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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27319
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| Title: | Uncovering the Risk-Return Relation in the Stock Market |
| Authors: | Guo, Hui
Whitelaw, Robert F. |
| Issue Date: | 21-Jul-2003 |
| Series/Report no.: | S-MF-03-11 |
| Abstract: | 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 added 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. |
| URI: | http://hdl.handle.net/2451/27319 |
| Appears in Collections: | Macro Finance
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