The Risk-Return Relationship and Financial Crises

20 Pages Posted: 7 May 2016

See all articles by Eric Ghysels

Eric Ghysels

University of North Carolina Kenan-Flagler Business School; University of North Carolina (UNC) at Chapel Hill - Department of Economics

Alberto Plazzi

Swiss Finance Institute; USI Lugano

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

Date Written: May 6, 2016

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

Suggested Citation

Ghysels, Eric and Plazzi, Alberto and Valkanov, Rossen, The Risk-Return Relationship and Financial Crises (May 6, 2016). Available at SSRN: https://ssrn.com/abstract=2776702 or http://dx.doi.org/10.2139/ssrn.2776702

Eric Ghysels

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Gardner Hall, CB 3305
Chapel Hill, NC 27599
United States
919-966-5325 (Phone)
919-966-4986 (Fax)

HOME PAGE: http://www.unc.edu/~eghysels/

Alberto Plazzi (Contact Author)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

USI Lugano ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

HOME PAGE: http://www.people.usi.ch/plazzia/

Rossen Valkanov

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)

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