Understanding the risk-return tradeoff in the stock market
AbstractWe find that past stock market variance forecasts excess stock market returns and that its predictive ability is greatly enhanced if the consumption-wealth ratio is also included in the forecasting equation. While the risk-return tradeoff is found negative if we use the latter as the instrumental variable for the conditional moments, the former suggests positive one. We argue that the consumption-wealth ratio is closely related to the hedge component of excess returns as in Merton's (1973) intertemporal capital asset pricing model: market risk is indeed positively priced if we control for the hedge component.
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Bibliographic InfoPaper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2002-001.
Date of creation: 2002
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2002-06-13 (All new papers)
- NEP-FIN-2002-06-13 (Finance)
- NEP-FMK-2002-06-13 (Financial Markets)
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- Guo, Hui, 2004.
"Limited Stock Market Participation and Asset Prices in a Dynamic Economy,"
Journal of Financial and Quantitative Analysis,
Cambridge University Press, vol. 39(03), pages 495-516, September.
- Hui Guo, 2003. "Limited stock market participation and asset prices in a dynamic economy," Working Papers 2000-031, Federal Reserve Bank of St. Louis.
- Hui Guo, 2002. "Stock market returns, volatility, and future output," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 75-86.
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