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The Asymmetric Effect Of The Business Cycle On The Relation Between Stock Market Returns And Their Volatility

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  • P.N. Smith
  • S. Sorensen
  • M.R. Wickens

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 ?ndings 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 e?ect of upturns. We also obtain a new result, that demand and supply shocks a?ect stock returns di?erently. 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.

Suggested Citation

  • P.N. Smith & S. Sorensen & M.R. Wickens, 2006. "The Asymmetric Effect Of The Business Cycle On The Relation Between Stock Market Returns And Their Volatility," CAMA Working Papers 2006-05, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    • Handle: RePEc:een:camaaa:2006-05
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    File URL: https://cama.crawford.anu.edu.au/sites/default/files/publication/cama_crawford_anu_edu_au/2021-06/5_smith_sorensen_wickens_2006.pdf
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    References listed on IDEAS

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    1. Peter Smith & Michael Wickens, 2002. "Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
    2. Turner, Christopher M. & Startz, Richard & Nelson, Charles R., 1989. "A Markov model of heteroskedasticity, risk, and learning in the stock market," Journal of Financial Economics, Elsevier, vol. 25(1), pages 3-22, November.
    3. Wickens, Michael R. & Smith, Peter N, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, Centre for Economic Policy Research.
    4. Smith, R. Todd, 1993. "Market risk and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 17(4), pages 555-569, July.
    5. P N Smith & S Sorensen & M R Wickens, "undated". "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York.
    6. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    7. P N Smith & S Sorensen & M R Wickens, "undated". "Macroeconomic Sources of Equity Risk," Discussion Papers 03/13, Department of Economics, University of York.
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    Cited by:

    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.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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