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Expected stock returns and volatility in a production economy: a theory and some evidence

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  • Padamja Singal
  • Stephen D. Smith
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    Abstract

    The sign of the relationship between expected stock market returns and volatility appears to vary over time, a result that seems at odds with basic notions of risk and return. In this paper we construct an economy where production involves the use of both labor and capital as inputs. We show that when capital investment is "sticky," the sign of the relation between stock market risk and return varies in accordance with the supply of labor but requires no time variation in preferences. In particular, we show that for asset market equilibria where firms face an elastic supply of labor, the traditional positive risk-return relation obtains. Conversely, a negative relation obtains for asset market equilibria where there is positive probability that labor supply will be highly inelastic. A nice feature of our model is that, unlike earlier work, the sign of the stock market risk-return relation can be associated with observable features of the business cycle. Post–World War II macroeconomic and stock return data are used to test the predictions from the model. Using standard measures of stock market volatility, our results provide support for a stock market risk-return relation that is negative at the peaks of business cycles and positive at the troughs.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 99-8.

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    Date of creation: 1999
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    Handle: RePEc:fip:fedawp:99-8

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    Keywords: Stock market ; Risk ; Production (Economic theory) ; Business cycles;

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    References

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    1. Barsky, Robert B, 1989. "Why Don't the Prices of Stocks and Bonds Move Together?," American Economic Review, American Economic Association, vol. 79(5), pages 1132-45, December.
    2. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-53, December.
    3. Lawrence R. Glosten & Ravi Jagannathan & David E. Runkle, 1993. "On the relation between the expected value and the volatility of the nominal excess return on stocks," Staff Report 157, Federal Reserve Bank of Minneapolis.
    4. Abel, Andrew B., 1988. "Stock prices under time-varying dividend risk : An exact solution in an infinite-horizon general equilibrium model," Journal of Monetary Economics, Elsevier, vol. 22(3), pages 375-393.
    5. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
    6. David K. Backus & Allan W. Gregory, 1992. "Theoretical Relations Between Risk Premiums and Conditional Variances," Working Papers 92-18a, New York University, Leonard N. Stern School of Business, Department of Economics.
    7. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
    8. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
    9. Romer, Christina, 1986. "Spurious Volatility in Historical Unemployment Data," Journal of Political Economy, University of Chicago Press, vol. 94(1), pages 1-37, February.
    10. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, vol. 83(1), pages 273-77, March.
    11. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
    12. Pagan, Adrian, 1984. "Econometric Issues in the Analysis of Regressions with Generated Regressors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 221-47, February.
    13. Restoy, Fernando & Rockinger, G Michael, 1994. " On Stock Market Returns and Returns on Investment," Journal of Finance, American Finance Association, vol. 49(2), pages 543-56, June.
    14. Naik, Vasanttilak, 1994. "Asset Prices in Dynamic Production Economies with Time-Varying Risk," Review of Financial Studies, Society for Financial Studies, vol. 7(4), pages 781-801.
    15. Whitelaw, Robert F, 1994. " Time Variations and Covariations in the Expectation and Volatility of Stock Market Returns," Journal of Finance, American Finance Association, vol. 49(2), pages 515-41, June.
    16. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    17. Rothschild, Michael & Stiglitz, Joseph E., 1971. "Increasing risk II: Its economic consequences," Journal of Economic Theory, Elsevier, vol. 3(1), pages 66-84, March.
    18. Michele Boldrin & Michael Horvath, 1994. "Labor Contracts and Business Cycles," Discussion Papers 1068, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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    Cited by:
    1. Robert E. Hall, 1999. "The Stock Market and Capital Accumulation," NBER Working Papers 7180, National Bureau of Economic Research, Inc.

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