The pricing of volatility risk across asset classes

We propose a new measure of volatility risk based on a Principal Component Analysis of a large cross-section of individual stock realized volatility innovations. A two factor model comprising our measure of volatility risk together with the market return factor, does a remarkable job of explaining the cross-section of risk returns across various asset classes including stocks, corporate bonds and options. Our finding that volatility risk is priced consistently (with a negative risk premium) across the diverse asset classes suggests that volatility as captured by our factor truly is a state variable in the ICAPM sense.