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Understanding the risk-return tradeoff in the stock market

  • Hui Guo
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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.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2002-001.

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Date of creation: 2002
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Handle: RePEc:fip:fedlwp:2002-001
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