Unconditional Volatility Framework: Theoretical and Empirical Insights

Abstract

This paper presents a study of volatility using the non-arbitrage valuation of equities as its foundation. The main objectives are (i) to develop a theory of volatility consistent with an asset pricing model, (ii) to theoretically explain the fundamental origins of volatility and (iii) to assess whether certain a-priori characteristics of volatility, predicted by the theory, are empirically observed. By integrating equity premium and volatility models, the framework provides an alternative approach to understand the relationship between risk and returns. It establishes a causal connection between business risk and equity price movements, offering an economic rationale for the existence of volatility. The framework’s predictive ability regarding volatility asymmetry and the low-volatility phenomena enhances an understanding in these areas. This research contributes to the literature on non-arbitrage valuation of equities, as well as to the literature on volatility asymmetry and the low-volatility phenomena. The theoretical justification for volatility’s existence challenges the foundations of behavioral finance, which often emphasizes the difficulty of explaining equity price fluctuations solely through rational arguments.