Uncovering the Risk-Return Relation in the Stock Market

43 Pages Posted: 11 Nov 2008

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: July 2003

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 e .ect of shocks to expected returns on ex post returns and use implied volatility from aded options to increase estimation e .ciency.As a result,the coe .cient of relative risk aversion is estimated more precisely,and we .nd it to be positive and reasonable in magnitude. Although volatility risk is priced,as theory dictates,it conibutes 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 conadictory and counter-intuitive results in the existing literature.

Suggested Citation

Guo, Hui and Whitelaw, Robert F., Uncovering the Risk-Return Relation in the Stock Market (July 2003). NYU Working Paper No. FIN-03-021. Available at SSRN: https://ssrn.com/abstract=1299391

Hui Guo

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business
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Cincinnati, OH 45221
United States
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513.556.0979 (Fax)

HOME PAGE: http://homepages.uc.edu/~guohu/

Robert F. Whitelaw

New York University ( email )

Stern School of Business
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New York, NY 10012-1126
United States
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212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

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United States

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