The Quarterly Review of Economics and Finance 74 (2019) 336–346

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The Quarterly Review of Economics and Finance

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The role of the volatility index in asset pricing: The case of the Indian
stock market
Pratap Chandra Pati a,∗ , Prabina Rajib b , Parama Barai b
a
Xavier Institute of Management, Bhubaneswar (XIMB), Odisha, 751013, India
b
Vinod Gupta School of Management, Indian Institute of Technology Kharagpur, West Bengal, 721302, India

a r t i c l e i n f o a b s t r a c t

Article history: This study examines whether the volatility index, a proxy for aggregate volatility risk, can be used as
Received 22 April 2018 an additional factor in the standard asset pricing model for the Indian stock market after controlling for
Received in revised form 26 March 2019 well-documented risk factors. This study first examines the empirical performance of the capital asset
Accepted 9 April 2019
pricing model, the Fama-French three-factor model and the Carhart four-factor model. On the basis of
Available online 22 April 2019
a GRS test, the Fama-French three-factor model is used as the baseline model to explore the role of
the volatility index as an additional factor considered in the asset pricing model. The factor mimicking
JEL classification:
portfolio returns for the volatility index innovations is constructed and is included as an additional factor
G11
G12
in the Fama-French three-factor model. The study provides strong evidence of size effects but relatively
weak value-growth and momentum effect. Further, stock’s sensitivity to volatility index innovation is
Keywords: a priced risk factor during high volatility period, but not during low volatility period. Nevertheless, the
India Volatility Index addition of volatility risk factor leads to marginal improvements in the capacity for the model to explain
Fama-French three-factor model the variation in stock returns. The results of this study will help financial analysts and corporate financial
Carhart four-factor model
managers to evaluate the performance of professionally managed portfolios.
Factor-mimicking portfolios for the
volatility index
© 2019 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.

1. Introduction returns in the asset pricing literature. Campbell (1993); Campbell,

The volatility index is playing an increasingly important role in
financial markets. Following the seminal work of Whaley (1993),
the Chicago Board Options Exchange (CBOE) launched a volatility
index based on the S&P 100 index, popularly known as VIX, to pro-
vide a new source of market-based volatility forecasting of the US
stock market. As the popularity of the CBOE VIX has grown, many
prominent stock exchanges have introduced the volatility index
following CBOE computation methodology. The volatility index
measures market’ forecasts of the future volatility of the underlying
index. It captures the sentiment of the market – whether the market
is complacent or anxious. Furthermore, it serves as the underlying
asset of a growing market of exchange-traded volatility option and
futures. Given the key role of the volatility index in today’s financial
markets, investigating the role of the volatility index in pricing is
very important and worthwhile.
Over the last four decade, there has been a growing interest in
identifying priced risk factors that explain the variation in stock
∗ Corresponding author.
E-mail addresses: pratap@ximb.edu.in (P.C. Pati), prabina@vgsom.iitkgp.ernet.in
(P. Rajib), parama@vgsom.iitkgp.ernet.in (P. Barai).
1996 and Chen (2002), based on the intertemporal capital asset
pricing model (ICAPM) developed by Merton (1973), demonstrated
that investors consider a rise in expected volatility as a reduction
in investment opportunities, as it changes the risk-return trade-off.
Generally, high volatility periods often coincide with downward
market movement (Whaley, 2000). To hedge, risk-averse investors
raise the demand for stocks that are highly sensitive to aggregate
volatility innovations. As a result, prices rise contemporaneously
and future expected returns decrease. Bakshi and Kapadia (2003),
using delta-hedged option portfolios, stated that stocks that are
highly sensitive to volatility risk provide protection against adverse
market movements due to the negative returns-volatility relation-
ship. In a seminal work, Ang, Hodrick, Xing, and Zhang, (2006)
stated that stock’s sensitivity to changes in the volatility index has
a cross-sectional effect on stock returns while stocks with greater
sensitivity to changes in the VIX have lower average returns than
low sensitivity stocks.
Previous studies demonstrate that volatility risk is a priced
factor that explains the variation in stock returns for the US mar-
ket (Ang et al., 2006; Banerjee, Doran, & Peterson, 2007; Delisle,
Doran, & Peterson, 2011; Durand, Lim, & Zumwalt, 2007; Labidi &
Yaakoubi, 2016) and for the Australian market (Mai, Ang, & Fang,
2016). Almost all past studies pertaining to the pricing of volatil-

https://doi.org/10.1016/j.qref.2019.04.010
1062-9769/© 2019 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.
 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346
ity risk are based on the US market. There is a paucity of literature
on this issue in reference to emerging markets. The empirical evi-
dence obtained from developed markets may not be generalized
to emerging markets such as India. Developed markets differ from
emerging markets which are characterized by low liquidity, thin
trading and higher volatility (Bekaert & Harvey, 1997). Further-
more, India is a large emerging market with a growing and maturing
equity market. Research on the volatility index of the Indian stock
market is in its infancy. Therefore this study attempts to address
this gap to extend the asset pricing literature by investigating
stock’s sensitivity to volatility index innovations as an additional
factor considered in the asset pricing model for the Indian stock
market.
India, the world’s 2nd most populous country with a popula-
tion of 1.31 billion, has emerged as one of the fastest growing and
globally competitive economies in the world. According to World
Fact Book 2016, the Indian GDP of $8.721 trillion in PPP (purchas-
ing power parity) positions the Indian economy as the world’s
4th largest economy. The country’s annual growth rate of 7.6%
for 2015–2016 positioned India 7th in the ranking of the global
economies, even outpacing China (6.6%). Emerging stock markets
constitute a significant component of the global portfolio today;
hence, more empirical work on the behaviors of these markets is
needed. In studying the Indian market, we can shed light on new
findings on the behavior of the volatility index that can enrich the
literature.
In light of the above discussion, this study examines whether
the volatility index, a proxy for aggregate volatility risk, is a priced
risk factor in explaining the variation in stock returns for the Indian
stock market after controlling for other well-documented risk fac-
tors. We construct a factor mimicking portfolio for volatility index
innovations and incorporate it as an additional factor into the
standard asset pricing model. Stock’s sensitivity to volatility index
innovations is found to be a priced risk factor for high volatility
periods, not for low volatility periods. Nevertheless, the addition
of volatility risk factors leads to a very marginal improvement in
the model’s capacity to explain the variation in stock returns. To
the best of our knowledge, this is the first comprehensive study to
investigate the role of the volatility index in the asset pricing model
in reference to the Indian stock market. The results of this study
may be useful to financial practitioners, academicians and policy
makers in evaluating the performance of professionally managed
portfolios, cost-of-capital calculations, valuation and risk manage-
ment.
The remainder of this paper is structured as follows. Section 2
reviews the existing literature on the role of the volatility index as
an additional factor considered in the asset pricing model. Section
3 delineates the data sample used for our analysis. Section 4 lays
down model specifications and factor construction and portfolio
formation processes. The penultimate section reports our empirical
results and analysis, and the last section concludes the study.
2. Literature review and hypothesis development
There are two strands of literature that report the pricing of
volatility risk in the asset pricing literature. One set of investiga-
tions explores the direct effects of the volatility index (VX) or of
changes in the VX ( VX) by incorporating it as an explanatory vari-
able in the CAPM model and its extensions, while the another set
of studies adopts a factor mimicking portfolio approach. However,
both approaches indicate that the volatility index has a differential
effect on returns during high and low volatility periods.
Banerjee et al. (2007) examined the predictive power of the
CBOE VIX in explaining future portfolio returns using daily data
from June, 1986 through June, 2005. They constructed 12 portfolios
337
from the 2 × 2 × 3 independent triple sort on size, book-to-market
equity, and market beta. They examined the effect of the VIX on
portfolio futures returns after separately controlling for Fama-
French-Carhart four risk factors for both 30 and 60 calendar days
holding periods during high and low volatility periods. They pro-
vided the evidence that the effect of the VIX is stronger in the case
of high beta portfolios and 60-day holding period returns. Durand
et al. (2007) examined whether the CBOE VIX is a priced factor
for the cross-section of US stock returns based on daily data for
February 1, 1993 to December 31, 2003. Using the Fama-French
three-factor and Carhart four-factor model, they examined the role
of the VIX in the 25 size-B/M sorted portfolios. They documented
that the VIX is statistically significant for 6 of the 25 portfolios in
the Fama-French model and for 7 of the 25 portfolios in the Carhart
model. The inclusion of the VIX brings marginal improvements
to the models; hence the VIX plays a marginal role in the cross-
section of returns. Durand, Lim, and Zumwalt, (2011), using daily
data for February 1, 1993 to July 30, 2007, investigated the dynamic
and causal relationship between changes in the VIX and factor
premia including market, size, book-to-market and momentum.
Through, Ganger causality, impulse response and variance decom-
position analysis in the vector auto-regression (VAR) framework,
they concluded that market risk premium and value premium are
more responsive to changes in the VIX, not to the size premium or
momentum premium. Shamsuddin and Kim (2015) explored the
dynamic interactions of sentiment measures (CBOE VIX, individual
investor sentiment, and advisor sentiment) and factor premiums
for market, size, book-to-market and momentum factors based
on weekly U.S. data for January 1990 to December 2011. From
the vector autoregressive model and generalized impulse response
functions, they found that factor premia have long-lasting and
strong effects on sentiment measures; however, the reverse effect
is weak and short-lived. In reference to the Indian stock market,
Kumar and Rao (2014) investigated the role of the India VIX as
an asset pricing factor by considering all 50 constituent stocks
included in NIFTY-50 index at daily frequencies. The sample period
extends from 2009 to 2013. For their empirical analysis, changes in
the IVIX were directly included as a factor in the Fama-French and
the Carhart four-factor model. They used 9 portfolios as test port-
folios constructed from 3 × 3 sorting on size and book-to-market
values. The IVIX was found to be statistically significant and posi-
tive for one out of 9 portfolios. Thus, they reported that the India
volatility index does not play a significant role in the asset pricing
model.
While the above studies directly applied changes or innovations
in the volatility index to the CAPM and its extensions, there have
been parallel attempts to create factor mimicking portfolios where
portfolios are constructed on the basis of the sensitivities of returns
to innovations in the volatility index. In a seminal paper, Ang et al.
(2006) investigated the pricing of aggregate volatility risk proxied
by the CBOE VIX in the cross-section of stock returns. For empirical
testing, they considered all stocks traded on the American Stock
Exchange (AMEX), National Association of Securities Dealers Auto-
mated Quotations (NASDAQ), and New York Stock Exchange (NYSE)
for the period of January 1986 to December 2000. They regressed
cross-sectional returns against market returns and changes in the
volatility index. The coefficients of changes in the volatility index,
denoted as ˇVIX , were used to sort stocks into quintiles. The differ-
ence in returns between the two extreme portfolios was used as an
additional risk factor in the CAPM equation. They found that the VIX
is a significant priced risk factor in asset pricing models after con-
trolling for size, book-to-market ratio, momentum, and liquidity.
They demonstrated that stocks with greater sensitivity to changes
in the VIX have lower average returns than low sensitivity stocks.
In other words, sensitivity to changes in the VIX innovation has a
negative risk premium.
338 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346
From the above discussion, it is found that the volatility index
is a risk factor in the asset pricing model along with market, size,
book-to-market, and momentum. The present study investigates
the following hypothesis for the Indian stock market:
Hypothesis I. Stock’s sensitivity to volatility index innovations is
a priced risk factor that explains the variation in stock returns in the
Indian stock market even after controlling for well-known factors.
In focusing on the asymmetric volatility responses of the volatil-
ity index, Delisle et al. (2011) extended the work of Ang et al. (2006)
and investigated the cross-sectional relationship between stock’s
sensitivity to the CBOE VIX (now known as the VXO) innovations
and its return. From monthly sample data for January 1986 through
December 2007, they reported that the VIX innovations are priced
risk factors when VIX rises; however, it is not priced factor when the
VIX falls. Sabbaghi (2015) studied whether the CBOE VIX based on
S&P 500 affects the cross-section of portfolio returns using monthly
data for the period of 1990-2011. He constructed a factor mimick-
ing portfolio for the VIX and investigated the variation in returns of
portfolios sorted on size and book-to-market equity. They demon-
strated that the VIX is not a priced risk factor, and the contradictory
results obtained can be attributed to asymmetric patterns of the VIX
and of jump risk components. Mai et al. (2016) explored the pricing
of aggregate volatility risk proxied by the Australia S&P/ASX 200
volatility index for the Australian stock market. The data sample
consists of all ordinary shares traded on the Australian Securities
Exchange from January 1, 2004 to December 31, 2014. They showed
that when the volatility index increases, it is a significantly priced
risk factor even after controlling for the effects of market, size, book-
to-market, momentum, and liquidity factors. However, when the
volatility index falls, it is not a priced risk factor. Labidi and Yaakoubi
(2016) explored whether aggregate volatility, which is measured by
innovations in CBOE VIX index, is a priced risk factor for all stocks
traded on the NYSE for the period from August 2001 to December
2008. They used both time series and cross-sectional analysis and
found that stock’s sensitivity to innovations in the volatility index
affects portfolio returns when investor sentiment is low even after
controlling for market, size, book-to-market, momentum and liq-
uidity factors. During periods of low investor sentiment, return
differential between stocks with high and low sensitivities to inno-
vations in the volatility index is found to be statistically significant.
Furthermore, portfolios of stocks with high sensitivity to VIX inno-
vations provide lower subsequent returns than portfolios of stocks
with low sensitivity to VIX innovations. However, during periods of
high sentiment (low VIX values), stock’s sensitivity to innovations
in the VIX index is statistically insignificant.
Thus, there is compelling evidence that volatility risk is priced,
but not uniformly across all states of the market. Irrespective of
whether or how volatility risk is priced systematically, the neg-
ative and asymmetric relation between stock index returns and
changes in the volatility index is a widely documented stylized fact
(Fleming, Ostdiek, & Whaley, 1995; Whaley, 2000; Low, 2004; Giot,
2005; Hibbert, Daigler, & Dupoyet, 2008; Frijns, Tallau, & Tourani-
Rad, 2010; Badshah, 2013, and Pati, Rajib, & Barai, 2017). This
implies that in bullish periods, when markets are rising, leading
to positive market returns on average, it is expected that change in
volatilities would be negative. Under this condition, if stock returns
are positively sensitive to volatility index changes (i.e., ˇVX > 0),
the incremental effect of declining volatility on stock returns is
expected to be negative. But, if stock returns are negatively sen-
sitive to volatility changes (i.e., ˇVX < 0), the incremental effect of
declining volatility on stock returns is expected to be positive. Thus,
irrespective of the cumulative effect of positive market returns, and
size, book-to-market and other factors, positive ˇVX stocks are
expected to have lower returns, while negative ˇVX stocks are
expected to have higher returns, as reported by Ang et al. (2006).
However, we posit that this will hold only during bullish market.
In bearish markets, we further hypothesize that the opposite effect
should prevail. Thus, under bearish conditions, while markets are
down, volatilities are expected to be high. Now, if stock returns are
positively sensitive to volatility changes (i.e., ˇVX > 0), the incre-
mental effect of rising volatility on stock returns is expected to be
positive. But, if stock returns are negatively sensitive to volatility
changes (i.e., ˇVX < 0), the incremental effect of rising volatility
on stock returns is expected to be negative. Hence, irrespective of
the cumulative effect of positive market returns, and size, book-
to-market and other factors, positive ˇVX stocks are expected to
have higher returns while negative ˇVX stocks are expected to
have lower returns under bearish states of the market.
To summarize, a negative premium of volatility risk is expected
during bullish market phases, while a positive premium of volatil-
ity risk is expected during bearish phases. Rather, stock returns
respond asymmetrically to volatility risk. Thus, this study investi-
gates the following hypothesis:
Hypothesis II. The role of the volatility index in asset pricing
model differs during high and low volatility periods.
This asymmetric effect was disregarded by Ang et al. (2006),
but was subsequently captured by Delisle et al. (2011), followed
by others. However, Delisle et al. (2011) explore the asymmet-
ric response by capturing different sensitivities to daily positive
and negative changes to the IVIX. For this, they constructed two-
factor mimicking portfolios – one based on coefficients of positive
changes in the VIX and another based on coefficients of negative
changes in the VIX, and they showed that the first portfolio is signif-
icantly negatively related to returns while the other is not related.
This study builds on the hypothesis of asymmetric response to
volatility risk, by exploring whether similar asymmetric responses
are observed over sustained periods of bullish and bearish mar-
kets. Consequently, we do not construct two-factor portfolios as in
Delisle et al. (2011); rather, we construct one-factor portfolio as
in Ang et al. (2006), and determine whether and how this factor
is priced in different periods of high and low volatility. To iden-
tify high and low volatility periods, we find structural breaks in the
India volatility index.
This study differs from an earlier study undertaken by Kumar
and Rao (2014) on several accounts in terms of datasets, theoretical
constructs methodologies and conclusions. First, the present study
examines 500 sample stocks included in the CNX 500 for October
2008 to August 2017. Instead of using changes in India VIX as an
asset pricing factor, we have constructed a factor mimicking port-
folio for innovation in India VIX and included it in the asset pricing
time-series regression as an additional priced risk factor. Follow-
ing past literature on differential asset pricing role of the volatility
index during high volatility versus low volatility periods, the study
identifies volatility periods using Bai-Perron structural break test
over the monthly times series of India VIX and explores the pric-
ing role of the volatility index in high volatility and low volatility
periods.
3. Data description
We perform asset pricing tests on monthly data for the CNX
500 constituent stocks traded on the National Stock Exchange of
India Limited (NSE) because these stocks are highly liquid, and thus
overcome issues related to illiquidity and very small-sizes. The S&P
CNX 500 is a free float market capitalization weighted index of
500 companies that represents about 95.2% of total market capi-
talization and approximately 91.7% of the traded value of all stocks
on the NSE as of March 2017. The NSE is an open electronic order
driven market without market makers. Its clearing system follows
T + 2 rolling settlement cycles. The NSE was the world’s 12th largest
 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346
stock exchange as of March 2016 with a total market capitalization
value of more than US$1.41 trillion and with approximately 1700
listed stocks. As per the World Federation of Exchanges (WFE) Mar-
ket Highlights Report and NSE annual reports, during the calendar
year of 2015-16, the NSE was ranked first in the world with respect
to contracts traded in stock index options, second rank in single
stock futures, and sixth rank in stock index futures.
In India, the fiscal year spans from April of year Y to March of year
Y + 1. Following Fama and French (1992), a six-month time gap is
given between the fiscal year end and portfolio formation period.
Thus we form portfolios from the beginning of October of each year
and hold them for exactly one year. Portfolios are rebalanced annu-
ally in October of each year and monthly returns are computed for
the 12 months i.e. October of year Y to September of year Y + 1. Data
for the India Volatility Index (IVIX) are available from November
2007. However, portfolios are formed at the start of October of each
year. Hence our sample period begins in October 2008 and ends
in August 2017. For factor construction and portfolio formulation,
monthly firm-specific information such as stock prices, market cap-
italizations, and annual accounting information on the book value
of equity are obtained from the Prowess database. From adjusted

share prices (p), continuously  compounded returns for each stock
pt
are computed i.e. log pt−1 . The return on the NIFTY-50 index,
the flagship stock market index of the NSE, is used as proxy for the
market portfolio. The 91-day Indian Treasury-bill yield issued by
the Reserve Bank of India (RBI) is used as a proxy for the risk-free
rate of return. To measure the aggregate volatility risk, we use the
India Volatility Index for the Indian stock market.
For a stock to be included in our portfolio formation for any
given year (Y ), it should satisfy the following criteria. First, for each
year starting from October, a stock should be traded daily for at
least the past 12 months. Thus, we only consider those stocks that
existed from the start of our study period. None of these stocks
ceased trading during the study period, eliminating the prospect
of survivorship bias. Second, stocks with negative book equity are
omitted. Third, stocks with missing accounting data on book equity
or market equity in a particular month are also excluded from the
data sample.
4. Model specifications and portfolio formation
4.1. Model specifications
The main objective of this study is to investigate whether
the volatility index can be considered an additional factor after
controlling for the well-established priced risk factors in asset
pricing models. Many alternative asset pricing models have been
used for empirical testing, such as the capital asset pricing model
(CAPM), the Fama-French three-factor model (FF3FM), the Carhart
four-factor model (C4FM) and the Fama-French five-factor model
(FF5FM). Fama and French (1998) provided evidence of size and
book-to-market effects for 11 and 12 markets, respectively, out of
16 emerging markets. Griffin et al., 2003Griffin, Ji, & Martin (2003)
found a relatively weak momentum effect for the Asian markets.
Nevertheless, size, book-to-market, and momentum are the well-
established priced risk factors in asset pricing models. In the current
literature, the Fama-French five-factor model (2015) has gained
wide popularity.
In this study, we are interested in whether the addition of
volatility risk improves the performance of the asset pricing model.
We begin by examining the empirical performance of the capi-
tal asset pricing model (CAPM) to capture the variations in stock
returns. Subsequently, we move to the Fama-French three-factor
model (FF3FM) and Carhart four-factor model (C4FM). The excess
339
returns of 16 size and book-to-market sorted portfolios are used as
the test portfolios in the time-series regressions.
Ri,t − Rf,t = ˛ + bi MKT t + εi,t (1)
Ri,t − Rf,t = ˛ + bi MKT t + si SMBt + hi HMLt + εi,t (2)
Ri,t − Rf,t = ˛ + bi MKT t + si SMBt + hi HMLt + wi WMLt + εi,t (3)
Here, MKT is the market risk premium or the excess return on the
market portfolio or Rm –Rf . SMB is the factor-mimicking portfolio
return for size. HML is the factor-mimicking portfolio return for
the book-to-market. The portfolios of small-capitalization firms are
expected to outperform the portfolios of big-capitalization stocks.
Likewise, the portfolio of value stocks with high book-to-market
ratios have, on an average, higher returns than growth or glam-
our stocks with low book-to-market ratios. WML (Winners minus
Losers) captures the momentum effect. The portfolios of winner
stocks are expected to outperform the portfolios of loser stocks.
To evaluate the effectiveness of an asset-pricing model, we
employed a GRS F-test (Gibbons, Ross, & Shanken, 1989) given by :
 
 T T − N − k −1
˛ˆ´ ˆ ˛
ˆ
GRS statistic = ˜F(N, T –N–k ) (4)
N T −k−1 ˆ −1 
´ ˝
1+
where T is the sample size, N is the number of test portfolios, kis
the number of explanatory factors, ˛
ˆ is an N ×1 vector of estimated

intercepts, ˆ is the residual covariance matrix, and  is a k ×1
vector of the sample means of explanatory factors. The GRS test
statistic follows F distribution with N and T –N–k degrees of free-
dom. It tests the null hypothesis that all regression intercepts are
jointly equal to zero across the test assets of interest i.e. H0 : ˛i = 0
∀ i. In an effective model, intercepts should be close to zero in the
time-series regression. A smaller value of the GRS statistic is pre-
ferred, as this indicates that all intercepts are jointly equal to zero
and that factors of the model adequately explain the variation in
returns for a portfolio. From the GRS test, the best asset pricing
model will be selected to explore the pricing of the volatility index.
Following the literature, we constructed factor-mimicking port-
folio returns for the India volatility index innovations (HVXMLVX)
and incorporated it into the asset pricing model as an explanatory
variable.
Ri,t − Rf,t = ˛ + bi MKT t + si SMBt + hi HMLt + vi HVXMLVX t + εi,t (5)
As it is argued under Hypothesis II, the pricing role of the volatil-
ity index may differ during high (i.e., low sentiment) and low
volatility periods (i.e., high sentiment). To identify different market
states (i.e., high volatility vs. low volatility), this study employs Bai
and Perron structural break test using monthly data for the India
volatility index time series. After identifying high and low volatil-
ity periods, asset pricing models are re-estimated against excess
returns of the 16 size-and B/M sorted portfolios.
4.2. Construction of factor mimicking portfolios
4.2.1. Market risk premium
The market risk premium (MKT) is the excess return on the mar-
ket portfolio (i.e., Rm –Rf ) where Rm is the return on the NIFTY-50
index and Rf is the risk-free rate of return proxied by the 91-day
Indian Treasury-bill yield issued by the RBI.
4.2.2. Construction of SMB, HML and WML factors
Following Fama and French (1993), we have constructed SMB
and HML factors, the factor-mimicking portfolio returns for size and
B/M respectively, through 2 ×3 independent double sorting on the
size and book-to-market. Firm size for year Y is measured from its
level of market capitalization (i.e., the product of a number of shares
340 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346
outstanding and of the share price) in billions of rupees measured
at the end of September of year. The book-to-market equity ratio
(B/M), used for portfolio formation at the end of September of each
year, is the firm’s book value of equity (BE) for the fiscal year ending
(i.e., March) in calendar year Y divided by the market value of equity
(ME) measured at the end of March of calendar year Y .
At the end of September of each year Y , stocks are ranked in
ascending order on the basis of their September market equity
(ME) values. Using the median ME as the breakpoint, stocks are
split into two size portfolios, small and big, with an equal number
of stocks. Stocks with a lower market cap than the median mar-
ket cap are put in the group of small stock (S). Stocks with higher
market cap than the median market cap are treated as the group
of big stocks (B). Subsequently, within each sized-based portfolio,
the same stocks are further sorted in descending order by their
book-to-market (B/M) ratios, and are partitioned into three groups
based on the breakpoints for the top 30% (high B/M), middle 40%
(medium B/M) and bottom 30% (low B/M). The first 30% of stocks
with the highest B/M ratio are considered as value stocks (V). The
middle 40% of stocks with medium B/M ratios are taken as neutral
stocks (N). The last 30% of stocks with the lowest B/M ratios are
considered growth stocks (G). From the intersections of two size
and three book-to-market portfolios, six portfolios are formed and
defined as SV, SN, SG, BV, BN, and BG. Here S and B denote small or
big, respectively, and V, N, and G denote value, neutral, and growth,
respectively. For instance, portfolio SV is comprised of stocks that
are small in size but which have high B/M ratios. Portfolio SM con-
sists of small-size and medium B/M ratio stocks while portfolio SG
consists of small-size and low B/M ratio stocks. Portfolio BV con-
sists of stocks that are big in size and high in B/M ratio. Portfolio
BM consists of big and medium B/M ratio stocks, and portfolio BG
consists of big and low B/M ratio stocks. We then calculate equally-
weighted monthly returns for each portfolio for October of year (Y )
to September of year Y + 1, during which the portfolios remain the
same. The portfolios are reconstructed in October of year Y + 1 and
this is repeated for each year through August 2017.
SMB is the difference between the simple average of returns
on the three small-size portfolios (Small Value, Small Neutral, and
Small Growth) and the simple average of returns on the three
big-size portfolios (Big Value, Big Neutral, Big Growth). SMB is cal-
culated in the following way:
SV + SN + SG BV + BN + BG
SMB = − (6)
3 3
SMB is meant to mimic the risk factor for returns related to size
without the influence of book-to-market effects and it represents
the size premium.
Similarly, HML is the spread in average returns between the two
highest book-to-market portfolios (Small Value, Big Value) and the
two lowest book-to-market portfolios (Small Growth, Big Growth).
HML is calculated in the following manner:
SV + BV SG + BG
HML = − (7)
2 2
HML mimics the risk factor in returns related to book-to-market
values without affecting the size effect.
The momentum factor is constructed following Carhart (1997).
We calculate the momentum return in the month of t as cumula-
tive returns for the past 12-months while skipping the most recent
month t − 1 i.e., return from month t − 2 to month t − 12. The one
month lag between portfolio formation and holding periods is stan-
dard practice in the momentum literature, as there is a reversal or
contrarian effect in returns that may be related to bid-ask bounce or
microstructure issues (Jegadeesh, 1990; Lo and MacKinaly, 1990;
Griffin et al., 2003).
At the beginning of October of each year Y,stocks are divided into
two-size portfolios depending on whether their September-end
market capitalization is above or below the median level of mar-
ket capitalization. Then, within each sized-based portfolio, stocks
are further sorted in descending order by their prior returns and
are partitioned into three groups based on a 30%: 40%: 30% split.
The top of 30% stocks with the highest prior returns are consid-
ered as winner stocks (W) or high-momentum stocks. The middle
of 40% stocks which have medium prior returns is treated as neu-
tral stocks. The bottom of 30% stocks with lowest prior returns is
considered as loser stocks (L) or low-momentum stocks. From the
intersection of two size-sorted portfolios and three prior returns-
sorted portfolios, the following six portfolios are formed: SW, SN,
SL, BW, BN, and BL. WML is the difference between the average of
returns on the two winner portfolios (Small Winner, Big Winner)
and the average of returns on the two loser portfolios (Small loser,
Big loser).
SW + BW SL + BL
WML = − (8)
2 2
4.2.3. Construction of factor-mimicking portfolios for the
volatility index
We construct the factor mimicking portfolio for the volatility
index (HVXMLVX) via 2 × 3 independent double sorting based
on size and stock’s sensitivity to volatility index innovations. The
factor-mimicking portfolio returns for the India volatility index
(HVXMLVX) is defined as the difference between the simple aver-
age of returns on two portfolios that are highly sensitive to volatility
index innovations and the average of returns on two portfolios that
are less sensitive to volatility index innovations.
First, the factor loading or the sensitivity of each stock i to the
India volatility index innovations (IVIX) are obtained by regress-
ing daily excess returns of the individual stock against IVIX while
controlling for the excess market return (MKT). Rolling regression
is employed using daily data for the past 12 months prior to port-
folio formation i.e., October of year Y − 1 to September of year Y .
The resulting model is specified as follows:
Ri,t − Rf,t = ˛ + bIVIX,i IVIXt + bMKT,i MKTt + εi,t (9)
where Ri,t − Rf,t is the excess return for stock i on day t. IVIX
is the first difference in daily India volatility index (IVIX) levels.
bIVIX,i and bMKT,i are the factor loadings or stock’s sensitivity to
IVIX and market factors respectively. These stocks’ sensitivities
to IVIX innovation (bIVIX ) are assigned for portfolio construction
i.e., October of year Y to through September of year Y + 1.
At the beginning of October of each year Y,stocks are divided
into small and big size portfolios based on median market capital-
ization. Then, within each sized-based portfolio, stocks are further
sorted in ascending order by their bIVIX values and are partitioned
into three groups based on a 30%: 40%: 30% split. In ascending order,
the first portfolio includes stocks with low sensitivity to volatil-
ity index innovations (LVX). The last portfolio contains stocks with
high sensitivity to volatility index innovations (HVX). From 2 × 3
double sorting on size and bIVIX , six portfolios are formed. Equally-
weighted returns on these portfolios are calculated for October
of year Y through September of year Y + 1. The factor-mimicking
portfolio returns for the India volatility index (HVXMLVX) are
defined as the difference between the simple average of returns
on the two high-sensitivity to volatility index innovations portfo-
lios (Small-size High-sensitivity, Big-size High-sensitivity) and the
average of returns on the two low-sensitivity to volatility index
innovations portfolios (Small-size Low-sensitivity, Big-size Low-
sensitivity). HVXMLVX is calculated in the following manner:
SHVX + BHVX SLVX + BLVX
HVXMLVX = − (10)
2 2
 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346 341

4.3. Formation of 16 size-B/M sorted test portfolios as a
dependent variable
For empirical testing, we have used the excess returns of 16 size-
B/M portfolios as the dependent variable in time-series regressions.
The 16 size-B/M sorted portfolios employed are very similar to the 6
size-B/M sorted portfolios used to construct SMB and HML factors,
though different breakpoints for sorting are used. Due to the small
number of stocks for any given year included in the sample, we use
16 size-B/M sorted portfolios rather than, the more commonly used
25 size-B/M sorted portfolios (Fama & French, 1993), so that each
portfolio includes a reasonable number of stocks (i.e., at least 20–30
stocks). Their excess returns are used as dependent variables in the
time-series regressions.
At the end of September of each year, stocks are arranged in
ascending order based on the September-end market capitaliza-
tion of year Y . Stocks are divided into four size-groups with an equal
number of stocks using sample quartile breakpoints. The first 25%
of stocks with smallest market capitalization are classified as S 1,
the next 25%–50% are classified as S 2, the next 50%–75% are clas-
sified as S 3, and the last 25% with largest market capitalization are
classified as S 4. Each sized-based portfolio, stocks are then again
sorted in descending order by book-to-market equity (B/M) ratio,
and divided into four groups with an equal number of stocks. In
descending order of B/M ratios, the first 25% of stocks with highest
B/M ratios are classified as B/M 4, the next 25%–50% are classified
as B/M 3, the next 50%–75% are classified as B/M 2, and the last
25% with lowest B/M values are classified as B/M 1. From the inter-
section of 4 size-based portfolios and 4 B/M-based portfolios, we
obtain 16 portfolios. For instance, S 1, B/M 4 is the portfolio of size 1
(smallest-size stocks) and B/M 4 (high B/M ratio i.e., value stocks).
Similarly, S 4, B/M 1 is the portfolio of size 4 (big stocks) and B/M 1
(growth stocks).
The WML premium is positive indicating that momentum strategy
has positive performance. In our sample, we find that growth stocks
have higher returns than value stocks, with a difference of 0.31%
per month. Similarly, portfolios of stocks with low-sensitivity to
volatility index innovations earn higher average returns compared
to high-sensitivity stocks, with a difference of 0.10% per month. It is
worth noting that HML premiums present a negative value i.e., on
average, stocks with high B/M ratios tend to achieve lower returns
than stocks with low B/M ratios. This contradicts Fama and French’s
finding that value stocks should outperform growth stocks. The
standard deviation of MKT (6.2% per month) is highest followed by
those of WML (4.7% per month), HML (3.7% per month), HVXMLVX
(2.6% per month) and SMB (2.6% per month). It can be observed from
Panel B of Table 1 that Pearson’s correlation between HVXMLVX
and WML is statistically significant and negative (i.e., -0.252). How-
ever, Pearson’s correlations between HVXMLVX and other factors
are statistically insignificant.
5.2. Estimation results of the capital asset pricing model
Table 2 presents results of the CAPM for the 16 size-B/M sorted
portfolios.
The results show that the market factor is statistically signifi-
cant for all portfolios and for the regression coefficient of MKT i.e.,
b values are close to one. The intercept (i.e., alphas) terms are sta-
tistically significant for 4 out of the 16 portfolios. To evaluate the
performance of the CAPM, the GRS test-statistic is calculated. The
Table 2
Results of the CAPM for 16 size-B/M sorted portfolios.
Ri,t − Rf,t = ˛ + bi MKT + εi,t
Portfolios ˛ b Adj. R2

S 1, B/M 4 0.011 1.321** 0.671

5. Empirical results and discussion (1.957) (17.870)
S 1, B/M 3 0.013** 1.213** 0.679
(2.131) (18.851)
5.1. Preliminary analysis S 1, B/M 2 0.014** 1.248** 0.672
(2.585) (14.763)
The empirical analysis begins by examining the descriptive S 1, B/M 1 0.011** 1.139** 0.681
statistics and correlations for the explanatory factors i.e., MKT, SMB, (2.172) (16.805)
S 2, B/M 4 −0.004 1.418** 0.740
HML, WML and HVXMLVX, as reported in Table 1. (-1.418) (18.323)
For the full sample period under study, SMB (0.90%) has the high- S 2, B/M 3 0.006 1.258** 0.786
est monthly average premium followed by WML (0.80%), market (1.302) (15.965)
factor (0.30%), HVXMLVX (-0.10%) and HML (-0.30%). SMB premium S 2, B/M 2 0.004 1.088** 0.771
(0.930) (22.131)
is positive meaning that small size-portfolios have performed bet-
S 2, B/M 1 0.014** 1.132** 0.803
ter than big size-portfolios, with a difference of 0.90% per month. (2.059) (14.590)
S 3, B/M 4 −0.008 1.355** 0.710
(-1.730) (13.534)
Table 1 S 3, B/M 3 −0.001 1.231** 0.804
Summary statistics and correlations matrix for the explanatory factors. (-0.209) (17.705)
S 3, B/M 2 0.001 1.249** 0.799
Panel A: Summary statistics for the risk factors
(0.421) (9.361)
MKT SMB HML WML HVXMLVX
S 3, B/M 1 0.005 1.017** 0.785
Mean 0.003 0.009 −0.003 0.008 −0.001
(1.425) (13.257)
Median 0.003 0.007 −0.001 0.009 −0.001
S 4, B/M 4 −0.005 1.194** 0.742
Std. Dev. 0.062 0.026 0.037 0.047 0.026
(−1.282) (11.690)
Maximum 0.245 0.081 0.130 0.099 0.091
S 4, B/M 3 −0.002 1.171** 0.878
Minimum −0.313 −0.062 −0.079 −0.165 −0.078
(-0.998) (28.684)
Panel B: Correlations matrix S 4, B/M 2 −0.001 0.980** 0.894
MKT SMB HML WML HVXMLVX (−0.510) (23.562)
MKT 1 S 4, B/M 1 0.001 0.980** 0.775
SMB 0.202** 1 (0.402) (8.921)
HML 0.431** 0.372** 1
GRS-F statistic: 2.075** ; p-value: 0.016.
WML −0.565** −0.292** −0.709** 1
Note: ** indicates statistical significance at the 5% level. t -statistics are given in
HVXMLVX 0.135 −0.120 −0.090 −0.252** 1
parentheses. All returns and risk factors are not expressed in percentages. The
Note: ** indicates rejection of the null hypothesis of no correlation. All returns and regressions are estimated with the ordinary least-squares method with Newey-
risk factors are not expressed in percentages. MKT is the excess market return; SMB, West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
HML, WML and HVXMLVX are factor mimicking portfolios for size, book-to-market, B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
momentum and the India volatility index, respectively. is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).
342 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346

GRS test-statistic is found to be statistically significant at the 5%
level; hence, we reject the null hypothesis that all intercepts or
alphas are jointly equal to zero. This suggests that the CAPM is not
an effective model. It performs poor in explaining the variation in
returns for a portfolio. This indicates that besides market factor,
other factors may better explain the variation in portfolio returns,
suggesting the inclusion of additional factors into the model. We
then apply the Fama-French three-factor model and the Carhart
four-factor model.
5.3. Results of the Fama-French three-factor model
Table 3 shows the estimation results of the Fama-French three-
factor model (FF3FM) for the 16 size-B/M sorted portfolios.
As one notable result from Table 3, all 16 portfolios have statisti-
cally insignificant regression intercepts. Further, the market factor
is statistically significant for all portfolios and its b values are valued
at more than one. The coefficient of SMB, s, is statistically signifi-
cant and positive for 15 of 16 portfolios. For each B/M quartile, as the
firm size increases, estimates of SMB decrease monotonically from
1 for the smallest-size portfolios to even negative values for the
big-size portfolios. The small-size portfolios actually demonstrate
a large positive and significant loading on SMB, while the big-size
portfolios have a slight negative and significant loading on SMB
in most cases. This implies that small-size firms are more riskier
than big-size firms, thereby earning a risk premium. This pattern
of the SMB factor is consistent with US and international evidence
(Fama & French, 1993) and supports a risk-based explanation of the
size effect. The coefficient of HML is statistically significant for 9 of
the 16 portfolios. Further, within each size quartile, the loading on
HML increases monotonically as we move from low B/M to high
B/M portfolios. The coefficient of HML is found to be negative for
growth portfolios and positive for value stock portfolios. These find-
ings are consistent with those of Fama and French (1993) and show
that value stock portfolios are more sensitive to HML and hence
more riskier than growth stock portfolios. We can thus conclude
that small size firms and value firms on average earn higher returns
than big-size firms and growth firms, respectively. It is found that
excess returns on market serve as the dominant factor in compar-
ison to size and B/M factors for the Indian equity markets. b values
for the 16 portfolios take an average value of 1.10 compared to
average absolute values of 0.750 and 0.36 found for s and h, respec-
tively. As the GRS test-statistic is statistically insignificant at the 5%
level, we cannot reject the null hypothesis that all of the intercepts
are jointly equal to zero.
5.4. Results of the Carhart four-factor model
Table 4 presents C4FM results for the 16 size-B/M sorted port-
folios.
Similar to the results of the Fama-French three-factor model,
the intercept terms are statistically insignificant in all 16 cases.
All market beta values are very close to 1. The SMB coefficient is
statistically significant and positive for 15 of 16 portfolios. Within

Table 3 Table 4
Results of the Fama-French model for 16 size-B/M sorted portfolios. Empirical results of the Carhart four-factor model.

Ri,t − Rf,t = ˛ + bi MKT + si SMB + hi HML + εi,t Ri,t − Rf,t = ˛ + bi MKT + si SMB + hi HML + wi WML + εi,t
2
Portfolios ˛ b s h Adj. R Portfolios ˛ b s h w Adj. R2

S 1, B/M 4 −0.000 1.047** 1.608** 0.537** 0.917 S 1, B/M 4 −0.000 1.034** 1.606** 0.501** −0.055 0.917
(−0.282) (11.854) (18.050) (5.761) (−0.111) (12.897) (17.184) (4.253) (−0.573)
S 1, B/M 3 0.000 1.024** 1.572** 0.221** 0.898 S 1, B/M 3 0.001 1.002** 1.570** 0.152 −0.101 0.901
(0.209) (17.852) (14.953) (2.763) (0.396) (17.834) (14.251) (1.337) (−0.958)
S 1, B/M 2 0.001 1.095** 1.562** 0.086 0.854 S 1, B/M 2 0.004 1.015** 1.551** −0.150 −0.335** 0.865
(0.535) (9.970) (15.308) (0.640) (1.266) (11.586) (17.536) (-0.956) (-2.843)
S 1, B/M 1 −0.001 1.023** 1.510** −0.033 0.870 S 1, B/M 1 0.000 0.996** 1.484** −0.202 −0.240** 0.876
(−0.473) (12.952) (14.537) (−0.307) (0.116) (15.824) (13.561) (−1.447) (−2.060)
S 2, B/M 4 −0.007 1.141** 0.680** 0.854** 0.876 S 2, B/M 4 −0.004 1.053** 0.668** 0.584** −0.368** 0.887
(−1.852) (10.360) (5.254) (5.960) (−1.180) (10.040) (5.573) (3.855) (−3.177)
S 2, B/M 3 −0.001 1.140** 0.824** 0.191 0.856 S 2, B/M 3 0.001 1.082** 0.817** 0.023 −0.237** 0.861
(−1.165) (12.335) (9.455) (1.846) (0.290) (14.424) (8.390) (0.172) (−2.287)
S 2, B/M 2 −0.004 1.008** 0.914** 0.011 0.860 S 2, B/M 2 −0.002 0.961** 0.907** −0.135 −0.207** 0.866
(−1.376) (29.773) (13.835) (0.144) (−0.815) (23.484) (13.344) (−1.358) (−2.250)
S 2, B/M 1 −0.004 1.089** 0.870** −0.110 0.873 S 2, B/M 1 −0.002 1.032** 0.861** −0.277** −0.235** 0.880
(−1.474) (12.977) (10.000) (−0.989) (−0.756) (14.436) (9.473) (−2.301) (−2.520)
S 3, B/M 4 −0.006 1.052** 0.221** 1.092** 0.862 S 3, B/M 4 −0.003 0.964** 0.209** 0.834** −0.364** 0.873
(−1.902) (11.055) (2.001) (7.882) (−0.972) (12.491) (2.037) (5.485) (−3.077)
S 3, B/M 3 −0.003 1.139** 0.423** 0.219 0.832 S 3, B/M 3 −0.002 1.083** 0.416** 0.052 −0.235** 0.838
(−1.027) (10.131) (3.712) (1.760) (−0.550) (10.875) (3.366) (0.338) (−1.991)
S 3, B/M 2 −0.002 1.237** 0.421** −0.091 0.810 S 3, B/M 2 0.000 1.145** 0.409** −0.364** −0.385** 0.826
(−0.703) (7.845) (3.966) (−0.571) (0.081) (9.019) (4.528) (−2.001) (−2.941)
S 3, B/M 1 −0.001 1.070** 0.447** −0.344** 0.817 S 3, B/M 1 0.000 1.042** 0.443** −0.427** −0.113 0.818
(−0.060) (15.378) (5.280) (−3.514) (0.195) (16.430) (4.954) (−3.780) (−1.401)
S 4, B/M 4 0.000 0.928** −0.250** 1.099** 0.915 S 4, B/M 4 0.002 0.887** −0.256** 0.978** −0.170** 0.918
(0.295) (22.458) (-2.569) (15.209) (0.715) (23.196) (−2.567) (11.134) (−2.334)
S 4, B/M 3 −0.000 1.086** −0.101 0.354** 0.898 S 4, B/M 3 0.002 1.008** −0.106 0.123 −0.326** 0.913
(−0.126) (25.595) (-1.187) (3.114) (0.845) (25.364) (−1.407) (1.035) (−3.367)
S 4, B/M 2 −0.003 1.014** 0.201** −0.193** 0.904 S 4, B/M 2 −0.003 1.020** 0.201** −0.180** 0.018 0.903
(−1.607) (25.271) (2.827) (−3.440) (−1.760) (24.735) (2.908) (−2.245) (0.286)
S 4, B/M 1 −0.002 1.081** 0.230** −0.452** 0.816 S 4, B/M 1 −0.001 1.033** 0.224** −0.588** −0.191 0.821
(−0.701) (11.120) (2.720) (−4.134) (−0.276) (12.235) (2.447) (−3.998) (−1.811)

GRS-F statistic: 1.0064 ; p-value: 0.458.
Note: ** indicates statistical significance at the 5% level. t -statistics are given in
parentheses. All returns and risk factors are not expressed in percentages. The
regressions are estimated with the ordinary least-squares method with Newey-
West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).
GRS-F statistic: 1.0496 ; p-value: 0.415.
Note: ** indicates statistical significance at the 5% level. t -statistics are given in
parentheses. All returns and risk factors are not expressed in percentages. The
regressions are estimated with the ordinary least-squares method with Newey-
West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).
 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346 343

each B/M quartile, as we move from the smallest-size portfolios Table 5

HVXMLVX-augmented Fama-French model for the full sample.
to big-size portfolios, SMB estimates decrease monotonically from
1 to even negative. The HML factor is statistically significant for 9 Ri,t − Rf,t = ˛ + bi MKT + si SMB + hi HML + vi HVXMLVX + εi,t
of 16 portfolios. Further, within each size quartile, the coefficients
Portfolios ˛ b s h v Adj. R2
of HML increase monotonically as we move from low B/M to high
S 1, B/M 4 −0.000 1.025** 1.635** 0.561** 0.239 0.920
B/M values. WML is found to be statistically significant for 11 of the
(−0.198) (14.301) (17.878) (6.221) (1.767)
16 portfolios. The negative coefficient of WML observed denotes a S 1, B/M 3 0.000 1.015** 1.584** 0.230** 0.104 0.898
negative momentum risk-premium. However, no clear pattern is (0.231) (20.031) (14.218) (3.022) (1.119)
observed from the WML coefficients. S 1, B/M 2 0.002 1.041** 1.628** 0.145 0.587** 0.880
Based on the GRS-statistics, the FF3FM is considered to be an (0.650) (13.467) (17.191) (1.354) (3.894)
S 1, B/M 1 −0.001 1.001** 1.528** −0.001 0.322 0.881
effective asset pricing model in explaining the variation in portfolio
(−0.385) (19.171) (13.040) (−0.002) (1.509)
returns. In the CAPM, the GRS- F statistic is statistically significant; S 2, B/M 4 −0.006 1.087** 0.746** 0.904** 0.583** 0.897
this necessitates the inclusion of additional factors into the model. (−1.937) (12.119) (6.255) (8.301) (5.750)
However, in the FF3FM and C4FM, the GRS- F statistic is statistically S 2, B/M 3 −0.001 1.093** 0.881** 0.241** 0.502** 0.877
(-0.057) (16.871) (8.575) (3.060) (3.041)
insignificant. This indicates that market, size and value factors are
S 2, B/M 2 −0.004 0.980** 0.950** 0.041 0.303** 0.870
sufficient in explaining the variation in stock returns. Since we find (−1.286) (28.066) (12.586) (0.626) (2.401)
the GRS statistic to be insignificant at the level of the FF3FM, we S 2, B/M 1 −0.004 1.046** 0.921** −0.064 0.460** 0.895
do not use other models with more explanatory variables such as (−1.323) (17.178) (8.775) (−0.805) (4.009)
the FF5FM. In turn, we use the Fama-French three-factor model as S 3, B/M 4 −0.005 1.006** 0.276** 1.141** 0.493** 0.877
(−1.736) (14.630) (2.113) (10.231) (2.923)
a baseline model to investigate the role of the volatility index as a
S 3, B/M 3 −0.003 1.100** 0.471** 0.261** 0.420** 0.847
factor in the asset pricing model. (−0.928) (12.670) (3.684) (2.466) (2.069)
S 3, B/M 2 −0.002 1.181** 0.501** −0.030 0.602** 0.840
5.5. Results of the Fama-French model with the HVXMLVX for the (−0.610) (9.982) (4.920) (−0.228) (2.890)
S 3, B/M 1 −0.000 1.042** 0.481** −0.313** 0.302** 0.828
full sample
(−0.014) (19.374) (4.901) (−3.420) (2.457)
S 4, B/M 4 0.001 0.900** −0.210** 1.136** 0.367** 0.926
Following the literature, the factor mimicking portfolio for the (0.394) (25.986) (−2.223) (19.264) (4.632)
volatility index (HVXMLVX) is constructed and included as an S 4, B/M 3 −0.000 1.062** −0.066** 0.381** 0.260** 0.904
additional factor in the asset pricing model. Table 5 reports the (−0.041) (31.060) (−0.745) (3.803) (2.380)
S 4, B/M 2 −0.003 1.004** 0.203** −0.182** 0.109 0.905
estimation results, in which the excess returns of each 16 size-B/M
(−1.557) (30.140) (2.922) (−3.554) (1.541)
sorted test portfolios are regressed against the Fama-French model S 4, B/M 1 −0.002 1.036** 0.282** −0.406** 0.456** 0.844
with HVXMLVX factor. (−0.599) (14.503) (2.870) (−4.527) (3.483)
From the regression results presented in Table 5 we observe GRS-F statistic: 0.996 ; p-value: 0.468.
similar patterns in the loadings of asset pricing factors. The regres- Note: ** indicates statistical significance at the 5% level. t -statistics are given in
sion intercepts also exhibit very much the same pattern. None of parentheses. All returns and risk factors are not expressed in percentages. The
the intercepts are statistically significant for any of the 16 cases. regressions are estimated with the ordinary least-squares method with Newey-
West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
In the HVXMLVX augmented model, the magnitude and signifi-
B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
cance of the factor loadings of the market and size factor remain is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).
relatively stable relative to those of the FF3FM. The sign of factor
loadings of HML and WML remain quite stable with minor vari-
ations in magnitude. In the HVXMLVX augmented Fama-French markets boom. Thus, to delve deeper into the role of stock’s sen-
three-factor model, the coefficient of HVXMLVX is found to be sta- sitivity to volatility index innovation in asset pricing during high
tistically significant and positive for 12 of 16 portfolios. We find and low volatility periods, we employ Bai and Perron (B&P) struc-
that the inclusion of HVXMLVX factor into the FF3FM results in an tural break test using monthly data for the IVIX for October 2008
increase in average adjusted R2 values from 0.866 to 0.881. More- to August 2017. To detect structural breaks, global plus sequential
over, insignificant GRS test statistics indicate that all intercepts of testing i.e., L + 1 breaks vs. global L procedure is used. The results
the 16 regressions are jointly equal to zero. From our compari- of the B&P test are given in Table 6.
son of GRS- F statistics of the two empirical models i.e., the FF3FM The first supFT 1/0 tests the null hypothesis of zero breaks
and HVXMLVX-augmented FF3FM, it is found that the HVXMLVX- against the alternative hypothesis of one break. The calculated F
augmented FF3FM presents lower GRS- F statistics (i.e., 0.996) than -statistic is greater than the Bai-Perron critical value at the 5% sig-
FF3FM (i.e., 1.006). The statistical significance of HVXMLVX factor nificance level (i.e. 8.58). Similarly, the supFT 2/1 tests the null
suggests that the volatility index is a priced risk factor in explain- hypothesis of one break against the alternative hypothesis of two
ing the variation in stock returns. The positive sign of v implies that breaks. The calculated F -statistic is greater than the Bai-Perron
portfolios of stock with high sensitivity to IVIX innovations provide critical value at the 5% significance level (i.e., 10.13) and hence 
the null hypothesis of one break is rejected. But, for supFT 3/2 ,
higher subsequent returns than portfolios of stocks with low sensi-    
tivity to IVIX innovations even after controlling for market, size and supFT 4/3 and supFT 5/4 , the calculated F -statistic is less than
book-to-market factors. However, from the comparison of GRS- F the Bai-Perron critical value at the 5% significance level; hence we
statistics presented in Tables 3 and 5, we find that the inclusion cannot reject the null hypothesis. From the Bai-Perron test, we have
of factor mimicking portfolio for the volatility index innovation detected two structural breaks on (i) February 2010 and (ii) June
in the Fama-French model results in only a marginal improve- 2012. Thus, there are three different volatility periods: October
ment in model’s efficiency in explaining the variation in stock 2008- January 2010; February 2010-May 2012; and June 2012-
returns. August 2017. The first sub-period (i.e., October 2008-January 2010)
includes the global sub-prime mortgage crisis, which can be con-
5.6. Asset pricing tests conducted over different volatility periods sidered a high volatility period. The second sub-sample period (i.e.,
February 2010-May 2012) includes the phase of recovery from the
Typically, the level of the volatility index increases in times of global crisis and the onset of the European debt crisis. The last
market turbulence and financial crisis and its value drops when sub-period (i.e., June 2012-August 2017) is characterized by sta-
344 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346

Table 6
Bai-Perron breakpoints specifications for Oct. 2008-Aug. 2017.

Estimated break dates

F-statistic ˆT 1 ˆT 2 ˆT 3 ˆT 4 ˆT 5
 
supFT 1/0 19.621** Feb. 2010
 
supFT 2/1 21.925** Feb. 2010 June 2012
 
supFT 3/2 3.707 Feb. 2010 June 2012 May 2016
 
supFT 4/3 1.014 Feb. 2010 June 2012 May 2014 May 2016
 
supFT 5/4 0.000 Feb. 2010 April 2012 Aug. 2013 Dec. 2014 May 2016
 
Note: ** indicates the rejection of the null hypothesis at the 5% level of significance. supFT 1/0 :: Test of the null hypothesis of 0 breaks against the alternative hypothesis
 
of 1 break, Bai-Perron critical value at 5% equal to 8.58. supFT 2/1 :Test of the null hypothesis of 1 break against the alternative hypothesis of 2 breaks; Bai-Perron critical
 
value at 5% equal to 10.13. supFT 3/2 : Test of the null hypothesis of 2 breaks against the alternative hypothesis of 3 breaks; Bai-Perron critical value at 5% equal to 11.14.
   
supFT 4/3 : Test of the null hypothesis of 3 breaks against the alternative hypothesis of 4 breaks; Bai-Perron critical value at 5% equal to 11.83. supFT 5/4 : Test of the
null hypothesis of 4 breaks against the alternative hypothesis of 5 breaks; Bai-Perron critical value at 5% equal to 12.25.

Fig. 1. Monthly comovement in IVIX and NIFTY levels for Oct. 2008-Aug. 2017.

bility and low levels of volatility. Conducting asset pricing tests
for the first sub-period with only 16 monthly observations could
lead to statistical estimation problems. To avoid sample insuffi-
ciency issues, we conduct asset pricing tests of the first and second
sub-periods as a high volatility period (i.e., October 2008 to May
2012) and of the third sub-period as a low volatility period (i.e.,
June 2012 to August 2017). It may be noted here that dividing the
full period further into sub-periods might introduce the possibility
of data snooping given that the full period is already short.
Fig. 1 shows the monthly time-series plot of the IVIX for the
period from October 2008 to August 2017.
Over the given sample period, the India Volatility Index expe-
rienced its highest values during the October 2008 global crisis.
Further, during the 2011 European sovereign debt crisis, spikes are
observed in the movements of the IVIX.
5.6.1. Results of the Fama-French model with HVXMLVX for the
high volatility period
Estimation results for the HVXMLVX-augmented Fama-French
three-factor model for the high volatility period are presented in
Table 7.
All regression intercept terms are statistically insignificant. The
statistical significance, the sign and the magnitude of MKT and
SMB factors remain almost the same as those of earlier models
i.e., the FF3FM and the HVXMLVX-augmented FF3FM for the full
sample period. Across the sample period, HML factors are found
to be statistically significant for 11 of 16 portfolios while under
the high volatility period, HML factors are statistically significant
for only 6 portfolios. During the high volatility period, the factor
loadings of HVXMLVX are found to be positive and statistically
significant for 14 of 16 portfolios while this is the case for 12
of the 16 portfolios under the full sample period. Interestingly,
the HVXMLVX-augmented FF3FM has a lower GRS- F statistic
(i.e., 0.962) for the high volatility period than for the full sam-
ple period. Hence the inclusion of the volatility index risk factor
improves the model’s explanatory power for the high volatility
period.
5.6.2. Results of the Fama-French model with HVXMLVX for the
low volatility period
Estimation results of the HVXMLVX-augmented Fama-French
model for the low volatility period are reported in Table 8.
As is shown in Table 8, all intercept terms are statistically
insignificant. The coefficients of market factor are highly signifi-
cant, but their values are slightly decreased. The SMB factors are
highly significant and positive across the 16 portfolios except in two
cases. During the low volatility period, the HML factors are statis-
tically significant for 12 of 16 portfolios which includes more cases
that the full sample period (i.e., 11) and high volatility period (i.e.,
6). We find that during the low volatility period, HVXMLVX factors
are positive and statistically significant for only 3 of 16 portfolios
while this is the case for 14 of 16 portfolios for the high volatility
period. Furthermore, the HVXMLVX- augmented-FF3FM for the low
volatility period has lowest average adjusted R2 (i.e., 0.818) and the
highest GRS- F statistic (i.e., 1.245) relative to models for the high
volatility and full sample periods. Hence, it can be concluded that
during low volatility periods, stock’s sensitivity to volatility index
innovation does not play an important role as a priced risk factor
in the asset pricing model.
 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346 345

Table 7 Table 8
Results of the Fama-French model with HVXMLVX for the high volatility period. Fama-French model with HVXMLVX for the low volatility period.

Ri,t − Rf,t = ˛ + bi MKT + si SMB + hi HML + vi HVXMLVX + εi,t Ri,t − Rf,t = ˛ + bi MKT + si SMB + hi HML + vi HVXMLVX + εi,t

Portfolios ˛ b s h v Adj. R2 Portfolios ˛ b s h v Adj. R2

S 1, B/M 4 −0.001 1.024** 1.444** 0.651** 0.626** 0.948 S 1, B/M 4 −0.001 0.785** 1.758** 0.663** −0.034 0.900
(−0.242) (15.863) (11.428) (4.867) (4.726) (−0.292) (8.711) (15.626) (7.017) (−0.290)
S 1, B/M 3 0.004 1.055** 1.642** 0.148 0.192 0.919 S 1, B/M 3 0.004 0.814** 1.545** 0.351** −0.003 0.862
(0.593) (16.089) (7.908) (0.734) (0.845) (1.285) (10.347) (10.964) (3.991) (−0.023)
S 1, B/M 2 −0.003 1.049** 1.867** 0.066 0.905** 0.930 S 1, B/M 2 0.006 0.816** 1.477** 0.311** 0.348** 0.794
(−0.653) (13.729) (12.686) (0.472) (3.511) (1.585) (7.487) (12.199) (2.511) (2.102)
S 1, B/M 1 −0.002 0.947** 1.562** 0.007 0.952** 0.927 S 1, B/M 1 −0.003 0.807** 1.519** 0.157 −0.093 0.848
(−0.353) (18.683) (7.581) (0.045) (2.744) (−0.672) (8.851) (11.078) (1.623) (−0.640)
S 2, B/M 4 −0.005 1.096** 0.832** 0.754** 0.693** 0.900 S 2, B/M 4 −0.008 1.037** 0.705** 1.002** 0.451** 0.889
(−0.881) (9.425) (3.560) (2.675) (3.882) (−1.018) (9.401) (5.360) (10.261) (3.177)
S 2, B/M 3 0.001 1.018** 0.860** 0.365 1.063** 0.903 S 2, B/M 3 −0.003 1.023** 0.901** 0.297** 0.186 0.847
(0.065) (15.177) (3.827) (1.886) (6.398) (−0.970) (10.452) (9.670) (3.318) (1.076)
S 2, B/M 2 −0.006 0.958** 1.071** −0.077 0.519** 0.920 S 2, B/M 2 −0.002 0.980** 0.876** 0.126 0.170 0.771
(−1.152) (20.418) (6.516) (−0.536) (3.168) (−0.840) (8.742) (10.727) (1.674) (0.998)
S 2, B/M 1 −0.006 1.042** 1.106** −0.111 0.700** 0.946 S 2, B/M 1 −0.002 0.912** 0.806** 0.043 0.283 0.765
(−1.550) (16.200) (7.476) (−0.826) (4.730) (−0.481) (9.814) (6.080) (0.443) (1.774)
S 3, B/M 4 −0.008 0.944** 0.503** 1.144** 1.119** 0.916 S 3, B/M 4 −0.006 0.866** 0.142 1.288** 0.104 0.850
(−1.180) (15.070) (2.268) (6.598) (6.863) (−1.458) (7.315) (1.064) (9.264) (0.587)
S 3, B/M 3 −0.009 1.113** 0.454 0.292 0.797** 0.914 S 3, B/M 3 0.001 0.802** 0.477** 0.411** 0.154 0.700
(−1.451) (14.134) (1.721) (1.411) (2.461) (0.120) (7.932) (3.160) (4.391) (0.662)
S 3, B/M 2 −0.002 1.182** 0.566** −0.078 1.230** 0.900 S 3, B/M 2 −0.003 0.818** 0.457** 0.214** 0.108 0.752
(−0.450) (10.460) (3.506) (−0.370) (4.930) (−1.086) (10.072) (4.763) (2.167) (0.867)
S 3, B/M 1 −0.003 1.035** 0.617** −0.329** 0.622** 0.900 S 3, B/M 1 0.001 0.867** 0.396** −0.194 0.077 0.898
(−0.426) (17.374) (2.994) (−2.288) (3.129) (0.600) (7.992) (3.462) (−1.723) (0.549)
S 4, B/M 4 −0.001 0.857** −0.149 1.131** 0.590** 0.947 S 4, B/M 4 0.001 0.909** −0.245** 1.166** 0.260** 0.900
(−0.199) (17.289) (−0.889) (7.406) (3.891) (0.380) (8.915) (−2.058) (16.521) (2.767)
S 4, B/M 3 −0.002 1.093** 0.111 0.110 0.240 0.937 S 4, B/M 3 0.000 1.038** −0.167 0.503** 0.205 0.840
(−0.502) (21.165) (1.014) (0.518) (1.172) (0.346) (12.115) (−1.386) (5.022) (1.393)
S 4, B/M 2 −0.004 0.984** 0.126** −0.053 0.254** 0.944 S 4, B/M 2 −0.003 0.960** 0.271** −0.200** 0.054 0.773
(−0.971) (24.922) (2.162) (−0.614) (2.011) (−1.118) (15.597) (4.555) (−2.909) (0.612)
S 4, B/M 1 −0.001 1.040** 0.258** −0.478** 0.695** 0.822 S 4, B/M 1 −0.003 0.919** 0.308** −0.299** 0.256 0.700
(−0.193) (13.105) (2.194) (−2.132) (4.624) (−1.255) (12.192) (3.241) (v4.272) (1.483)

GRS-F statistic: 0.962 ; p-value: 0.521.
Note: ** indicates statistical significance at the 5% level. t -statistics are given in
parentheses. All returns and risk factors are not expressed in percentages. The
regressions are estimated with the ordinary least-squares method with Newey-
West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).
GRS-F statistic: 1.245 ; p-value: 0.276.
Note: ** indicates statistical significance at the 5% level. t -statistics are given in
parentheses. All returns and risk factors are not expressed in percentages. The
regressions are estimated with the ordinary least-squares method with Newey-
West corrected errors used for heteroskedasticity and serial correlation (HAC). S 1,
B/M 4 is the portfolio of Size 1 (small stocks) and B/M 4 (high B/M ratio). S 4, B/M 1
is the portfolio of Size 4 (big stocks) and B/M 1 (low B/M ratio).

From the above empirical analysis, we find that volatility index
innovations is a priced risk factor in explaining the variation in stock
returns for the Indian stock market after controlling for the effect
of the market, size and book-to-market factors. Furthermore, dur-
ing periods of high volatility, stock’s exposure to volatility risk is
priced. Portfolios of stock with high sensitivity to volatility index
innovations provide higher subsequent returns than portfolios of
stock with low sensitivity to IVIX innovations. However, during low
volatility periods, the return differential between the portfolio of
stocks with high and low sensitivity to innovations in the volatility
index is statistically insignificant. This finding is consistent with the
prior literature (Delisle et al., 2011; Labidi & Yaakoubi, 2016; Mai
et al., 2016). Nevertheless, the addition of volatility risk factor to
the asset pricing model results in only a marginal improvement in
the model’s explanatory power in describing the variation in stock
returns.
6. Conclusions
Through this study we have sought to provide evidence on
whether stock’s exposure to volatility risk is a priced factor in
explaining the variation in stock returns for the Indian stock mar-
ket. The Fama-French three-factor model is considered to be the
standard asset pricing model in this study. We perform asset pric-
ing tests using monthly data of CNX 500 constituent stocks for the
period of October 2008 to August 2017. To explore the pricing role
of volatility index innovation, factor mimicking portfolio returns
for the volatility index is constructed and used as an additional fac-
tor in the Fama-French three-factor model. The excess returns of 16
size-B/M sorted portfolios, formed from 4 × 4 independent double
sorts on size and B/M, are used as test portfolios in the time-series
regressions. Furthermore, to investigate the pricing of the volatil-
ity index during periods of varying volatility, we employ Bai and
Perron (B&P) structural break test using monthly data for the India
Volatility Index from October 2008 to August 2017.
Our results suggest that beta and size factors continue to play an
important role in the Indian stock market over this sample period.
During high volatility periods, there is an increase in the number of
cases in which the HVXMLVX coefficient is statistically significant.
The HVXMLVX-augmented model presents a lower GRS- F statistic
in high volatility periods than the full sample and low volatil-
ity periods. However, during the low volatility period, HVXMLVX
factors are positive and statistically significant for only 3 of 16 port-
folios in the Fama-French model. Thus, this study shows that the
volatility index does not play an important role as a priced risk
factor during low volatility periods. Stock’s sensitivity to volatil-
ity index innovation is found to be a priced risk factor during high
volatility periods. Further, portfolios of stock with high sensitivity
to IVIX innovation provide higher subsequent returns than port-
folios of stocks with low sensitivity to IVIX innovations. However,
during low volatility periods, differences in returns between the
portfolios of stocks with high and low sensitivity to innovation in
the volatility index are statistically insignificant. Nevertheless, the
addition of volatility risk factor to the asset pricing model results
346 P.C. Pati et al. / The Quarterly Review of Economics and Finance 74 (2019) 336–346
in only a marginal improvement in the model’s explanatory power
in describing variation in stock returns.
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