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Understanding the risk-return tradeoff in the stock market

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  • Hui Guo

Abstract

We find that past stock market variance forecasts excess stock market returns and that its predictive ability is greatly enhanced if the consumption-wealth ratio is also included in the forecasting equation. While the risk-return tradeoff is found negative if we use the latter as the instrumental variable for the conditional moments, the former suggests positive one. We argue that the consumption-wealth ratio is closely related to the hedge component of excess returns as in Merton's (1973) intertemporal capital asset pricing model: market risk is indeed positively priced if we control for the hedge component.

Suggested Citation

  • Hui Guo, 2002. "Understanding the risk-return tradeoff in the stock market," Working Papers 2002-001, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2002-001
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    References listed on IDEAS

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    1. Burnside, A. Craig & Eichenbaum, Martin S. & Rebelo, Sergio T., 1996. "Sectoral Solow residuals," European Economic Review, Elsevier, vol. 40(3-5), pages 861-869, April.
    2. Ellen R. McGrattan & James A. Schmitz, 1999. "Maintenance and repair: too big to ignore," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 2-13.
    3. Ambler, Steve & Paquet, Alain, 1994. "Stochastic Depreciation and the Business Cycle," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 35(1), pages 101-116, February.
    4. King, Robert G. & Rebelo, Sergio T., 1999. "Resuscitating real business cycles," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 14, pages 927-1007 Elsevier.
    5. Steve Ambler & Alain Paquet, 1992. "Stochastic Depreciation and the Business Cycle Puzzle," Cahiers de recherche CREFE / CREFE Working Papers 8, CREFE, Université du Québec à Montréal.
    6. Mico Loretan & William B. English, 2000. "Evaluating "correlation breakdowns" during periods of market volatility," International Finance Discussion Papers 658, Board of Governors of the Federal Reserve System (U.S.).
    7. repec:adr:anecst:y:2000:i:58:p:05 is not listed on IDEAS
    8. Collard, Fabrice & Kollintzas, Tryphon, 2000. "Maintenance, Utilization, and Depreciation along the Business Cycle," CEPR Discussion Papers 2477, C.E.P.R. Discussion Papers.
    9. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 1993. "Labor Hoarding and the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 245-273, April.
    10. repec:adr:anecst:y:2000:i:58:p:06 is not listed on IDEAS
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    Cited by:

    1. Guo, Hui, 2004. "Limited Stock Market Participation and Asset Prices in a Dynamic Economy," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(03), pages 495-516, September.
    2. Hui Guo, 2002. "Stock market returns, volatility, and future output," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 75-86.

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    Keywords

    Stock market ; Hedging (Finance);

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