who examine the effect of excess volatility at the individual stock level. We investigate the implications of
uncertainty about aggregate volatility on betas and on the cross-section of expected returns.
7
Pollet and Wilson (2010) show that increases in market volatility can be due to either increases in average
volatilities or average correlations, or both. Furthermore, Buraschi, Porchia, and Trojani (2010) and Buraschi,
Trojani, Vedolin (2014) show that investors have hedging demands against both stochastic aggregate volatility risk
and stochastic correlation risk. In their model, both risk factors stem as a result of uncertainty (disagreement in
beliefs across agents) in the economy. We do not take a direct stand on the correlation structure in this paper.
However, because our measure RVIX essentially captures uncertainty in expected volatility of the market portfolio,
it is closely linked to both sources of risk.
8
See Hsu and Li (2009) who document counter-cyclicality of volatility across different asset classes.
9
For the predictive ability of option-implied volatility measures ranging from intra-day forecasts to one-year ahead
forecasts, and in different markets such as foreign exchange, stock, and bond markets, see Poon and Granger (2005),
Taylor, Yadav, and Zhang (2010), Busch, Christensen, and Nielsen (2011), Han and Park (2013), and Bianconi,
MacLachlan, and Sammon (2015).
10
Among the most widely used macro conditioning variables in the literature are the dividend yield (Fama and
French (1988)), default spread (Keim and Stambaugh (1988)), term spread (Campbell (1987)), short term treasury
bill rate (Fama and Schwert (1977)) and log consumption-wealth ratio (Lettau and Ludvigson (2001)).
11
Our study is also related to the recent strand of literature showing that the difference in option-implied volatility
measures has significant explanatory power in the cross-section of stock returns. Among them are studies by Bali
and Hovakimian (2009), Bollerslev, Tauchen, and Zhou (2009), Cremers and Weinbaum (2010), and Atilgan, Bali
and Demirtas (2015).

Electronic copy available at: http://ssrn.com/abstract=1847670

 In particular, we propose a volatility-based threshold CAPM (V-CAPM) where asset

betas change with respect to investors' assessment of aggregate risk conditions, proxied by

uncertainty about market’s expectations regarding changes in aggregate volatility. The

contribution of the proposed V-CAPM is fourfold. First, we propose a novel measure to proxy

expected changes in aggregate risk conditions, i.e. range of the VIX index (RVIX). 12 VIX is

inherently a forward-looking volatility measure and it reveals important information about

investors’ expectations of near term volatility in the market.13 Defined as the difference between

the maximum and minimum level of the VIX index, RVIX essentially captures expected changes

in near-term aggregate volatility, or put differently the degree of uncertainty in future aggregate

volatility. In a recent paper, Baltussen et al. (2014) show that the volatility of volatility (vol-of-

vol) is an important factor in the cross-section of stock returns. Using the volatility of option-

implied volatility as a measure of uncertainty about volatility, they document that stocks with

high vol-of-vol underperform stocks with low vol-of-vol. The authors argue that the volatility of

option-implied volatility is an intuitive measure, which is tightly related to the literature that

models uncertainty as second-order beliefs. In a similar vein, RVIX can be interpreted as a

measure that captures uncertainty regarding future aggregate volatility. Hence, if investors hold

second order beliefs and care about this uncertainty, then stocks or portfolios with different

sensitivities to changes in uncertainty could have different risk-return dynamics, which could

also imply different market risk premium dynamics at times of increased uncertainty about

expected aggregate volatility.

12
We examine whether using other conditioning variables documented in the literature (such as one month T-bill
rate, aggregate dividend yield, inflation rate, term spread and credit spread) result in significant regime changes in
portfolio betas as implied by the threshold CAPM model. None of the examined variables yield significant regime
shifts in portfolio betas as strong as RVIX.
13
Often referred to as the “fear” or “market sentiment” index, VIX estimates near-term (roughly next 30-day)
expected volatility by weighted-averaging the prices of puts and calls written on the S&P 500 index over a range of
strike prices.

3
 Second contribution is our approach to modelling time variation in betas. In standard

conditional CAPM setting, betas practically change at each point in time, however this approach

might have a tendency to overstate the time variation in betas and result in estimates that are

highly volatile. Our setting differs from the standard conditional CAPM models by allowing

betas to change only when the degree of uncertainty about expected aggregate volatility moves

beyond a certain threshold level, admitting a discrete variation in betas in two distinct regimes.

Third, our model implicitly allows for time variation in aggregate volatility which is not possible

in the static CAPM setting. By endogenously incorporating changes in investors’ expectations

about aggregate volatility in a dynamic way, we allow betas to capture potential shifts in the

investment opportunity set linked to expected changes in aggregate risk conditions.14 Our fourth

contribution is econometric. We formally test the hypothesis on the existence of a relation

between betas and uncertainty about aggregate volatility using Hansen's (2000) threshold

regression methodology, which is intuitive and fully supported by the econometric theory.15 The

proposed model is rich in its predictions and offers a volatility-based explanation to some of the

empirical asset pricing anomalies documented in the literature.

Using RVIX as proxy for uncertainty about aggregate volatility expectations, and

portfolios sorted with respect to market capitalizations and book-to-market ratios as test assets,

our results can be summarized as follows.16 First, using the modified sup LM test suggested by

14
We also investigate whether the documented regime changes in betas with respect to uncertainty about aggregate
volatility expectations is linked to downside risk as in Ang, Chen and Xing (2006) and Bali, Demirtas and
Levy(2009). Using upside and downside betas of Ang, Chen and Xing (2006), we do not find a strong correlation
between high uncertainty vs. downside betas and low uncertainty vs. upside betas. Furthermore, dividing the sample
period into months that correspond to high vs. low uncertainty about aggregate volatility and months that correspond
to upside and downside markets, we find major differences between the corresponding time periods.
15
See Hansen (2000) for a detailed explanation of the threshold estimation methodology.
16
We also use an orthogonalized version of RVIX (RVIXORTH) in order to ensure that the results are not driven by
potential variables that have been documented to be important in the literature. RVIXORTH is defined as the
residual term obtained from regressing RVIX on aggregate dividend yield, the default spread, the term spread, the
short-term treasury bill rate, and the VIX. The results are robust to use of RVIXORTH as the conditioning variable.

4
Hansen (1996), we document significant time variation in betas. 15 out of 22 test portfolios have

significant bootstrap p-values at 5% level.17 The evidence confirms the existence of aggregate

volatility related changes in betas of most portfolios, most particularly for the extreme size and

book-to-market portfolios as well as SMB and HML portfolios. The initial results support the

hypothesis that asset betas change discretely in time and uncertainty about aggregate volatility

expectations is a key determinant of investors' assessment about an asset’s systematic risk.

Next, we test whether different size and book-to-market portfolios have different beta

sensitivities with respect to investors’ expectations about uncertainty of aggregate volatility and

risk conditions. The threshold estimates suggest that investors overwhelmingly update their beta

risk assessments when monthly range of the VIX index is beyond 9.33 points.18 What makes the

results further remarkable is the direction of this update. Looking at the changes in portfolio

betas, one can see that stocks in small (and value) portfolios have consistently higher betas at

times when uncertainty about expected aggregate volatility is high (i.e. when RVIX in a given

month is above the threshold level). On the contrary, the portfolio of largest market capitalization

stocks (and the growth portfolio) exhibits lower betas during these uncertain times. The increase

in betas is most pronounced for the smallest decile, highest book-to-market decile, SMB and

HML portfolios.

French, Schwert, and Stambaugh (1987), and Campbell and Hentschel (1992) document

that periods of high volatility usually coincide with downward market moves. Furthermore, risk-

averse investors are reluctant to lose wealth in periods of high volatility because it represents a

deterioration in investment opportunities, which usually coincides with periods of low

17
9 (17) portfolios exhibit significant change in betas at 1% (10%) level.
18
The threshold estimates (which could practically be any positive real number) are quite stable for portfolios that
exhibit significant beta changes (ranging from 6.07 to 11.10), confirming the robustness of the chosen threshold
variable, RVIX.

5
consumption (recessions).19 The increase in betas of small and value portfolios implies that

stocks with these characteristics are perceived to be riskier at times of increased uncertainty

about expected volatility. This also holds for SMB and HML portfolios whose sensitivities to

market returns become higher during those times. Investors view small and value firms riskier

because their returns correlate strongly with market returns in episodes when uncertainty about

expected aggregate volatility is high. On the other hand, returns on big and growth stocks

correlate less with market returns during those times. Our results are consistent with those of

Lettau and Ludvigson (2001) and Petkova and Zhang (2005) whofind that value and small stocks

correlate more with the consumption growth (market returns) during bad times relative to big and

growth stocks, while the opposite holds during good times. We argue that investors view small

and value stocks riskier than their big and growth counterparts because their returns are much

more sensitive to market risk at times of increased uncertainty about aggregate volatility and

adverse market conditions.

To test the robustness of the above results and to further examine the effect of time

variation in investors’ expectations of near term volatility on asset risk-return dynamics, we next

calculate Jensen’s alphas and Sharpe ratios of our test assets in the full sample as well as in two

different regimes (i.e. high and low uncertainty about volatility) implied by the threshold level of

RVIX estimated via the V-CAPM. It is well-documented that small and value stocks (and the

associated SMB and HML strategies) produce significantly higher average returns than their

large and growth counterparts. Looking at Jensen’s alphas and betas of different size and book-

to-market portfolios, we confirm the previous findings that the static CAPM is unable to offer a

risk-based explanation to SMB and HML return differentials. On the other hand, the analysis of

alphas implied by the proposed V-CAPM helps us uncover an important aspect of size and value
19
Hsu and Li (2009) document that equity market volatility is higher in bear markets and recessions.

6
vs. growth puzzles. In particular, we document that size and value strategies yield significant and

positive risk-adjusted returns during calm times when uncertainty about near-term aggregate

volatility is low. On the other hand, the trade-off for size and value strategies is that they have

extremely bad (significant and negative) risk-adjusted returns at times of high uncertainty about

expected volatility.

Portfolio Sharpe ratios also offer a similar volatility-based time-varying risk explanation

to size and value vs. growth anomalies. In periods when uncertainty about aggregate volatility is

low, the strategy in the smallest (value) decile portfolios command higher reward-to-variability

ratios as opposed to the biggest (growth) decile portfolios. However, in periods of high

uncertainty about aggregate volatility, investors experience much worse reward-to-variability

ratios for the smallest (value) decile portfolio relative to biggest (growth) decile portfolio. The

results confirm our hypothesis that market’s expectation of uncertainty about aggregate volatility

is an important determinant of investors’ assessment of risk and expected returns. Changes in

betas and risk-adjusted returns during periods with different levels of uncertainty about aggregate

volatility expectations contribute to our understanding of why small and value stocks on average

earn higher returns than their big and growth counterparts. We show that investing in small and

value stocks are risky strategies in periods when there is high uncertainty about expected

aggregate volatility, and thus investors get compensated for the risk that they are taking against

this uncertainty.

We finally test the pricing implications of the proposed V-CAPM by dividing the sample

into periods of high and low uncertainty about expected aggregate volatility and by estimating

the betas and the corresponding risk premium in the cross-section. To avoid the problem of

factor structure related biases in the estimation procedure, we estimate the betas and the risk

7
premia at the individual stock level rather than at the portfolio level. We start with examining the

relationship between stocks’ betas and future returns. To that end, we first estimate the beta

loadings via monthly regressions using daily returns as in Ang et al. (2006). Classifying betas as

high uncertainty (RVIX>9.33) vs. low uncertainty (RVIX<9.33) betas, we form decile portfolios

each month by sorting individual stocks according to their betas. We then examine out-of-sample

average decile returns for the following month to investigate whether stocks’ beta exposures

determined by uncertainty about aggregate volatility explain the cross-sectional dispersion in

their next-month returns. Univariate portfolio sorts indicate that stocks in the highest uncertainty

(calm) beta decile underperform (outperform) stocks in the lowest uncertainty (calm) beta decile

by 0.72% (0.60%) per month. Furthermore, the differences in risk-adjusted returns (CAPM and

FF 3-factor alphas) of portfolios with highest and lowest exposure to uncertainty betas are also

negative and statistically significant. The results are robust to using value-weighted returns.

We finally estimate the corresponding risk premia for uncertainty and calm betas using

the standard Fama and MacBeth (1973) cross-sectional regression methodology. Consistent with

the previous studies, we document an insignificant market risk premium throughout the full

sample period, confirming the inability of a static version of CAPM to explain the cross-section

of stock returns. On the other hand, we document a positive and significant market risk premium

during calm times when uncertainty about aggregate volatility is low. This result is robust to the

inclusion of different factor exposures such as SMB beta, HML beta and MOM beta as well as

various firm characteristics such as idiosyncratic volatility, size, book-to-market ratio, and firm-

level momentum. On the contrary, during periods of high uncertainty about aggregate volatility,

the market risk commands a significant and negative premium, however its significance

disappears when different portfolio exposures and firm characteristics are included. The results

8
imply a major improvement over pricing relative to static CAPM by re-establishing a positive

market risk premium during calm periods when uncertainty about aggregate volatility is fairly

low.

The remainder of the paper is organized as follows. Section 2 introduces the threshold V-

CAPM and the related econometric framework. Section 3 presents data and some stylized facts.

Section 4 documents empirical findings for time-series and cross-sectional tests of the proposed

V-CAPM. The final section offers concluding remarks.

2. The threshold CAPM

To capture the effect of uncertainty about aggregate volatility expectations on market

beta, we start with the following conditional CAPM:

Eri ,t 1 Z t    i   t Erm,t 1 | Z t    it 1 , 1

where ri,t+1 is the excess return on asset i, rm,t+1 is the excess return on the market portfolio and E

is the expectation operator. t captures time-variation in market betas, and Zt is the conditioning

information on investors’ assessment of near-term aggregate volatility risk. Using monthly range

of the VIX index as a proxy for investors’ information set for expected changes in aggregate

volatility, we model time-variation in betas as in Ferson and Harvey (1999):20

 t  11{Z }   2 1{Z } ,

t t
2

where 1{} is the indicator function and  is the threshold parameter for aggregate volatility.

Combining equations (1) and (2), we have the following threshold volatility CAPM:

   
ri ,t 1  11Zt     2 1Zt   11{Zt }   2 1{Zt } rm,t 1   i ,t 1 , 3

20
See Section 2 for details on the construction of the conditioning variable RVIX.

9
where Zt is the monthly range of the VIX index (RVIX) that summarizes investors’ information

set regarding the evolution of uncertainty about near-term aggregate volatility.

2.1. Econometric Model

The observed sample is {rt+1, rm,t+1, Zt}, t = 1, …, T-1. The random variables rt, rm,t, and

Zt are real-valued. The threshold variable Zt is assumed to have a continuous distribution.21 The

threshold regression has the same format as in equation (3), which can be rewritten as:

rt 1   xt 1   xt 1 ( )  et 1 (4)

where xt+1 = rm, t+1 , xt 1 ( )  xt 11{ zt } ,  = 2 and  = 1- 2.

The above model can further be generalized to the case where only a subset of parameters

switches between the regimes and to the case where some regressors only enter in one of the two

regimes. Also,  takes values in a bounded subset of the real line, . This applies to the case of

our conditioning variable RVIX, which is bounded below by zero by definition. We assume r mt,

Zt, and et are strictly stationary ergodic and -mixing. 22

2.2. Testing for a Threshold

We use the heteroskedasticity-consistent Lagrange Multiplier (LM) test for a threshold, as

in Hansen (1996). We test for the null of H0:  = 0 against H1:   0. If the null is rejected, this

implies a significant change in betas with respect to levels above or below threshold RVIX.

For all    we have the following LM statistics for the null of no threshold:

21
See Hansen (2000) for detailed explanations related to the assumptions.
22
The -mixing coefficients satisfy m½ < . The -mixing assumption controls the degree of time series
dependence and allows the processes to be autocorrelated and heteroskedastic, and is sufficiently flexible to embrace
many non-linear time series processes, including threshold autoregressions.

10
 
 
LMT ( )  T Rˆ( ) RVˆT* ( ) R Rˆ( ) ,
1

where,

R  0, I ,
1

   T  T 
ˆ ( )  ˆ( ) , ˆ( )    xt*1 ( ) xt*1 ( )   xt*1 ( )rt 1  ,
 t 1   t 1 
x *t 1 ( )  xt 1 , xt 1 ( ) ,
~
V̂T* ( )  M T ( ) 1VT ( ) M T ( ) 1 ,
1 T *
M T ( )   xt 1 ( ) xt*1 ( )  ,
T t 1
~ 1 T *
VT ( )   xt 1 ( ) xt*1 ( ) e~t 1 ,
2

T t 1

and where ~et is obtained from the restricted least squares. One limitation of the LM test is the

large sample limit for the sup-LM, which is not nuisance free because the threshold is not

identified under the null of no-threshold effect. Because of this issue, Hansen (1996) suggests a

bootstrap analog of the sup-LM test and shows that this bootstrap method yields asymptotically

correct p-values. We use the bootstrap analog following the steps outlined in Hansen (1996) and

estimate the unkown threshold parameter, , as in Hansen (2000).

3. Data

The market and stock return data is from Center for Research in Security Prices (CRSP)

value-weighted market index for all NYSE, AMEX, and NASDAQ stocks. The risk-free rate is

the one-month T-Bill rate obtained from Ibbotson Associates. Data on VIX and VXO is obtained

from Chicago Board Options Exchange’s (CBOE). The sample covers the period from January

11
1986 to December 2012, with a total of 324 months.23 The test portfolios consist of stocks sorted

according to their market capitalizations, and book-to-market ratios. More precisely, we use 10

portfolios sorted according to their market capitalizations, 10 portfolios sorted according to their

book-to-market ratios, and 2 factor portfolios SMB and HML.24 For cross-sectional tests

performed in Section 4.3, we use the CRSP universe covering all NYSE/AMEX/NASDAQ

common stocks with share codes 10 and 11.

In order to proxy investors’ expectations about the evolution of near-term aggregate

volatility, we use the monthly range of the VIX index (RVIX). Similar to Chou (2005), we

define RVIX in a given month as:

RVIXt = Max{VIXτ} - Min{VIXτ}, τ = 1,2, … , T (5)

where τ denotes trading days in a given month, and t denotes months. Taking the difference

between the maximum and minimum level of VIX index in a given month, RVIX summarizes

investors’ expectations regarding changes in near-term aggregate volatility.

Range based volatility measures have gained recent interest, and they fare quite well in

predicting future volatility.25 To the best of our knowledge, this is the first study to propose a

range based measure of the VIX index.26 We further tested a battery of volatility measures

23
VIX data is available from January 1990 onwards. In order to have as much data as possible, we use the VXO
index (which is based on S&P 100 index options) from January 1986 to December 1989, and the VIX index from its
introduction in January 1990 onwards. The results remain unaffected when we limit the sample period to 1990-2012
using the VIX index only, or omitting VIX and using VXO throughout the 1986-2012 period.
24
SMB (Small Minus Big) is the average return on the three small portfolios minus the average return on the three
big portfolios, and HML (High Minus Low) is the average return on the two value portfolios minus the average
return on the two growth portfolios.
25
See Alizadeh et al. (2002), Chou (2005), Brandt and Jones (2006), Chou and Liu (2010), Harris et al. (2011),
Bannouh, Martens, and van Dijk (2013), and Asai and Brugal (2013) for articles that motivate the use of range based
volatility measures in different settings.
26
Previous studies such as Garman and Klass (1980) and Parkinson (1980) as well as many others use the
logarithmic transformation of the stock price as a measure of stock volatility. Although the asymptotic properties
and forecasting power of price-based range measures has been extensively documented, as far as the authors are
aware of, this is the first paper that applies the concept of range to implied volatility. To have a better understanding
of the properties of RVIX, we check the predictive ability of RVIX to forecast realized variance (VAR) as defined in
Goyal and Welch (2010). The pairwise correlation between RVIX in month t-and VAR in month t +1 is 0.27.

12
ranging from statistical and historical measures of volatility such as standard deviation of returns,

squared returns, GARCH based volatility estimates to forward-looking measures of volatility

such as change in the VIX index and S&P 500 straddle returns. 27 The proposed RVIX together

with S&P 500 straddle returns are the most successful in capturing time-variation in betas.

We argue that the success of RVIX in detecting changes in betas is due to its ability to

characterize uncertainty about future aggregate volatility much better than alternative measures.

By using a measure which essentially captures volatility of option-implied aggregate volatility,

we have the advantage of first identifying investors’ expectations about the evolution of near-

term aggregate volatility (VIX), and second measuring the degree of uncertainty in expected

aggregate volatility captured by the range of the this forward-looking option-implied aggregate

volatility measure (RVIX). Aggregate volatility risk has been documented to be an important

factor that determines investors’ risk-return tradeoff and time-variation in investment opportunity
28
set. Because RVIX is essentially a proxy for the degree of uncertainty regarding aggregate

volatility expectations, we expect RVIX to be a strong conditioning variable that captures

uncertainty in investors’ information set regarding aggregate volatility risk, and hence to have

implications regarding asset pricing, portfolio allocation, and stock return predictability as an

important conditioning variable.

We further test whether the chosen conditioning variable RVIX is correlated with other

business cycle measures documented in the literature.29 Towards that end, we are particularly

interested in the dividend yield (DIV) of the S&P 500 index, the default spread (DEF) which the

spread between BAA and AAA rated corporate bond yields, the term spread (TERM) which is

27
The reader is referred to section 4.4 for a detailed discussion of results.
28
See Campbell (1993), Chen (2002), Ang et al. (2006) and Barinov (2012) for papers that document pricing of
aggregate volatility risk.
29
See Ang and Chen (2002) and Ang and Bekaert (2002) for studies that document increase in correlations during
recessions.

13
the spread between 10-year, 1-year U.S. government bond yields and the short-term treasury bill

rate (TB) and the VIX index, all of which have been documented as strong predictors of business

cycles and hence the conditional CAPM information set.30 To check whether our results are not

affected from a potential correlation with the business cycle variables documented in the

literature, we create an orthogonalized measure of RVIX (RVIXORTH), which is defined as the

residual term from the following regression:

RVIX t     MKT MKTt   SMBDIVt   DEF DEFt  TERM TERM t  TBTBt  VIX VIX t   t (6)

Table 1 reports the summary statistics of RVIX, the market portfolio, as well as the

orthogonalized version of RVIX (RVIXORTH), and macro variables used in the analysis.

Looking at the mean (6.66), median (4.98), the minimum (0.92) and the maximum (129.04) of

the RVIX, one can say that VIX index (expectations of near-term market volatility) and its range

(expected changes in near-term aggregate volatility) are quite stable and do not move

significantly in most of the months during our sample period. Without much surprise, the

maximum level of RVIX was recorded in October 1987, where the VXO index skyrocketed from

its minimum value on 3rd October 1987 of 21.15 points to its historical maximum of 150.19

points on black Monday. Finally, similar to the negative correlation documented in previous

studies between the VIX index and market returns, the correlation between RVIX and the market

is -0.41.

<< Insert Table 1 about here >>

30
Dividend yield data is from Robert Shiller’s website (http://www.econ.yale.edu/~shiller/data.htm), government
and corporate bond yields are from St. Louis Fed website (https://research.stlouisfed.org/fred2/ ), and short-term
Treasury bill rates are from Ken French’s data library, (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
data_library.html )

14
3.1. Stylized Facts

This section documents some stylized facts about the chosen threshold parameter, market

returns, and the empirically documented size and value vs. growth anomalies.

First, looking at Figure 1, one can see that the proposed conditioning variable RVIX

indeed tracks significant negative market moves. Given the empirical evidence that negative

market moves are most associated with increases in aggregate volatility, our novel measure

RVIX is essentially capable of providing a relationship between the evolution of near-term

market volatility and downward market moves.

<< Insert Figure 1 about here >>

<< Insert Table 2 about here >>

Next, we conduct a simple exercise to examine returns on different size and book-to-

market portfolios in different volatility regimes in more detail. Using threshold estimates of the

RVIX index, we divide the sample into two regimes, where regime 1 (2) represents calm

(uncertain) months in which RVIX is below (above) the estimated threshold level of the

associated portfolio. This way of decomposing returns into calm and uncertain months gives us

interesting insights regarding investor’ expectations about uncertainty in near-term aggregate

volatility and portfolio return dynamics. For example, looking at columns 5 and 10 of Table 2,

one can see that asset classes, regardless of their portfolio characteristics, lose much more when

market volatility is expected to be highly volatile. This is in line with Hsu and Liu (2009) who

document that volatile periods coincide with bear markets. On the other hand, columns 2, 3, 7

and 8 document the typical size and value vs. growth anomalies. More particularly, static CAPM

fails to offer a clear and linear relationship between betas and portfolio returns, i.e. high (low)

returns are not always justified by high (low) CAPM betas. However, looking at columns 4, 5, 9,

15
and 10 of Table 2, one can gain interesting insights. For example, in calm months (when RVIX is

below the estimated threshold), one can see almost a monotonous decrease in returns going from

small and value portfolios through big and growth portfolios. The opposite is true for episodes

when uncertainty about aggregate volatility is high, when small and value portfolios become the

worst performers. Despite their higher average returns relative to big and growth portfolios,

small and value stock portfolios become the worst performers at times of high uncertainty about

expected aggregate volatility when the market is expected to do badly.31 On the other hand, by

losing less than the market portfolio, big and growth portfolios can be seen as relatively safer

asset classes during uncertain periods about aggregate volatility and market conditions.

The preliminary findings informally confirm our hypotheses that size and book-to-market

portfolios have different sensitivities to market risk during periods of different expectations

regarding the evolution of aggregate volatility. Thus, we posit that an asset pricing model that

correctly takes into account this volatility-based time variation in risk and returns is expected to

do better in pricing and in explaining size and value vs. growth anomalies.

4. Tests of V-CAPM

We begin by examining whether there are statistically significant regime shifts in betas

due to changes in investors’ expectations regarding uncertainty about aggregate volatility and

market conditions. Our conditioning variable is range of the VIX index and Table 3 reports the

associated bootstrap p-values for the sup-LM test. The null hypothesis is that there is no

significant regime shift in portfolio betas. According to bootstrap p-values presented in Table 3,

there are significant regime changes in betas of most portfolios. For portfolios sorted with

31
This also holds for the zero-cost SMB and HML portfolios, which earn on average 58 and 71 basis points per
month during calm market conditions, but which become extremely risky strategies and lose 269 and 231 basis
points, respectively, during high expected volatility periods.

16
respect to market capitalizations, eight out of ten experience significant changes in their betas

between uncertain and calm periods about expected aggregate volatility. For portfolios sorted

with respect to book-to-market ratios, the evidence indicates a regime shift in betas of seven out

of ten portfolios. SMB and HML portfolios also exhibit significant regime shifts in betas. The

results are also robust to using the orthogonalized version of RVIX (RVIXORTH). Taking into

account that the threshold parameter RVIX captures investors’ expectations about uncertainty in

near-term volatility, uncertainty about the evolution of aggregate volatility seems to be an

important determinant of their assessment of aggregate risk conditions and an asset’s sensitivity

to overall market risk. The results, if persistent, offer new evidence and an alternative

explanation to the empirically observed size and value vs. growth anomalies.

<< Insert Table 3 about here >>

The conditional CAPM models may have a tendency to overstate the time variation, and

as a result, continuous approximations of CAPM produce highly volatile beta estimates. This is

further confirmed with the evidence reported in Braun, Nelson, and Sunier (1995), who use a

bivariate EGARCH model to estimate conditional betas and document weak evidence of time

variation. On the other hand, our threshold methodology using RVIX as a conditioning variable

suggests that portfolio betas are stable during different expected volatility regimes, however

investors update their beta estimates when their expectations regarding the uncertainty about

near-term volatility change considerably.

4.1. The Relation Between Aggregate Volatility Expectations and Beta

Having detected significant regime shifts in betas for most of the portfolios, we proceed

to test the magnitude of this change, and estimate asset betas and their associated threshold

17
parameters during uncertain and calm periods about expected aggregate volatility. Table 4

reports the static CAPM betas, betas estimated via the V-CAPM in calm (regime 1) and high

uncertainty (regime 2) regimes, together with the threshold estimate of RVIX, which determines

the change in uncertainty about aggregate volatility expectations, above (or below) which

investors re-assess a stock’s riskiness.

Before going into detailed analysis of portfolio betas Table 4, looking at the last column

of Panel A, one can see that the estimated threshold level of RVIX is very stable across size

portfolios, which is estimated at 9.33 in 7 of the 11 cases. 32 Given that RVIX can take on any

positive real number, this consistent level of the threshold estimate affirms the robustness of the

threshold estimation procedure, the proposed model, and the chosen threshold parameter, RVIX.

We argue that the stability of RVIX across portfolios signals to the degree of uncertainty that the

market views as critical regarding aggregate volatility expectations. When range of VIX index in

a given month is below 9.33, the uncertainty in the market is tolerable and betas remain

unaffected. However, when RVIX is more than 9.33, this indicates that uncertainty in the market

regarding the evolution of expected aggregate volatility has increased, and hence investors

update their information set and risk-return dynamics with respect to this information, which is

also reflected in betas accordingly.

Next, a detailed analysis of columns 3 and 4 of Panel A reveals important insights about

how the riskiness of different size sorted portfolios changes from one volatility regime to the

other. We note significant changes in beta risk of size sorted portfolios. In particular, betas of

small stock portfolios increase considerably at times of high uncertainty about expected

32
The threshold levels of 17.69 and 6.07 for deciles 6 and 8 might seem as big deviations from 9.33 at first sight,
however, note that these are the two portfolios where the sup-LM test was unable to detect significant regime
changes. This is also the case for decile 8 of book-to-market sorted portfolios, which is detected as a portfolio with
insignificant regime shift and has a relatively high threshold estimate of 15.00.

18
aggregate volatility. Furthermore, it is only the biggest decile portfolio, which exhibits a decrease

in its beta during high uncertainty episodes.

<< Insert Table 4 about here >>

The above findings imply that investors re-assess the riskiness of size sorted portfolios

when range of the VIX index is above (or below) the threshold level of 9.33. For example, when

aggregate volatility is expected to be volatile significantly (i.e. when RVIX is above the

threshold), investors re-estimate the beta for the smallest decile portfolio, and update it from 0.91

in calm periods to 1.24 in uncertain periods. Similarly, the riskiness of the biggest decile

portfolio changes when the RVIX is above (or below) the threshold level of 9.33. More

specifically, the beta for the biggest portfolio drops from 0.98 in calm volatility periods to 0.92

in uncertain periods. Furthermore, the beta differential between the smallest and biggest

portfolios (SMB) increases from -0.06 in the low expected volatility regime to 0.30 in the high

uncertainty regime about expected aggregate volatility.

Our findings imply that the sensitivity of an asset’s return with respect to the level of

uncertainty regarding expected aggregate volatility is an important determinant of an asset’s

riskiness. This has clear implications on pricing and portfolio allocation. For example, by having

a lower covariance with the market at times of high uncertainty about market volatility, biggest

decile portfolio tends to lose less than any other size-based strategy during volatile periods. Also

given that volatile episodes usually coincide with downward market moves and recessions, a

strategy invested in the biggest decile portfolio appears to be relatively less risky for risk-averse

investors, who are reluctant to lose wealth during those times. This implies a demand for big

stocks, thus pushing their prices up and resulting in lower average returns. Similarly, the risk of

small stock portfolios goes up when near-term aggregate volatility is expected to be volatile.

19
Because uncertainty and increases in aggregate volatility are mostly associated with bad market

conditions and deteriorations in investor wealth, by correlating highly with the market at times of

high uncertainty about aggregate volatility, small stocks are viewed as riskier at times when extra

dollar of loss is much more important.

Panel B of Table 4 offers similar results for portfolios sorted with respect to book-to-

market ratios. Value portfolios have consistently higher betas at times of high uncertainty about

expected volatility, whereas it is only the growth portfolio whose beta decreases during those

times. The results indicate significant time variation in the risk assessments of value and growth

portfolios with respect investors’ expectations about uncertainty in near-term aggregate

volatility. Investors view value stocks much riskier because they have a higher correlation with

the market at times of high uncertainty about aggregate volatility. Similarly, a portfolio strategy

in growth stocks tends to be less risky at those times. The results are in line with Lettau and

Ludvigson (2001) and Petkova and Zhang (2005), who also document time variation in riskiness

and expected returns of value and growth stocks, in conditional CCAPM and conditional CAPM

settings, respectively.

4.2. The Relation Between Aggregate Volatility Expectations and Risk-adjusted Returns

The documented evidence so far indicates that asset betas change significantly between

different volatility regimes, depending on whether investors expect significant uncertainty about

aggregate volatility or not. Furthermore, the proposed V-CAPM reveals a distinctive pattern

regarding change of beta risk among different asset classes. More particularly, small market

capitalization and high book-to-market (value) portfolios become riskier at times of high

uncertainty about aggregate volatility expectations. On the other hand, big market capitalization

20
and low book-to-market (growth) portfolios become less risky at those times. The findings of our

model offer a potential remedy to the static CAPM and its failure in explaining the well

documented size and value vs. growth anomalies. In order to examine the robustness of the

proposed volatility-based time-varying beta risk explanation, and to see whether investors’

expectations about uncertainty in aggregate volatility has a similar time-varying effect on risk-

adjusted returns, we next compare Jensen’s alphas and Sharpe ratios within the full sample, and

in calm and high uncertainty regimes determined by the threshold level of RVIX implied by the

proposed V-CAPM.

4.2.1. Comparison of Jensen’s Alphas

It is well-documented that small and value stocks on average produce significantly higher

returns than their large and growth counterparts.33 However, looking at Jensen’s alphas and betas

of different size and book-to-market portfolios in Table 5, we confirm previous studies that static

CAPM is unable to offer a risk-based explanation to these abnormal returns. On the other hand,

alphas implied by different volatility regimes help us uncover an important aspect of size and

value vs. growth puzzles, offering a volatility-based time-varying risk explanation.

<< Insert Table 5 about here >>

We initially document that size and value strategies pay off at times of low expected

volatility yielding significant and positive risk-adjusted returns. However, the trade-off for these

strategies is that they have extremely bad (significant and negative) risk-adjusted returns at times

of high uncertainty about expected volatility. For example, a strategy invested in the smallest

decile portfolio earns an average risk-adjusted return of 56 basis points during calm months,

33
Although excess returns on small stocks over big stocks have been disappearing during the last two decades,
excess returns on value stocks over growth stocks have been significantly persistent over years.

21
whereas the same strategy yields a risk-adjusted return of -211 basis points in months when

uncertainty about volatility is high. Similarly, a strategy invested in the highest book-to-market

(value) portfolio earns an average risk-adjusted return of 59 basis points during calm months, but

yields an average risk-adjusted return of -142 basis points in months when uncertainty about

volatility is high. SMB and HML strategies also yield similar and significant risk-adjusted

returns over calm and uncertainty periods. On the contrary, although strategies in biggest and

lowest book-to-market (growth) portfolios disappoint their investors in calm months with

average risk-adjusted returns of 8 and 24 basis points, respectively, they yield positive and

significant risk-adjusted returns in months when uncertainty about volatility is high (24 and 75

basis points, respectively).

4.2.2. Comparison of Sharpe Ratios

Next, we look at another popular measure of risk-adjusted return proposed by Sharpe

(1966, 1975). Sharpe ratio is a commonly used measure to track the performance of mutual funds

and it can be easily applied to measure the reward-to-variability of any investment asset or

portfolio. By scaling an asset’s excess return to the standard deviation of excess returns on the

asset, it is an ideal way of measuring of reward-to-variability of a managed fund and the

sensitivity of returns on an investment class or a trading strategy per unit of risk taken. 34 The

measure is model free, hence it provides an indirect test for the robustness of our chosen

volatility parameter RVIX, as we will compare the Sharpe ratios of test assets within the whole

sample with those obtained in two different volatility regimes determined by RVIX. Analyzing

reward-to-variability ratios in different volatility regimes will give us further insight about the

34
The excess return on the asset can be on any benchmark such as the S&P 500 returns or the risk-free rate. As in
most studies, we choose returns in excess of the risk-free rate to measure an asset’s excess return.

22
risk-return dynamics of the test assets with respect investors’ expectations regarding the

uncertainty about the evolution of near-term volatility.

<< Insert Table 6 about here >>

Looking at Panel A of Table 6, one can detect no clear pattern in Sharpe ratios of

portfolios sorted with respect to market capitalizations within the full sample. One can even say

that during the sample period, an investment strategy based on stocks in the smallest size decile

commands a lower reward per unit of risk taken as opposed to a strategy based on stocks in the

highest decile, which is not consistent with a rational risk-based explanation. On the other hand,

when we decompose the sample into two volatility regimes determined by the RVIX, we see

different risk-return dynamics across size sorted portfolios in different volatility regimes. In calm

periods, the strategy in the smallest decile portfolio commands a higher reward-to-variability

ratio compared to the biggest decile portfolio (0.2727 vs. 0.2250), however in periods when

uncertainty about volatility is high, the situation is reversed, investors experience a much worse

reward-to-variability ratio for the smallest decile portfolio against the biggest decile (-0.4513 vs.

-0.1727). This different pattern in Sharpe ratios is also consistent with our previous results

documenting significant differences in betas and Jensen’s alphas of those strategies and explains

why investors would want to be compensated for the extra risk that they are taking by investing

in small stocks.

We observe a similar pattern for the Sharpe ratios of portfolios sorted with respect to

book-to market ratios. Although there is not a significant in Sharpe ratios in the full sample, we

document that value portfolios command higher (lower) reward-to-variability ratios compared to

growth portfolios in calm (uncertain) periods, offering a coherent volatility-based risk-return

explanation to the empirically documented value vs. growth anomaly. The results confirm our

23
hypothesis that market’s expectation of uncertainty in aggregate volatility is an important

determinant of investors’ assessment of risk-return dynamics. Changes in betas and risk-adjusted

returns help us uncover why small and value stocks on average earn higher returns than their big

and growth counterparts. By conditioning asset returns using a novel forward-looking volatility

measure (RVIX), which summarizes investors’ expectations about the uncertainty of near-term

aggregate volatility, the proposed V-CAPM offers a volatility-based time-varying risk

explanation to the size and value vs. growth anomalies.

4.3. Cross-sectional Analysis

The time-series analyses at the portfolio level in the first part indicate distinct exposure of

size and book-to-market ratio sorted portfolios to uncertainty about aggregate volatility

expectations, which manifests itself with significant changes in portfolio betas during low and

high uncertainty periods about aggregate volatility. However, it is important to note that stocks

can exhibit significant cross-sectional variation within each portfolio. Therefore even though

time-series analysis at the portfolio level point towards RVIX being a potentially important

conditioning variable in explaining stock returns, this explanatory power might result from

stocks’ other characteristics. In the next section, we examine whether cross-sectional differences

in beta-return relationship are attributable to RVIX at the individual stock level, and whether

betas implied by high vs. low uncertainty about aggregate volatility is a priced risk factor in the

cross-section.

4.3.1. Univariate Portfolio Sorts Based on Threshold RVIX Betas

We start with examining whether stock betas estimated via threshold level of RVIX can

predict the cross-sectional differences in their returns. Following Ang et al. (2006), we estimate

24
Equation (3) using monthly regression windows with daily data. In line with our previous results,

we use the most commonly observed RVIX threshold level to identify low (high) expected

volatility periods. More particularly, we identify months in which the threshold parameter RVIX

is greater (less) than 9.33 as periods of high (low) uncertainty about expected aggregate

volatility. We denote corresponding betas as 𝛽𝑈𝑁𝐶 and 𝛽𝐶𝐴𝐿𝑀 , respectively. The sample is the

universe of CRSP stocks covering all NYSE/AMEX/NASDAQ common stocks with share codes

10 and 11. The regressions are estimated each month from January 1986 to December 2010 (300

months).

We next conduct portfolio-level analysis to investigate cross-sectional predictive power

of 𝛽𝑈𝑁𝐶 and 𝛽𝐶𝐴𝐿𝑀 . For each month, from February 1986 to December 2010, stocks are sorted

into decile portfolios based on their 𝛽𝑈𝑁𝐶 and 𝛽𝐶𝐴𝐿𝑀 . Our portfolio formation exercise uses

information available only as of the formation date. Hence it avoids potential look-ahead bias in

the estimation of betas. Decile 1 (10) contains stocks with the lowest (highest) betas. Next-month

post-ranking portfolio returns are calculated using both equally- and value-weighted weighting

schemes, and the procedure is repeated each month. Table 7 reports next-month returns, CAPM

and Fama and French (1993) 3-factor alphas of 𝛽𝑈𝑁𝐶 and 𝛽𝐶𝐴𝐿𝑀 sorted deciles.

<<Insert Table 7 about here>>

Univariate portfolio sorts indicate an almost monotone and negative relationship between

the betas and next-month average returns when uncertainty about expected aggregate volatility is

high. Portfolio of stocks with lowest 𝛽𝑈𝑁𝐶 (portfolio 1) earns 1.72% per month, whereas return

on the portfolio of stocks with highest 𝛽𝑈𝑁𝐶 (portfolio 10) is 1.16% per month. The spread

portfolio which is long in the highest 𝛽𝑈𝑁𝐶 stocks and short in the lowest 𝛽𝑈𝑁𝐶 stocks (10-1)

loses on average 0.72% per month with a t-statistic of –2.92. Next month’s risk-adjusted returns

25
(CAPM and FF 3-factor alphas) as well as value-weighted returns (both raw and risk-adjusted)

also imply a negative beta next-month stock return relationship during periods of high

uncertainty about expected aggregate volatility, with alphas and raw returns of the spread

portfolio ranging from -0.49% to -0.73% with almost all but one being significant at 5% level.

On the other hand, our proposed model is able to establish a positive beta next-month

stock return relationship during periods of low uncertainty about expected aggregate volatility. In

particular, portfolio of stocks with lowest 𝛽𝐶𝐴𝐿𝑀 (portfolio 1) earns 1.84% per month, whereas

return on the portfolio of stocks with highest 𝛽𝐶𝐴𝐿𝑀 (portfolio 10) is 2.44% per month. The

spread portfolio which is long in the highest 𝛽𝐶𝐴𝐿𝑀 stocks and short in the lowest 𝛽𝐶𝐴𝐿𝑀 stocks

earns on average 0.60% per month which is significant at 5% level. Although value-weighted

returns further confirm a positive beta stock return relationship at periods of low uncertainty

about aggregate volatility, next month’s risk-adjusted returns (CAPM and FF 3-factor alphas) of

the spread portfolio are relatively lower and insignificant. Overall, betas implied by the threshold

level of RVIX capture uncertainty about expected aggregate volatility indicating that cross-

section of expected returns are systematically related to the level of uncertainty about aggregate

volatility.

4.3.2 Fama-MacBeth (1973) Tests for Risk Premia

There is now a consensus on time variation in market risk. The conditional CAPM is an

attempt to capture this variation. However, Ghysels (1998) shows that the conditional CAPM is

unable to specify time variation accurately, leading to higher pricing errors compared to the

unconditional CAPM. In view of these findings, we believe that it is crucial to understand the

true dynamics of time variation in beta risk and incorporate this dynamics in the pricing model.

26
Our previous findings establish that beta risk exhibits significant changes triggered by shifts in

investors’ expectations regarding the evolution of near-term aggregate volatility. Hence, the next

natural step would be to analyze whether this risk is priced in the cross-section.

We employ standard Fama and MacBeth (1973) two-pass regression methodology. The

full model to be tested is,

K
ri ,jt   t j   MKT ,i ,t  MKT ,t    k ,i ,t  k ,t   i ,t , j  0 ,1, 2
j j j k j
( 7)
k 1

where λ’s represent unconditional prices of risk for various loadings and characteristics, and j =

0, 1, and 2 represent full sample, low and high uncertainty about expected volatility,

respectively. In line with our previous results, we use the most commonly observed RVIX

threshold level to identify low (high) uncertainty periods. More particularly, we identify months

in which the threshold parameter RVIX is greater (less) than 9.33 as uncertain (calm) periods

about expected aggregate volatility.35

In the first pass, beta loadings are estimated at each month using daily observations. In

the second pass, a cross-sectional regression is run each month, with beta loadings obtained from

the first pass regressions and additional firm characteristics. The associated estimates for the

intercept term, α, and the risk premia, λ’s, are given by the average of those cross-sectional

regression estimates. Table 7 summarizes the risk premium estimates of associated models

implied by Equation (7).

<< Insert Table 8 about here >>

1 We test 7 different specifications of Equation (7). The first column represents the market

model using the full sample. Consistent with earlier findings, CAPM fails to produce a positive

35
We further tried six other threshold levels of RVIX ranging from 8.42 to 11.10, which coincide with the next
commonly observed RVIX threshold levels in our tests after 9.33. The results are robust to different threshold levels
found in portfolio level analyses.

27
and significant risk premium. The second column estimates the price of market risk in low

volatility regime. One can see that, for months where RVIX is less than 9.33 (257 months)

market risk premium is positive and significant, hence the proposed V-CAPM is successful in

establishing a significant sign regarding the price of market risk in periods when market

volatility is not expected to change significantly. Column 3 estimates the price of market risk in

high volatility periods, which corresponds to 43 months in our sample estimation period. We

document a negative and significant market risk premium when the market is expected to exhibit

high volatility.

A negative and significant market risk premium might seem counter-intuitive at first, and

at odds with theoretical predictions of CAPM and relevant risk-based asset pricing theories

where investors should be compensated with a positive risk premium for holding risky assets

such as the market portfolio. However, from an empirical point of view, average realized returns

can be negative in narrowly defined periods in which the reward for taking risk does not

materialize. For example, according to data compiled by Shiller (2013), equity risk premium has

been negative around 75% of the time during the period starting with Nifty Fifty of the 1970’s to

the end of 2007 just before the crisis. Our explanation for the negative risk premium is flight to

safety during episodes when uncertainty about expected aggregate volatility is high. For

uncertainty averse investors, these episodes reflect increase in ambiguity of expected returns

where it becomes extremely difficult to assess which direction the market will go. These

episodes are characterized as periods of unknown unknowns as argued by Baltussen et al. (2014),

i.e. periods when investors don’t know what they don’t know about expected market volatility.

One natural implication to avoid this ambiguity would be to fly to safe heavens such as bonds,

which provide payoffs that are more known and certain. A second order implication for the

28
cross-section of stocks is that there will also be a flight to safety from small and value stocks to

big and growth stock because small and value stocks have higher sensitivities to overall market

risk during periods of increased uncertainty about expected aggregate volatility.

To see whether the above results are robust and to make sure the cross-sectional tests are

not suffering from an omitted variables bias, we test the proposed V-CAPM in the presence of

different factor loadings as well as several firm characteristics that have been documented as

important in asset pricing literature. The estimation in specification IV includes market loading

as well as SMB, HML, and MOM loadings, all estimated in monthly windows using daily data.

We see that market risk premium is still significant and positive, confirming the robustness of a

significant and positive market risk premium in calm months. Furthermore, column V shows that

the significance of negative market risk premium disappears when SMB, HML, and MOM

factors are included in high uncertainty regime estimations. Finally, columns VI and VII include

three firm characteristics, which are idiosyncratic volatility, market capitalization and book-to-

market ratio. Idiosyncratic volatility puzzle (the fact that stocks with low (high) idiosyncratic

volatility earn higher (lower) returns) has received considerable interest since it has been first

documented by Ang et al. (2006). We would like to explore whether idiosyncratic volatility is a

priced risk factor or not using the implications of our threshold V-CAPM and the threshold

RVIX variable.36 We further incorporate firm size and B/M ratio as additional firm

characteristics.

36
We measure idiosyncratic volatility as outlined in Ang et al. (2006). More particularly, first on a daily basis we
estimate the regression residual from the Fama and French (1993) three-factor mode; i.e.
ri ,t  i  i , MKT MKTt  i , SMBSMBt  i , HML HMLt   i ,t .
The idiosyncratic volatility is expressed as,
1
 1 T 2  2
IDIOVOLi ,t     i,t  ,
 T  1 t 1
where T is the number of trading days within a calendar month.

29
 Column VI confirms our previous finding that market risk premium is positive and

significant in the presence of further additional variables. Specification VII confirms a negative

but insignificant market risk premium in high uncertainty regime. We further document that

idiosyncratic risk is also priced in both regimes. More interestingly, we document a positive

relationship between idiosyncratic risk and returns in calm periods when uncertainty about

aggregate volatility expectations is low, and a negative relationship only in high expected

uncertainty periods. Idiosyncratic volatility risk is priced positively as in Malkiel and Xu (2006)

during periods when expected aggregate volatility does not change significantly. On the others

side, the idiosyncratic volatility puzzle (stocks with high idiosyncratic risk earn lower returns) is

shown to be a phenomenon that is pertinent to episodes where investors’ expect significant

uncertainty about near-term aggregate volatility. Our results offer a partial uncertainty-based

explanation to the idiosyncratic volatility puzzle.

Overall, the proposed V-CAPM does a good job in establishing a positive risk-return

relationship based on market risk. During low uncertainty months, the price of market risk is

positive and significant, which confirms our hypothesis that investors’ expectation about the

evolution of uncertainty about near-term aggregate volatility is an important determinant of their

risk-return tradeoff. Furthermore, during high uncertainty months, the price of market risk is

negative and significant, but the significance of negative market risk premium disappears and is

subsumed by the HML strategy and idiosyncratic volatility during those months. CAPM has

been much criticized due to its failure in establishing a positive risk-return relationship and its

silence regarding several anomalies. The pricing tests in this section confirm that CAPM is still

alive but need to be modified by taking into account investors’ expectations regarding

30
uncertainty about near-term volatility, and the proposed threshold V-CAPM is a step in this

direction. The findings also offer interesting insights regarding the idiosyncratic volatility puzzle.

4.4. Alternative Measures of Volatility and Further Robustness Tests

One limitation of using RVIX as a conditioning variable is obviously its time span. The

data regarding VIX index can be traced back to January 1986. On the other hand, using statistical

measures of volatility has the advantage of covering much longer time horizons. To test the

sensitivity of our results to alternative measures of volatility, we repeat tests presented in

previous sections using several historical, statistical and option-based measures as a proxy for

aggregate volatility. These include the standard deviation of market returns, squared returns,

monthly range of the market index (given by the maximum and minimum level of the market

index in a given month), GARCH (1, 1) volatility, change in VIX index (ΔVIX), and monthly

returns on at-the-money straddles written on the S&P 500 index. Neither of the four backward-

looking statistical measures, nor the forward-looking option-based measure (ΔVIX) proved to

yield significant results to model time variation in betas.37

On the other hand, monthly ATM S&P 500 straddle returns produce very similar results

to those obtained by range of the VIX index.38 The results using monthly returns on ATM S&P

500 straddles as the conditioning variable can be summarized as follows.39 Similar to previous

findings, most portfolios exhibit significant bootstrap p-values indicating a significant change in

37
This confirms our argument that forward-looking volatility measures do a better job in capturing investors’
expectations on aggregate market risk compared to statistical measures. The results also lend indirect support to Ang
et al. (2006) who find that statistical measures of aggregate volatility, such as sample volatility, extreme value
volatility estimates, and realized volatility estimates, do not produce enough spread in the cross-section.
38
The significance of ATM straddle returns over ΔVIX supports Cremers et al. (2012) who document that ΔVIX
loses its significance in capturing volatility risk premium in the presence of measures constructed using ATM
straddle returns.
39
The results in detail related to ATM straddle returns are available upon request.

31
beta risk due to changes in returns on ATM straddles. Second, the direction of change in betas is

very similar to results obtained using RVIX. We observe an increase in beta risk for small and

value portfolios and a decrease in the risk of big and growth portfolios at times of high volatility,

confirming our explanation that investors see small and value stocks much riskier in volatile

market episodes, which usually coincides with deteriorations in investment opportunities and

reductions in wealth.

We further examine Jensen’s alphas, Sharpe ratios and the pricing performance of the

proposed V-CAPM using ATM straddle returns as the conditioning variable and confirm that our

volatility-based time-varying risk explanation to the observed size and value vs. growth

anomalies is robust to the use of an alternative forward-looking market based volatility measure.

Finally, looking at the cross-sectional price of risk, using individual stock level data, we find that

market risk is priced in the cross-section especially at times of low expected aggregate volatility,

and is significantly positive.

5. Conclusion

We propose an asset pricing model where betas change discretely at different points in

time. This change is due to investors’ assessment of uncertainty about near-term aggregate

volatility. Proxying investors’ expectations regarding the uncertainty about near-term aggregate

volatility with the range of the VIX index, RVIX, we document the following.

First we find that there exists significant time variation in market betas with respect to

uncertainty in expected aggregate volatility. In particular, small market capitalization and value

portfolios have consistently higher betas compared to big market capitalization and growth

portfolios at times of high uncertainty about expected volatility. Moreover, the beta dispersions

32
between small-big and value-growth portfolios are negative (positive) during calm (uncertain)

periods about expected volatility. Because they correlate more with the market at times when

investors expect significant uncertainty in aggregate volatility, small and value portfolios are

viewed as riskier than big and growth portfolios in bad times when uncertainty about aggregate

market volatility is expected to be high. This volatility-based risk explanation is further

confirmed by the risk-adjusted returns implied by the V-CAPM. During calm periods when

uncertainty about expected aggregate volatility is low, small and value portfolios earn on average

higher risk-adjusted returns than big and growth portfolios, however they become extremely

risky strategies at times of increased uncertainty regarding expected volatility exhibiting negative

and significant risk-adjusted returns. Finally, the proposed V-CAPM is able to establish a

positive market risk premium during calm periods when uncertainty about expected aggregate

volatility is low.

CAPM has been much criticized due to its failure in establishing a positive risk-return

relationship and its silence regarding several pricing anomalies. There is now a consensus on

time-variation in betas, but not on how this variation should be modelled. By using a novel

forward looking option-implied volatility measure, we allow asset betas to incorporate

information regarding investors’ expectations about uncertainty in near-term aggregate volatility

in a dynamic way. The proposed model and the related empirical results support the view of a

risk-based rational asset pricing theory and offers a volatility-based explanation of risk-return

dynamics where asset return sensitivities to market risk change discretely in time with respect to

uncertainty in investors’ expectations regarding near-term aggregate volatility.

33
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 Table 1. Descriptive Statistics

This table reports the descriptive statistics for monthly returns on the market portfolio (MKT), and monthly range of
the VIX index (RVIX), as well as orthogonalized measure of RVIX (RVIXORTH), and 4 business cycle related
measures. The market portfolio is the CRSP value-weighted index for all NYSE, AMEX, and NASDAQ stocks.
RVIX is the difference between maximum and minimum level of VIX in a given month, i.e. RVIX t = Max{VIXτ} -
Min{VIXτ}, τ = 1,2, … , T, where τ denotes trading days in a given month, and t denotes months. . DIV is the
dividend yield of the S&P 500 index. DEF is defined as the spread between BAA and AAA rated corporate bond
yield and TERM is the spread between 10-year and 1-year U.S. government bond yields. TB is the one-month
Treasury Bill rate. RVIXORTH is the residual term from the following regression:
RVIX t     MKT MKTt   SMBDIVt   DEF DEFt  TERM TERM t  TBTBt  VIX VIX t   t
The sample covers the period from January 1986 to December 2012 (324 months). For the period covering January
1986 to December 1989, VIX is replaced by VXO which is based on S&P 100 index options. All return figures are
in percentages.

Panel A: Summary statistics

MKT RVIX RVIXORTH TERM DEF DIV TB
Mean 0.89 6.66 0 1.43 1.00 0.02 0.31
Median 1.49 4.98 0.04 1.47 0.91 0.02 0.37
Maximum 12.88 129.04 84.04 3.40 3.38 0.39 0.79
Minimum -22.64 0.92 -16.67 -0.41 0.55 0.01 0
Std.Dev. 4.61 8.36 6.11 1.07 0.40 0.01 0.20
Skewness -0.89 10.25 8.60 0.10 2.87 0.34 -0.11
Kurtosis 5.48 144.02 121.09 1.82 14.94 1.85 2.08
Panel B: Correlations
MKT 1
RVIX -0.41 1
RVIXORTH 0 0.73 1
TERM -0.04 0.09 0 1
DEF -0.08 0.28 0 0.29 1
DIV 0.02 0.08 0 0.13 0.32 1
TB 0.04 -0.05 0 -0.71 -0.34 0.36 1

40
 Figure 1. Time-series of RVIX and Market Returns
120 .15

.10
100
.05
80
.00

60 -.05

-.10
40
-.15
20
-.20

0 -.25
86 88 90 92 94 96 98 00 02 04 06 08 10 12

MARKET RVIX

41
 Table 2. Stylized Facts About Portfolio Returns
This table presents the returns on several portfolios that have been used as test assets in this study and the market
portfolio during the full sample period from January 1986 through December 2012 (324 months) and two different
volatility regimes. Size represents portfolios which contain stocks sorted with respect to their market capitalizations.
B/M represents portfolios which contain stocks sorted with respect to their book-to-market ratios. SMB is a portfolio
that is long in stocks in the smallest decile and short in stocks in the biggest decile. HML is a portfolio that is long in
stocks which are in the highest B/M decile and short in stocks which are in the lowest B/M decile.

Size Beta Full Regime1 Regime2 B/M Beta Full Regime1 Regime2
sample (Calm) (Volatile) sample (Calm) (Volatile)
Small 1.0163 0.0097 0.0176 -0.0365 High 1.0557 0.0115 0.0187 -0.0298
Decile2 1.1604 0.0096 0.0170 -0.0330 Decile2 0.9864 0.0107 0.0160 -0.0203
Decile3 1.1434 0.0104 0.0173 -0.0297 Decile3 0.9716 0.0091 0.0149 -0.0239
Decile4 1.1262 0.0094 0.0158 -0.0271 Decile4 0.9512 0.0102 0.0147 -0.0156
Decile5 1.1380 0.0104 0.0164 -0.0240 Decile5 0.9467 0.0090 0.0135 -0.0167
Decile6 1.0713 0.0104 0.0157 -0.0213 Decile6 0.9029 0.0096 0.0143 -0.0179
Decile7 1.0673 0.0108 0.0164 -0.0205 Decile7 0.8487 0.0098 0.0153 -0.0221
Decile8 1.0795 0.0103 0.0156 -0.0203 Decile8 0.8445 0.0102 0.0141 -0.0124
Decile9 1.0101 0.0101 0.0148 -0.0170 Decile9 0.9228 0.0093 0.0129 -0.0109
Big 0.9449 0.0087 0.0118 -0.0096 Low 1.0501 0.0090 0.0116 -0.0066
SMB 0.0716 0.0010 0.0058 -0.0269 HML 0.0059 0.0026 0.0071 -0.0231
Market 0.0089 0.0129 -0.0143 Market 0.0089 0.0128 -0.0143

42
 Table 3. Bootstrap p-values for 10 Size and B/M portfolios

This table reports the bootstrap p-values of the modified sup-LM test suggested by Hansen (1996). We test the null
hypothesis of no significant regime shifts in portfolio betas due to changes in the level of uncertainty regarding
aggregate volatility expectations, captured by RVIX, as well as an orthogonalized measure of RVIX (RVIXORTH).
RVIXORTH is the residual term from the following regression:
RVIX t     MKT MKTt   SMBDIVt   DEF DEFt  TERM TERM t  TBTBt  VIX VIX t   t
Size represents portfolios which contain stocks sorted with respect to their market capitalizations, and B/M
represents portfolios which contain stocks sorted with respect to their book-to-market ratios, respectively. The
sample period covers January 1986 to December 2012 (324 months). *, **, *** denote significance levels at 10%, 5%,
and 1%, respectively.

Size RVIX RVIXORTH B/M RVIX RVIXORTH

Small 0.000*** 0.000*** High 0.012** 0.000***
Decile2 0.000*** 0.024** Decile2 0.009*** 0.001***
Decile3 0.000*** 0.035** Decile3 0.013** 0.000***
Decile4 0.015** 0.042** Decile4 0.144 0.148
Decile5 0.025*** 0.051* Decile5 0.029** 0.009**
Decile6 0.140 0.044** Decile6 0.067* 0.022**
Decile7 0.016** 0.003*** Decile7 0.008*** 0.030**
Decile8 0.144 0.009*** Decile8 0.435 0.642
Decile9 0.056* 0.018** Decile9 0.219 0.167
Big 0.008*** 0.007*** Low 0.000*** 0.000***
SMB 0.009*** 0.058** HML 0.001*** 0.000***

43
 Table 4. Threshold Estimates for 10 Size and 10 Book-to-Market Portfolios

This table reports the unconditional CAPM betas, the threshold beta estimates with respect to low and high
volatility regimes, and their associated threshold volatility estimates, proxied by S&P 500 at-the-money straddle
returns. Panels A and B present results for portfolios sorted with respect to market capitalizations, and book-to-
market ratios, respectively. SMB is a portfolio that is long in stocks in the smallest decile and short in stocks in the
biggest decile. HML is a portfolio that is long in stocks which are in the highest B/M decile and short in stocks
which are in the lowest B/M decile. The sample covers the period from January 1986 to December 2012 (324
months). Regime 1 (2) corresponds to low (high) uncertainty about volatility regimes where monthly RVIX is
lower (higher) than the estimated threshold level.

Panel A: 10 size portfolios

CAPM Beta Beta for Regime 1 Beta for Regime 2 Threshold Estimate
Small 1.0163 0.9093 1.2350 8.80
Decile2 1.1604 1.0772 1.1662 8.42
Decile3 1.1434 1.0453 1.2060 9.33
Decile4 1.1262 1.0401 1.1874 9.33
Decile5 1.1380 1.0684 1.1884 9.33
Decile6 1.0713 1.0330 1.2516 17.69
Decile7 1.0673 1.0109 1.1067 9.33
Decile8 1.0795 1.0478 1.0919 6.07
Decile9 1.0101 0.9723 1.0190 9.33
Big 0.9449 0.9762 0.9223 9.33
SMB 0.0716 -0.0616 0.3026 9.33
Panel B: 10 B/M portfolios
CAPM Beta Beta for Regime 1 Beta for Regime 2 Threshold Estimate
High 1.0557 0.9776 1.0831 9.58
Decile2 0.9864 0.9357 1.0513 9.58
Decile3 0.9716 0.9247 1.0606 9.58
Decile4 0.9512 0.9038 1.0399 9.58
Decile5 0.9467 0.8687 1.0648 11.10
Decile6 0.9029 0.8308 1.0127 11.10
Decile7 0.8487 0.7983 0.8906 10.92
Decile8 0.8445 0.7425 0.9266 15.00
Decile9 0.9228 0.8373 0.9944 10.78
Low 1.0501 1.1249 0.9892 9.33
HML 0.0059 -0.1514 0.0930 9.33

44
 Table 5. Comparison of Jensen’s Alphas
This table reports Jensen’s alphas for the unconditional CAPM and for the threshold volatility model (V-CAPM)
with respect to low and high volatility regimes. The sample covers the period from January 1986 to December 2012
(324 months). Regime 1 (2) corresponds to low (high) uncertainty about volatility regimes where monthly RVIX is
lower (higher) than the estimated threshold level. The numbers in parantheses denote the associated t-statistics with
Newey-West corrected standard errors.
Panel A: 10 Size portfolios
α CAPM α V-CAPM, Regime1 α V-CAPM, Regime2
Small 0.0636 0.5601 -2.1113
(0.25) (1.98**) (-4.47***)
Decile2 -0.0221 0.3322 -1.5210
(-0.11) (1.37) (-3.50***)
Decile3 0.0680 0.3908 -1.1887
(0.41) (1.96*) (-2.85***)
Decile4 -0.0177 0.2389 -0.9651
(-0.12) (1.32) (-2.48**)
Decile5 0.1753 0.2750 -0.6550
(0.58) (1.80*) (-2.22**)
Decile6 0.1089 0.2543 -0.4421
(0.94) (2.00) (-1.50)
Decile7 0.1521 0.3319 -0.5203
(1.43) (3.02***) (-1.77*)
Decile8 0.0938 0.2158 -0.4439
(0.92) (1.94*) (-1.86*)
Decile9 0.1147 0.1997 -0.2266
(1.49) (2.35**) (-1.25)
Big 0.0111 -0.0792 0.3373
(0.20) (-1.27) (2.37**)
SMB -0.3088 0.2543 -2.6881
(-0.85) (1.33) (-4.48***)
Panel B: 10 B/M portfolios
α CAPM α V-CAPM, Regime1 α V-CAPM, Regime2
High 0.2306 0.5930 -1.4147
(0.94) (2.26**) (-3.40***)
Decile2 0.2241 0.4556 -0.6294
(1.40) (2.34**) (-2.27**)
Decile3 0.1143 0.4352 -1.1103
(0.61) (2.29**) (-2.54**)
Decile4 0.2190 0.3595 -0.3378
(1.33) (1.75*) (-1.14)
Decile5 0.0443 0.1756 -0.1842
(0.35) (1.16) (-0.63)
Decile6 0.1256 0.3015 -0.4080
(0.89) (1.77*) (-1.21)
Decile7 0.1060 0.3309 -0.7462
(0.73) (1.95*) (-2.50**)
Decile8 0.1566 0.1791 0.1433
(1.58) (1.75*) (0.49)
Decile9 0.0547 0.0167 0.3516
(0.62) (0.15) (1.61)
Low -0.0222 -0.2426 0.7474
(-0.18) (-1.88*) (2.66**)
HML 0.0600 0.4331 -2.4016
(0.17) (2.53**) (-4.10***)
45
 Table 6. Comparison of Sharpe Ratios and Volatilities
This table reports portfolio ex-post Sharpe ratios and standard deviations for the full sample and two subsamples
representing two different volatility regimes. Regime 1 (2) corresponds to low (high) uncertainty about volatility
regimes where monthly RVIX is lower (higher) than the estimated threshold level. Panels A and B presents results
for portfolios sorted with respect to market capitalizations, and book-to-market ratios, respectively. SMB is a
portfolio that is long in stocks in the smallest decile and short in stocks in the biggest decile. HML is a portfolio that
is long in stocks which are in the highest B/M decile and short in stocks which are in the lowest B/M decile. The
sample covers the period from January 1986 to December 2012 (324 months).

Panel A: 10 Size portfolios

Sfull σfull SRegime1 σRegime1 SRegime2 σRegime2
Small 0.1047 6.1800 0.2727 5.2697 -0.4513 8.6296
Decile2 0.0995 6.4755 0.2486 5.5158 -0.3761 9.4052
Decile3 0.1197 6.0513 0.2833 4.9713 -0.3423 9.3709
Decile4 0.1073 5.8601 0.2605 4.8034 -0.3200 9.2201
Decile5 0.1264 5.7654 0.2774 4.7388 -0.2899 9.1022
Decile6 0.1369 5.2880 0.2894 4.3103 -0.2692 8.4899
Decile7 0.1475 5.1879 0.3159 4.1494 -0.2799 8.4778
Decile8 0.1374 5.1926 0.2912 4.2296 -0.2718 8.3341
Decile9 0.1451 4.7889 0.2965 3.8871 -0.2493 7.7732
Big 0.1238 4.4706 0.2250 3.8149 -0.1727 6.9428
SMB -0.0664 3.2503 0.0570 3.2547 -0.5456 2.8644
Panel B: 10 B/M portfolios
Sfull σfull SRegime1 σRegime1 SRegime2 σRegime2
High 0.1376 6.0808 0.3009 5.1259 -0.3601 8.9403
Decile2 0.1548 4.8706 0.3275 3.9062 -0.2871 7.8923
Decile3 0.1305 4.5919 0.3300 3.5221 -0.3430 7.6930
Decile4 0.1564 4.5171 0.3034 3.7634 -0.2560 7.0277
Decile5 0.1240 4.7423 0.2702 3.7813 -0.2403 7.9366
Decile6 0.1389 4.6370 0.2981 3.7196 -0.2668 7.6018
Decile7 0.1360 4.8830 0.3072 3.9252 -0.3128 7.8432
Decile8 0.1503 4.6758 0.2802 3.8612 -0.1958 7.5451
Decile9 0.1306 4.7558 0.2433 3.9492 -0.1732 7.6979
Low 0.1125 5.1623 0.1829 4.5820 -0.1185 7.5777
HML 0.0180 3.0837 0.0943 2.9435 -0.3368 3.5854

46
 Table 7. Univariate Portfolio Sorts Based on Threshold RVIX Betas

This table reports next-month equally- and value-weighted returns, next-month CAPM alpha, next-month Fama and
French (1993) 3-factor alpha and post-ranking average betas of βUNC and βCALM sorted decile portfolios, where βUNC
corresponds to betas estimated in periods of high uncertainty about aggregate volatility (RVIX > 9.33) and βCALM
corresponds to betas estimated in periods of low uncertainty about aggregate volatility (RVIX < 9.33). Decile 1 (10)
contains stocks with the lowest (highest) betas. The test assets are all NYSE/AMEX/NASDAQ common stocks with
share codes 10 and 11. The sample period is from January 1986 to December 2010 (300 months).

Panel A: Portfolios Based on βUNC

1 2 3 4 5 6 7 8 9 10 10-1
(low) (high)
Equally-weighted
Average Return 1,719 1,243 1,328 1,232 1,204 1,175 1,101 1,175 1,166 0,999 -0,720
[3,31] [3,10] [3,54] [3,39] [3,32] [3,07] [2,68] [2,75] [2,34] [1,61] [-2,92]
CAPM Alpha 1,675 1,166 1,256 1,143 1,094 1,068 0,929 1,044 1,069 0,945 -0,730
[3,57] [3,27] [3,68] [3,46] [3,23] [2,97] [2,38] [2,57] [2,23] [1,54] [-2,33]
FF 3-Factor Alpha 1,629 1,116 1,225 1,144 1,108 1,078 0,956 1,083 1,140 1,018 -0,612
[3,58] [3,27] [3,71] [3,48] [3,24] [3,01] [2,44] [2,64] [2,36] [1,67] [-2,03]
Value-weighted
Avg. Return 1,469 1,175 1,245 1,160 1,144 1,110 1,057 1,116 1,071 0,855 -0,614
[2,97] [3,06] [3,51] [3,40] [3,35] [3,05] [2,69] [2,71] [2,22] [1,42] [-2,48]
CAPM Alpha 1,405 1,084 1,174 1,071 1,020 0,994 0,885 0,976 0,969 0,788 -0,617
[3,15] [3,14] [3,62] [3,41] [3,18] [2,86] [2,33] [2,45] [2,05] [1,31] [-1,96]
FF 3-Factor Alpha 1,366 1,043 1,154 1,078 1,040 1,009 0,920 1,020 1,045 0,876 -0,490
[3,14] [3,14] [3,64] [3,44] [3,21] [2,89] [2,40] [2,52] [2,20] [1,46] [-1,63]
Panel B: Portfolios Based on βCALM
1 2 3 4 5 6 7 8 9 10 10-1
(low) (high)
Equally-weighted
Average Return 1,843 1,910 1,930 1,792 1,864 1,845 1,905 1,991 2,010 2,441 0,598
[3,11] [4,23] [5,30] [5,11] [5,79] [6,03] [6,35] [6,31] [5,89] [5,31] [2,15]
CAPM Alpha 1,712 1,758 1,800 1,592 1,730 1,726 1,771 1,893 1,868 2,257 0,545
[2,60] [3,52] [4,60] [4,29] [5,14] [5,39] [5,97] [6,10] [5,68] [5,25] [1,32]
FF 3-Factor Alpha 1,730 1,766 1,765 1,560 1,614 1,630 1,679 1,653 1,608 1,940 0,210
[2,40] [3,30] [4,17] [4,01] [4,47] [4,84] [5,42] [5,51] [5,16] [4,29] [0,53]
Value-weighted
Avg. Return 1,682 1,802 1,849 1,731 1,781 1,771 1,803 1,882 1,916 2,173 0,491
[2,94] [4,15] [5,29] [5,21] [5,90] [6,22] [6,45] [6,39] [5,87] [5,00] [1,78]
CAPM Alpha 1,559 1,671 1,729 1,554 1,659 1,653 1,680 1,795 1,777 1,978 0,419
[2,38] [3,40] [4,52] [4,35] [5,16] [5,53] [6,00] [6,18] [5,62] [4,85] [0,99]
FF 3-Factor Alpha 1,631 1,701 1,717 1,553 1,579 1,597 1,619 1,604 1,550 1,700 0,068
[2,30] [3,25] [4,14] [4,10] [4,54] [5,04] [5,48] [5,56] [5,12] [3,92] [0,17]

47
 Table 8. Fama-MacBeth Risk Premium Estimates

This table reports the estimates for the average coefficients from cross-sectional Fama-MacBeth (1973) regressions,
K
ri ,jt   t j   MKT , i , t MKT , t    k , i , t k , t   i , t , j  0 ,1, 2
j j j k j

k 1
where λ’s represent unconditional prices of risk for various factor loadings and firm characteristics, and j = 0, 1, and
2 represent full sample, calm (low expected volatility) and volatile (high expected volatility) periods, respectively.
We identify months in which RVIX is less (greater) than threshold level 9.33 as calm (volatile) episodes. The test
assets are all NYSE/AMEX/NASDAQ common stocks with share codes 10 and 11. The sample period is from
January 1986 to December 2010 (300 months). Regime 1 (Regime 2) corresponds to months where aggregate
volatility is below (above) the threshold parameter. SMB and HML are portfolio loadings on Fama and French
(1993) factors and MOM is the portfolio loading on the Carhart (1997) momentum factor model, all of which are
measured using monthly data from the end of month t-36 to the end of month t. IDIOVOL is the idiosyncratic
volatility measured each month using daily data as in Ang et al. (2006).SIZE and B/M are the log of market
capitalization and the book-to-market ratio observed at the end of month t, respectively. MOM is firm-level
momentum calculated using the stock return from month t-12 to t-2. The numbers in parentheses are the Newey-
West (1987) corrected t-statistics for each coefficient estimate. The term adjusted R2 denotes the cross-sectional R2
statistic adjusted for the degrees of freedom. ***, **, and *denotes significance at 1%, 5% and 10% level,
respectively.

I II III IV V VI VII
BETA 0.14
(0.68)
BETA-CALM 0.41 0.51 0.77
(2.17**) (2.06**) (3.03***)
BETA-UNC -1.50 -1.00 -0.96
(-1.87*) (-1.02) (-1.10)
SMBBeta 0.31 -0.43 0.22 0.07
(1.68*) (-1.03) (1.29) (0.59)
HMLBeta 0.00 -1.03 -0.09 -0.22
(0.03) (-2.04**) (-0.49) (-2.00**)
MOMBeta 0.05 -0.66 0.13 0.08
(0.16) (-0.80) (0.45) (0.42)
IDIOVOL 0.77 -1.83
(2.91*** ) (-6.50*** )
SIZE -0.27 -0.19
(-5.37***) (-4.47***)
B/M 0.43 0.27
(8.14*** ) (4.44*** )
MOM 0.07 0.14
(5.26*** ) (9.64*** )
CONST 1.11 1.59 -1.81 1.19 -2.18 4.51 2.60
(4.13***) (6.23***) (-1.83*) (7.12***) (-3.34***) (6.74***) (4.57***)

Adj R2 1.74 1.46 3.51 7.13 10.69 9.78 13.74

48