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State dependence of aggregated risk aversion: Evidence for the German stock market

Author

Listed:
  • Marc Hansen

    (Christian-Albrechts-University Kiel)

  • Helmut Herwartz

    (Georg-August-University Göttingen)

  • Malte Rengel

    (Georg-August-University Göttingen)

Abstract

We propose a dynamic generalization of the Capital Asset Pricing Model (CAPM) that allows for a time-varying market price of risk (MPR) reflecting both cross market dependence and future investment opportunities. The realized volatility approach is employed to determine market risk. The advocated state space model takes autoregressive dynamics of the MPR and predetermined state variables into account. For the case of the DAX, the major German stock index, the empirical analysis strongly underpins time variation of risk compensation. The MPR is conditioned upon the EURIBOR, a national and an international term spread, returns of the Dow-Jones-Industrial-Average-Index (DOW), and a dummy variable hinting at excess activity of noise traders. Moreover, we document forecasting results based on a short horizon trading strategy. The proposed model is characterized by strong market timing ability.

Suggested Citation

  • Marc Hansen & Helmut Herwartz & Malte Rengel, 2014. "State dependence of aggregated risk aversion: Evidence for the German stock market," Journal of Applied Economics, Universidad del CEMA, vol. 17, pages 257-282, November.
    • Handle: RePEc:cem:jaecon:v:17:y:2014:n:2:p:257-282
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    More about this item

    Keywords

    risk-return trade-off; stock return predictability; noise trading; realized volatility; Kalman-filter;
    All these keywords.

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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