There is a Risk-Return Tradeoff after All
56 Pages Posted: 18 Jun 2004
Date Written: January 2004
This paper studies the ICAPM intertemporal relation between the conditional mean and the conditional variance of the aggregate stock market return. We introduce a new estimator that forecasts monthly variance with past daily squared returns - the Mixed Data Sampling (or MIDAS) approach. Using MIDAS, we find that there is a significantly positive relation between risk and return in the stock market. This finding is robust in subsamples, to asymmetric specifications of the variance process, and to controlling for variables associated with the business cycle. We compare the MIDAS results with tests of the ICAPM based on alternative conditional variance specifications and explain the conflicting results in the literature. Finally, we offer new insights about the dynamics of conditional variance.
Keywords: ICAPM, risk-return tradeoff, conditional variance, forecasting returns
JEL Classification: G00, G12, C22
Suggested Citation: Suggested Citation