Asset Pricing with an Excess Volatility Factor : A Multi-Index Model Approach

Abstract: This paper evaluates the impact that the integration of an excess volatility factor has on the asset-pricing performance of the Fama-French (1992, 1993) and of the Carhart (1997) models, with reference to the retrospective and prospective explanation of the time series and of the cross section of excess returns on stocks. Specifically, the research intends to determine whether or not a new excess volatility factor is able to capture common sources of excess returns on stocks, related to excess volatility, and left unexplained by the available asset-pricing models. The key motivation behind this research is to put in contact the current multi-index asset-pricing models with the behavioural finance perspectives over the determinants of speculative asset prices fluctuations. According to Shiller (2013) and Wang and Ma (2014) the excess volatility with which speculative asset prices fluctuate through time is explained by the behavioural principle of investors’ overreaction. The constancy with which this phenomenon affected stock prices for more than a hundred years suggests us its likely persistence through time. Hence, asset- pricing models should evaluate its role in explaining stock’s excess returns. The analysis is performed according to Fama and French’s (1993) methodology. The results indicate that the excess volatility factor is a statistically significant determinant of excess returns on stocks, and that its introduction into fundamental multi-index models ameliorates their asset- pricing and predictive performance. The research concludes with a theoretical contextualization of its findings and several examples of their practical implications for the financial industry.