Annals of Finance

, Volume 7, Issue 1, pp 83–94

Does knowing the volatility states affect the market risk premium?

Research Article

DOI: 10.1007/s10436-010-0158-2

Cite this article as:
Bae, J. Ann Finance (2011) 7: 83. doi:10.1007/s10436-010-0158-2
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Abstract

Mayfield (J Financ Econ 73:465–496, 2004) has devised a method for estimating the market risk premium, based on a variant of Merton’s ICAPM wherein volatility is specified as a two-state Markov process. In this study, we assess Mayfield’s key assumption that investors know the current volatility state with certainty, via empirical testing of the assumption of exogenous Markov-switching in Mayfield’s model. We detect strong evidence of endogenous switching. This indicates that investors infer the current volatility state, as opposed to simply observing it. We also find that the risk premium estimates are affected by the switching type.

Keywords

Risk premium Endogenous Markov-switching Volatility states Investors’ information set 

JEL Classification

G12 G19 

Copyright information

© Springer-Verlag 2010

Authors and Affiliations

  1. 1.Department of EconomicsKonkuk UniversitySeoulKorea