Working Paper: NBER ID: w2573
Authors: Alberto Giovannini; Philippe Jorion
Abstract: Recent empirical work indicates that, in a variety of financial markets, both conditional expectations and conditional variances of returns are time- varying. The purpose of this paper is to determine whether these joint fluctuations of conditional first and second moments are consistent with the Sharpe-Lintner-Mossin capital-asset-pricing model. We test the mean-variance model under several different assumptions about the time-variation of conditional second moments of returns, using weekly data from July 1974 to December 1986, that include returns on a portfolio composed of dollar, Deutsche mark, Sterling, and Swiss franc assets, together with the US stock market. The model is estimated constraining risk premia to depend on the time-varying conditional covariance matrix of the residuals of the expected returns equations. The results indicate that estimated conditional variances cannot explain the observed time-variation of risk premia. Furthermore, the constraints imposed by the static CAPH are always rejected.
Keywords: risk; return; foreign exchange; stock markets; CAPM
JEL Codes: G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| conditional variances (C29) | expected returns (G17) |
| time-varying conditional covariance matrix (C32) | understanding risk premia (D81) |
| lagged conditional variances (C22) | expected returns (G17) |
| interest rates (E43) | conditional variances (C29) |
| interest rates (E43) | expected returns (G17) |