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Uncovering the Risk–Return Relation in the Stock Market

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  • HUI GUO
  • ROBERT F. WHITELAW

Abstract

There is 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 intertemporal capital asset pricing model (ICAPM) that separately identifies the two components of expected returns, namely, 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.

Suggested Citation

  • Hui Guo & Robert F. Whitelaw, 2006. "Uncovering the Risk–Return Relation in the Stock Market," Journal of Finance, American Finance Association, vol. 61(3), pages 1433-1463, June.
    • Handle: RePEc:bla:jfinan:v:61:y:2006:i:3:p:1433-1463
    DOI: 10.1111/j.1540-6261.2006.00877.x
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    JEL classification:

    • G1 - Financial Economics - - General Financial Markets

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