Uncovering the Risk-Return Relation in the Stock Market

42 Pages Posted: 25 Aug 2003 Last revised: 4 Nov 2010

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: August 2003

Abstract

There is an ongoing debate in the literature about the apparent weak or negative relation between risk (conditional variance) and return (expected returns) in the aggregate stock market. We develop and estimate an empirical model based on the ICAPM to investigate this relation. Our primary innovation is to model and identify empirically the two components of expected returns--the risk component and the component due to the desire to hedge changes in investment opportunities. We also explicitly model the effect of shocks to expected returns on ex post returns and use implied volatility from traded options to increase estimation efficiency. As a result, the coefficient of relative risk aversion is estimated more precisely, and we find it to be positive and reasonable in magnitude. Although volatility risk is priced, as theory dictates, it contributes only a small amount to the time-variation in expected returns. Expected returns are driven primarily by the desire to hedge changes in investment opportunities. It is the omission of this hedge component that is responsible for the contradictory and counter-intuitive results in the existing literature.

Suggested Citation

Guo, Hui and Whitelaw, Robert F., Uncovering the Risk-Return Relation in the Stock Market (August 2003). NBER Working Paper No. w9927. Available at SSRN: https://ssrn.com/abstract=437496

Hui Guo

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business
418 Carl H. Lindner Hall
Cincinnati, OH 45221
United States
513.556.7077 (Phone)
513.556.0979 (Fax)

HOME PAGE: http://homepages.uc.edu/~guohu/

Robert F. Whitelaw (Contact Author)

New York University ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0338 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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