The Risk-Return Relationship and Financial Crises

Abstract

The risk-return trade-off implies that a riskier investment should demand a higher expected return relative to the risk-free return. The approach of Ghysels, Santa-Clara, and Valkanov (2005) consisted of estimating the risk-return trade-off with a mixed frequency, or MIDAS, approach. MIDAS strikes a compromise between on the one hand the need for longer horizons to model expected returns and on the other hand to use high frequency data to model the conditional volatility required to estimate expected returns. Using the approach of Ghysels, Santa-Clara, and Valkanov (2005), after correcting a coding error pointed out to us, we find that the Merton model holds over samples that exclude financial crises, in particular the Great Depression and/or the subprime mortgage financial crisis and the resulting Great Recession. We find that a simple flight to safety indicator separates the traditional risk-return relationship from financial crises which amount to fundamental changes in that relationship.

Keywords: risk, return, financial crisis, flight-to-safety

JEL Classification: G10