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Modeling The Risk And Return Relation Conditional On Market Volatility And Market Conditions



    (Department of Econometrics and Business Statistics, Monash University, PO Box 197, Caulfield East, Victoria 3145, Australia)



    (Department of Accounting and Finance, Monash University, Clayton, VIC 3800, Australia)

This paper investigates whether the risk-return relation varies, depending on changing market volatility and up/down market conditions. Three market regimes based on the level of conditional volatility of market returns are specified — "low", "neutral" and "high". The market model is extended to allow for these three market regimes and a three-beta asset-pricing model is developed. For a set of US industry sector indices using a cross-sectional regression, we find that the beta risk premium in the three market volatility regimes is priced. These significant results are uncovered only in the pricing model that accommodates up/down market conditions.

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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 08 (2005)
Issue (Month): 01 ()
Pages: 75-95

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Handle: RePEc:wsi:ijtafx:v:08:y:2005:i:01:p:75-95
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  1. Pettengill, Glenn N. & Sundaram, Sridhar & Mathur, Ike, 1995. "The Conditional Relation between Beta and Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(01), pages 101-116, March.
  2. Bhardwaj, Ravinder K & Brooks, LeRoy D, 1993. "Dual Betas from Bull and Bear Markets: Reversal of the Size Effect," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 16(4), pages 269-83, Winter.
  3. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
  4. Bos, T & Newbold, P, 1984. "An Empirical Investigation of the Possibility of Stochastic Systematic Risk in the Market Model," The Journal of Business, University of Chicago Press, vol. 57(1), pages 35-41, January.
  5. Engle, Robert F & Ng, Victor K, 1993. " Measuring and Testing the Impact of News on Volatility," Journal of Finance, American Finance Association, vol. 48(5), pages 1749-78, December.
  6. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  7. Jagannathan, Ravi & Wang, Zhenyu, 1996. " The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
  8. Bollerslev, Tim & Engle, Robert F. & Nelson, Daniel B., 1986. "Arch models," Handbook of Econometrics, in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 49, pages 2959-3038 Elsevier.
  9. Kim, Moon K. & Zumwalt, J. Kenton, 1979. "An Analysis of Risk in Bull and Bear Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 14(05), pages 1015-1025, December.
  10. Brooks, Robert D. & Faff, Robert W. & Yew, Kee Ho, 1997. "A new test of the relationship between regulatory change in financial markets and the stability of beta risk of depository institutions," Journal of Banking & Finance, Elsevier, vol. 21(2), pages 197-219, February.
  11. Faff, Robert, 2001. "A Multivariate Test of a Dual-Beta CAPM: Australian Evidence," The Financial Review, Eastern Finance Association, vol. 36(4), pages 157-74, November.
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