Working Paper: NBER ID: w9927
Authors: Hui Guo; Robert F. Whitelaw
Abstract: There is an ongoing debate in the literature about the apparent weak or negative relation between risk (conditional variance) and return (expected returns) in the aggregate stock market. We develop and estimate an empirical model based on the ICAPM to investigate this relation. Our primary innovation is to model and identify empirically the two components of expected returns--the risk component and the component due to the desire to hedge changes in investment opportunities. We also explicitly model the effect of shocks to expected returns on ex post returns and use implied volatility from traded options to increase estimation efficiency. As a result, the coefficient of relative risk aversion is estimated more precisely, and we find it to be positive and reasonable in magnitude. Although volatility risk is priced, as theory dictates, it contributes only a small amount to the time-variation in expected returns. Expected returns are driven primarily by the desire to hedge changes in investment opportunities. It is the omission of this hedge component that is responsible for the contradictory and counter-intuitive results in the existing literature.
Keywords: No keywords provided
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk and hedge components (G13) | total variation in stock market returns (G17) |
| volatility (E32) | total variation in stock market returns (G17) |
| hedge component (G11) | risk-return relation (G11) |
| omission of hedge component (G19) | bias in estimates of relative risk aversion (D11) |
| volatility feedback effect (E32) | unexpected returns (C59) |
| coefficient of relative risk aversion (D11) | expected returns (G17) |