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Uncovering the risk-return trade-off through ridge regressions

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  • Alemany, Nuria
  • Aragó, Vicent
  • Salvador, Enrique

Abstract

Using ridge regressions, we introduce a novel methodology to estimate a time-varying version of the market risk-return trade-off. Our model improves available techniques since it allows for flexible patterns in the relationship and does not need a long span of data or additional state variables to accurately estimate the trade-off. We find that this relationship is positive during almost all the sample but it occasionally turns out negative during deep recessions. Our results may help solve the controversy in the previous literature. Investors, policymakers, and regulators must monitor this relationship to optimise investment, manage risks, and prevent financial instability.

Suggested Citation

  • Alemany, Nuria & Aragó, Vicent & Salvador, Enrique, 2025. "Uncovering the risk-return trade-off through ridge regressions," Finance Research Letters, Elsevier, vol. 71(C).
    • Handle: RePEc:eee:finlet:v:71:y:2025:i:c:s1544612324014491
    DOI: 10.1016/j.frl.2024.106420
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    References listed on IDEAS

    as
    1. Tobias Adrian & Richard K. Crump & Erik Vogt, 2019. "Nonlinearity and Flight‐to‐Safety in the Risk‐Return Trade‐Off for Stocks and Bonds," Journal of Finance, American Finance Association, vol. 74(4), pages 1931-1973, August.
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    3. Hui Guo & Zijun Wang & Jian Yang, 2013. "Time‐Varying Risk–Return Trade‐off in the Stock Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 623-650, June.
    4. Chelikani, Surya & Marks, Joseph M. & Nam, Kiseok, 2024. "State-dependent intertemporal risk-return tradeoff: Further evidence," Journal of Economics and Business, Elsevier, vol. 130(C).
    5. Liu, Xiaochun, 2017. "Unfolded risk-return trade-offs and links to Macroeconomic Dynamics," Journal of Banking & Finance, Elsevier, vol. 82(C), pages 1-19.
    6. Ghysels, Eric & Guérin, Pierre & Marcellino, Massimiliano, 2014. "Regime switches in the risk–return trade-off," Journal of Empirical Finance, Elsevier, vol. 28(C), pages 118-138.
    7. Yu, Jianfeng & Yuan, Yu, 2011. "Investor sentiment and the mean-variance relation," Journal of Financial Economics, Elsevier, vol. 100(2), pages 367-381, May.
    8. Salvador, Enrique & Floros, Christos & Arago, Vicent, 2014. "Re-examining the risk–return relationship in Europe: Linear or non-linear trade-off?," Journal of Empirical Finance, Elsevier, vol. 28(C), pages 60-77.
    9. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    10. Alemany, Nuria & Aragó, Vicent & Salvador, Enrique, 2023. "The time-varying risk–return trade-off and its explanatory and predictive factors," The North American Journal of Economics and Finance, Elsevier, vol. 68(C).
    11. repec:mcb:jmoncb:v:45:y:2013:i::p:623-650 is not listed on IDEAS
    12. Cotter, John & Salvador, Enrique, 2022. "The non-linear trade-off between return and risk and its determinants," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 100-132.
    13. Barroso, Pedro & Maio, Paulo, 2024. "The risk–return tradeoff among equity factors," Journal of Empirical Finance, Elsevier, vol. 78(C).
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Risk-return trade-off; Time-varying parameters; Ridge regressions;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G19 - Financial Economics - - General Financial Markets - - - Other

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