This study examines the influence of investor sentiment, as captured by the India VIX, in conjunction with the Fama-French factors and Carhart’s momentum factor, on equity risk premia in the Indian stock market. By focusing on periods of heightened uncertainty, specifically the subprime crisis and the COVID-19 pandemic, the research explores how market volatility and risk factors interact to shape stock returns. Using Granger causality tests, the analysis uncovers directional relationships between the India VIX and various equity risk premia, while Impulse Response Functions and Variance Decomposition are employed to understand shock transmission and the sources of volatility among factors. The findings indicate strong interconnectedness between market volatility (VIX) and key risk factors, particularly the market risk premium and momentum. Notably, the study identifies a bidirectional causality between the size and market risk premia, emphasizing the pivotal role of the size factor during periods of increased volatility. Variance decomposition results further reveal that, although risk premia are predominantly influenced by their own shocks, there are modest interactions across different factors, underscoring the broader influence of market sentiment. The results suggest that tracking market volatility can enhance portfolio adjustment strategies during turbulent times. This research is limited to the Indian context and specific asset pricing factors, suggesting future studies should consider cross-country analyses and incorporate additional behavioral variables. Overall, the study provides new insights into the dynamic interplay be-tween investor sentiment and asset pricing, offering valuable guidance for investors, financial strategists, and policymakers aiming to better understand and navigate periods of market stress.
Dutta et al. (Sat,) studied this question.