On the Relationship between the Conditional Mean and Volatility of Stock Returns: A Latent VAR Approach

51 Pages Posted: 11 Jul 2002 Last revised: 19 Jul 2002

See all articles by Qiang Kang

Qiang Kang

The University of Hong Kong - School of Economics and Finance

Michael W. Brandt

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)

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Date Written: July 2002

Abstract

We model the conditional mean and volatility of stock returns as a latent vector autoregressive (VAR) process to study the contemporaneous and intertemporal relationship between expected returns and risk in a flexible statistical framework and without relying on exogenous predictors. We find a strong and robust negative correlation between the innovations to the conditional moments that leads to pronounced counter-cyclical variation in the Sharpe ratio. We document significant lead-lag correlations between the conditional moments that also appear related to business cycles. Finally, we show that although the conditional correlation between the mean and volatility is negative, the unconditional correlation is positive due to the lead-lag correlations.

Suggested Citation

Kang, Qiang and Brandt, Michael W., On the Relationship between the Conditional Mean and Volatility of Stock Returns: A Latent VAR Approach (July 2002). NBER Working Paper No. w9056. Available at SSRN: https://ssrn.com/abstract=318851

Qiang Kang

The University of Hong Kong - School of Economics and Finance ( email )

8th Floor Kennedy Town Centre
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Michael W. Brandt (Contact Author)

Duke University - Fuqua School of Business ( email )

1 Towerview Drive
Durham, NC 27708-0120
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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