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The Asymmetric Effect of the Business Cycle on the Realtion between Stock Market Returns and their Volatility

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Author Info
P N Smith
S Sorensen
M R Wickens

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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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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 06/04.

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Date of creation: Jan 2006
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Handle: RePEc:yor:yorken:06/04

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Postal: Department of Economics and Related Studies, University of York, York, YO10 5DD, United Kingdom
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Related research
Keywords: Equity returns; risk premium; asymmetry;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions
C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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References listed on IDEAS
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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. [Downloadable!] (restricted)
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Cited by:
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  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. [Downloadable!]
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