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Understanding the risk-return tradeoff in the stock market

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  • Hui Guo
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Abstract

We 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 Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2002-001.

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Date of creation: 2002
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Handle: RePEc:fip:fedlwp:2002-001

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Keywords: Stock market ; Hedging (Finance);

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Cited by:
  1. 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.
  2. 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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