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A new approach to risk-return trade-off dynamics via decomposition

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  • Frazier, David T.
  • Liu, Xiaochun

Abstract

This paper revisits the puzzling time series relation between risk premium and conditional volatility by proposing a flexible risk-return trade-off that allows for a variety of possible shapes and incorporates potential nonlinearities inherent in excess return dynamics. We derive this flexible risk-return relation using the decomposition approach of Anatolyev and Gospodinov (2010), which splits excess returns into the product of absolute returns and signs. Using this decomposition strategy, we study four major international financial markets. The empirical results support a significant and positive risk-return trade-off that is driven by conditional volatility, market timing and the interdependence between the two components, which is generically related to return skewness.

Suggested Citation

  • Frazier, David T. & Liu, Xiaochun, 2016. "A new approach to risk-return trade-off dynamics via decomposition," Journal of Economic Dynamics and Control, Elsevier, vol. 62(C), pages 43-55.
    • Handle: RePEc:eee:dyncon:v:62:y:2016:i:c:p:43-55
    DOI: 10.1016/j.jedc.2015.11.002
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    More about this item

    Keywords

    Absolute return and sign; Copulas; Nonlinear dependence; Return skewness and asymmetry; Asset pricing; International financial markets;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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