Uncovering the risk-return relation in the stock market

Description

"There is an ongoing debate in the literature about the apparent weak or negative relation between risk (conditional variance) and return (expected returns) in the aggregate stock market. We develop and estimate an empirical model based on the ICAPM to investigate this relation. Our primary innovation is to model and identify empirically the two components of expected returns--the risk component and the component due to the desire to hedge changes in investment opportunities. We also explicitly model the effect of shocks to expected returns on ex post returns and use implied volatility from traded options to increase estimation efficiency. As a result, the coefficient of relative risk aversion is estimated more precisely, and we find it to be positive and reasonable in magnitude. Although volatility risk is priced, as theory dictates, it contributes only a small amount to the time-variation in expected returns. Expected returns are driven primarily by the desire to hedge changes in investment opportunities. It is the omission of this hedge component that is responsible for the contradictory and counter-intuitive results in the existing literature"--Federal Reserve Bank of St. Louis web site.

Subjects

Series Statement

• NBER working paper series -- no. 9927.
• Working paper series (National Bureau of Economic Research) -- working paper no. 9927.

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Other Editions

• Uncovering the risk-return relation in the stock marketElectronic resourceFederal Reserve Bank of St. Louis2001-01-01
• Uncovering the risk-return relation in the stock marketNational Bureau of Economic Research2003