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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

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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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University 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:een:camaaa:2006-05

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  1. Smith, Peter N & Wickens, Michael R, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, C.E.P.R. Discussion Papers.
  2. P N Smith & S Sorensen & M R Wickens, . "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York.
  3. P N Smith & S Sorensen & M R Wickens, . "Macroeconomic Sources of Equity Risk," Discussion Papers 03/13, Department of Economics, University of York.
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Cited by:
  1. 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.

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