Measuring Risk Aversion from Excess Returns on a Stock Index

41 Pages Posted: 17 Oct 2007 Last revised: 17 Jun 2021

See all articles by Ray Chou

Ray Chou

Georgia Institute of Technology - Scheller College of Business

Robert F. Engle

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); New York University (NYU) - Volatility and Risk Institute

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS)

Date Written: March 1991

Abstract

We distinguish the measure of risk aversion from the slope coefficient in the linear relationship between the mean excess return on a stock index and its variance. Even when risk aversion is constant, the latter can vary significantly with the relative share of stocks in the risky wealth portfolio, and with the beta of unobserved wealth on stocks. We introduce a statistical model with ARCH disturbances and a time-varying parameter in the mean (TVP ARCH-N). The model decomposes the predictable component in stock returns into two parts: the time-varying price of volatility and the time-varying volatility of returns. The relative share of stocks and the beta of the excluded components of wealth on stocks are instrumented by macroeconomic variables. The ratio of corporate profit over national income and the inflation rate ore found to be important forces in the dynamics of stock price volatility.

Suggested Citation

Chou, Ray and Engle, Robert F. and Kane, Alex, Measuring Risk Aversion from Excess Returns on a Stock Index (March 1991). NBER Working Paper No. w3643, Available at SSRN: https://ssrn.com/abstract=351421

Ray Chou (Contact Author)

Georgia Institute of Technology - Scheller College of Business

800 West Peachtree St., NW
Atlanta, GA 30308-1149
United States

Robert F. Engle

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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New York University (NYU) - Volatility and Risk Institute ( email )

44 West 4th Street
New York, NY 10012
United States

Alex Kane

University of California, San Diego (UCSD) - Graduate School of International Relations and Pacific Studies (IRPS) ( email )

9500 Gilman Drive
La Jolla, CA 92093-0519
United States

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