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Can macroeconomic dynamics explain the time variation of risk–return trade-offs in the U.S. financial market?

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  • Liu, Xiaochun

Abstract

This paper explores potential economic sources that drive risk–return trade-off dynamics both in-sample and out-of-sample. Using the stochastic dominance test, I find statistical evidence that the risk–return trade-off procyclically varies with business cycles and asymmetrically responses to market timing. Moreover, based on a set of commonly used macroeconomic variables, the macroeconomic fluctuations explain about 30.4% on average of risk–return trade-off dynamics, with significantly delayed macroeconomic effect up to 12 months. For the purpose of robustness, the results from macroeconomic predictive regressions are further generalized by the principle component analysis with an expanded number of macroeconomic variables.

Suggested Citation

  • Liu, Xiaochun, 2017. "Can macroeconomic dynamics explain the time variation of risk–return trade-offs in the U.S. financial market?," The Quarterly Review of Economics and Finance, Elsevier, vol. 66(C), pages 275-293.
    • Handle: RePEc:eee:quaeco:v:66:y:2017:i:c:p:275-293
    DOI: 10.1016/j.qref.2017.03.006
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    More about this item

    Keywords

    Flexible partial risk–return relation; Stochastic dominance tests; Return decomposition; Time-varying skewness; Principle components;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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