Risk and Return: Some New Evidence

Abstract

We develop a structural asset pricing model to investigate the relationship between stock market risk and return. The structural model is estimated using the conditional market variance implied by S&P 100 index option prices. Relative risk aversion is precisely identified and is found to be positive, with point estimates ranging from 3.06 to 4.01. However, the implied volatility data only spans the period November 1983 to May 1995. As a robustness check, the structural model is also examined with postwar monthly data, in which the conditional market variance is estimated. We again find a positive and significant risk-return relation and get similar point estimates for relative risk aversion. Additionally, we document some facts about stock market return. First, stock price movements are primarily driven by changes in investment opportunities, not by changes in market volatility. Second, there is some evidence of a leverage effect. Third, relative risk aversion is quite stable over time.