Is There a Positive Relationship between Stock Market Volatility and the Equity Premium?

This paper investigates whether evidence for a positive relationship between stock market volatility and the equity premium is more decisive when the volatility feedback effects of large and persistent changes in market volatility are taken into account. The analysis has two components. First, a log- linear present value framework is employed to derive a formal model of volatility feedback under the assumption of Markov-switching market volatility. Second, the model is estimated for a variety of assumptions about information available to economic agents. The empirical results suggest the existence of a negative and significant volatility feedback effect, supporting a positive relationship between stock market volatility and the equity premium.