Understanding the Risk-Return Tradeoff in the Stock Market
51 Pages Posted: 19 Dec 2001
Date Written: December 2001
We find that past stock market variance forecasts excess stock market returns and that its predictive ability is greatly enhanced if the consumption-wealth ratio is also included in the forecasting equation. While the risk-return tradeoff is found negative if we use the latter as the instrumental variable for the conditional moments, the former suggests a positive one. We argue that the consumption-wealth ratio is closely related to the hedge component of excess returns as in Merton's (1973) intertemporal capital asset pricing model: market risk is indeed positively priced if we control for the hedge component.
Keywords: Risk-Return Tradeoff, Hedge Component of Excess Returns
JEL Classification: G1
Suggested Citation: Suggested Citation