Multi-factor volatility and stock returns

- Volatility of dynamic factors helps to explain the cross section of expected stock returns.
- The risk premium for volatility of the size and book-to-market factor is positive.
- The model can better forecast stock returns.
- The model brings significant economic values in asset allocation.

In light of inconclusive evidence on the relation between market volatility and stock returns, this paper proposes a multi-factor volatility model and examines its impact on cross-sectional pricing. We also evaluate the out-of-sample performance and economic significance of multi-factor volatility. We find that conditional variances of the size and value dynamic factor earn significant and positive variance risk premia. In addition, multi-factor volatility can significantly improve the out-of-sample return predictability with a positive economic gain in asset allocation.