What is the Shape of the Risk-Return Relation?
58 Pages Posted: 23 Mar 2009 Last revised: 9 Apr 2010
Date Written: March 25, 2010
Using a flexible econometric approach that avoids imposing restrictive modeling assumptions, we find evidence of a non-monotonic relation between conditional volatility and expected stock market returns: At low-to-medium levels of conditional volatility there is a positive trade-off between risk and expected returns, but this relationship gets inverted at high levels of volatility as observed during the recent financial crisis. We propose a new measure of risk based on the conditional covariance between daily observations of a broad economic activity index and stock returns. Using this covariance measure, we find clear evidence of a monotonically increasing risk-return trade-off. Our finding of a non-monotonic mean-volatility relation helps explain the absence of a consensus in the empirical literature on the sign of the risk-return trade-off. At the same time, our finding that the expected return is a monotonically rising function of the conditional covariance measure also suggests that a positive risk-return relation can be established once a better measure of risk is used.
Keywords: risk-return trade-off, time-varying expected returns, conditional volatility, economic activity index, covariance risk, boosted regression trees.
JEL Classification: G12
Suggested Citation: Suggested Citation