Abstract
We use options and return data to show that negative stock market returns are significantly more painful to investors when they occur in periods of low volatility. In contrast, asset pricing theories based on habits and long-run risks imply that the pricing of stock market risk does not vary with volatility, or that it moves in the opposite direction. An explanation of our finding that is consistent with prior empirical evidence and the time-varying disaster risk model of Gabaix (2012) is that volatility evolves independently of the pricing kernel.