The intra- and interstate excess market return for low- and high-volatility level

This paper provides a method to estimate the market risk premium that accounts for shifts in investment opportunities by explicitly modeling the volaiility level. This method decomposes the market risk premium into two components., the expected risk premium within the volatility state and risk premium associate with an unexpected change in volatility state. I find that the expected risk premium within the state is negatively related to the market volatility, which is consistent with empirical observations. Whereas the positive relationship between estimated market risk premium and market volatility is consistent with the theoretical relationship. Finally, evidences show the simple historical average of excess market returns overstate in the high-volatility state and understate in the low-volatility state. Therefore, different market risk premium should be used accordingly for different volatility level.