Understanding Stock Return Volatility

This article studies the e¤ect of limited commitment on stock return volatility in a dynamicgeneral equilibrium economy populated by investors with heterogeneous beliefs. Due to het-erogeneity of beliefs investors disagree about the fundamentals, introducing an additional riskfactor denoted sentiment risk. Limited commitment introduces an endogenous solvency con-straint which scales up sentiment risk every time it binds, which is labeled solvency risk. Theequilibrium market price of risk which drives the short-run stock return volatility has threecomponents: endowment risk, sentiment risk, and solvency risk. The three components arepersistent, in line with volatility clustering or GARCH effects. The solvency risk component inthe market price of risk is novel, and it is the main contribution of the paper. It is related to theoptimal exercise boundary of an American-style contingent claim, and exhibits a markedly dif-ferent pattern with transient persistence according to the binding of solvency constraints. Thisis consistent with multifactor volatility models.[...]