The risk-return tradeoff: A COGARCH analysis of Merton's hypothesis
AbstractWe analysed daily returns of the CRSP value weighted and equally weighted indices over 1953-2007 in order to test for Merton's theorised relationship between risk and return. Like some previous studies we used a GARCH stochastic volatility approach, employing not only traditional discrete time GARCH models but also using a COGARCH -- a newly developed continuous-time GARCH model which allows for a rigorous analysis of unequally spaced data. When a risk-return relationship symmetric to positive or negative returns is postulated, a significant risk premium of the order of 7-8% p.a., consistent with previously published estimates, is obtained. When the model includes an asymmetry effect, the estimated risk premium, still around 7% p.a., becomes insignificant. These results are robust to the use of a value weighted or equally weighted index. The COGARCH model properly allows for unequally spaced time series data. As a sidelight, the model estimates that, during the period from 1953 to 2007, the weekend is equivalent, in volatility terms, to about 0.3-0.5 regular trading days.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Empirical Finance.
Volume (Year): 18 (2011)
Issue (Month): 2 (March)
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Web page: http://www.elsevier.com/locate/jempfin
Continuous-time GARCH modelling Market risk Pseudo-maximum likelihood Risk free rate Risk premium Stochastic volatility;
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