The Asymmetric Effect Of The Business Cycle On The Relation Between Stock Market Returns And Their Volatility

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The Asymmetric Effect Of The Business Cycle On The Relation Between Stock Market Returns And Their Volatility

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P.N. Smith ()
S. Sorensen
M.R. Wickens

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Abstract

We examine the relation between US stock market returns and the US business cycle for the period 1960-2003 using a new methodology that allows us to estimate a time-varying equity premium. We identify two channels in the transmission mechanism. One is through the mean of stock returns via the equity risk premium, and the other is through the volatility of returns. We provide support for previous findings based on simple correlation analysis that the relation is asymmetric with downturns in the business cycle having a greater negative impact on stock returns than the positive effect of upturns. We also obtain a new result, that demand and supply shocks affect stock returns differently. Our model of the relation between returns and their volatility encompasses CAPM, consumption CAPM and Merton's (1973) inter-temporal CAPM. It is implemented using a multi-variate GARCH-in-mean model with an asymmetric time-varying conditional heteroskedasticity and correlation structure.

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Paper provided by Australian National University, Centre for Applied Macroeconomic Analysis in its series CAMA Working Papers with number 2006-05.

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Length: 38 pages
Date of creation: Jan 2006
Date of revision:
Handle: RePEc:acb:camaaa:2006-05

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Paper
- P N Smith & S Sorensen & M R Wickens, 2006. "The Asymmetric Effect of the Business Cycle on the Realtion between Stock Market Returns and their Volatility," Discussion Papers 06/04, Department of Economics, University of York. [Downloadable!]
- Peter N Smith & S Sorensen & M R Wickens, 2005. "The asymmetric effect of the business cycle on the relation between stock market returns and their volatility," Money Macro and Finance (MMF) Research Group Conference 2005 47, Money Macro and Finance Research Group. [Downloadable!]

Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models
C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

Smith, Peter N & Wickens, Michael R, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
Other versions:
- Mike R Wickens and Peter N Smith, . "Macroeconmic Sources of FOREX Risk," Discussion Papers 01/13, Department of Economics, University of York. [Downloadable!]

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities," Money Macro and Finance (MMF) Research Group Conference 2006 140, Money Macro and Finance Research Group. [Downloadable!]

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