A Re-Examination of the Causes of Time-Varying Stock Return Volatilities

The decline of average stock return volatility in the 2001-2006 period provides a good opportunity to test various theories on why the average return volatility increased in the pre-2000 period. This paper compares fundamentals-based theories with trading-based theories. While both fundamentals-based theories and trading-based theories explain the upward trend in the average volatility in US stocks from 1976 to 2000, only the fundamentals-based theories explain the volatility pattern for 2001-2006. Much of the variation in the stock return volatilities can be explained by the variation in the volatilities in earnings and, to a lesser degree, by proxies for growth options, but not by trading-related variables.