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The Risk-Return Tradeoff and Leverage Effect in a Stochastic Volatility-in-Mean Model

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  • Bent Jesper Christensen

    ()
    (Aarhus University, School of Economics and Management, Bartholins Allé 10, Aarhus, Denmark & CREATES)

  • Petra Posedel

    ()
    (University of Zagreb)

Abstract

We study the risk premium and leverage effect in the S&P500 market using the stochastic volatility-in-mean model of Barndor¤-Nielsen & Shephard (2001). The Merton (1973, 1980) equilibrium asset pricing condition linking the conditional mean and conditional variance of discrete time returns is reinterpreted in terms of the continuous time model. Tests are per- formed on the risk-return relation, the leverage effect, and the overidentifying zero intercept restriction in the Merton condition. Results are compared across alternative volatility proxies, in particular, realized volatility from high-frequency (5-minute) returns, implied Black-Scholes volatility backed out from observed option prices, model-free implied volatility (VIX), and staggered bipower variation. Our results are consistent with a positive risk-return relation and a significant leverage effect, whereas an additional overidentifying zero intercept condition is rejected. We also show that these inferences are sensitive to the exact timing of the chosen volatility proxy. Robustness of the conclusions is verified in bootstrap experiments.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-50.

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Length: 25
Date of creation: 01 Sep 2010
Date of revision:
Handle: RePEc:aah:create:2010-50

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Web page: http://www.econ.au.dk/afn/

Related research

Keywords: Financial leverage effect; implied volatility; realized volatility; risk-return relation; stochastic volatility; VIX;

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  1. Muller, Ulrich A. & Dacorogna, Michel M. & Olsen, Richard B. & Pictet, Olivier V. & Schwarz, Matthias & Morgenegg, Claude, 1990. "Statistical study of foreign exchange rates, empirical evidence of a price change scaling law, and intraday analysis," Journal of Banking & Finance, Elsevier, vol. 14(6), pages 1189-1208, December.
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