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Uncovering the risk-return relation in the stock market

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  • Hui Guo
  • Robert Whitelaw
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Abstract

There is an ongoing debate about the apparent weak or negative relation between risk (conditional variance) and expected returns in the aggregate stock market. We develop and estimate an empirical model based on the ICAPM that separately identifies the two components of expected returns–the risk component and the component due to the desire to hedge changes in investment opportunities. The estimated coefficient of relative risk aversion is positive, statistically significant, and reasonable in magnitude. However, expected returns are driven primarily by the hedge component. The omission of this component is partly responsible for the existing contradictory results.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2001-001.

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Date of creation: 2005
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Publication status: Published in Journal of Finance, June 2006, 61(3), pp. 1433-63
Handle: RePEc:fip:fedlwp:2001-001

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Keywords: Stock market ; Econometric models ; Asset pricing;

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