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Modelling the Risk and Return Relation Conditional on Market Volatility and Market Conditions

  • Don U.A. Galagedera

    ()

  • Robert Faff

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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File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2004/wp8-04.pdf
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Paper provided by Monash University, Department of Econometrics and Business Statistics in its series Monash Econometrics and Business Statistics Working Papers with number 8/04.

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Length: 28 pages
Date of creation: Apr 2004
Date of revision:
Handle: RePEc:msh:ebswps:2004-8
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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. Robert F. Engle & Victor K. Ng, 1991. "Measuring and Testing the Impact of News on Volatility," NBER Working Papers 3681, National Bureau of Economic Research, Inc.
  3. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
  10. 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.
  11. 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.
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