The Asymmetric Effect of the Business Cycle on the Relation between Stock Market Returns and Their Volatility

University of York, Discussion Paper No. 2006/03

37 Pages Posted: 3 Mar 2005

See all articles by Peter N. Smith

Peter N. Smith

University of York - Department of Economics and Related Studies; Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA)

Steffen Sorensen

Moody's Investor Services

Michael Wickens

University of Cardiff; Centre for Economic Policy Research (CEPR); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)

Date Written: January 2006

Abstract

We examine the relation between US stock market returns and the US business cycle for the period 1960 - 2003 using a new methodology that allows us to estimate a time-varying equity premium. We identify two channels in the transmission mechanism. One is through the mean of stock returns via the equity risk premium, and the other is through the volatility of returns. We confirm previous findings based on simple correlation analysis that the relation is asymmetric with downturns in the business cycle having a greater negative impact on stock returns than the positive effect of upturns. We also obtain a new result, that demand and supply shocks affect stock returns differently. Our model of the relation between returns and their volatility is derived from the stochastic discount factor model of asset pricing which encompasses CAPM, consumption CAPM and Merton's (1973) inter-temporal CAPM. It is implemented using a multi-variate GARCH-in-mean model with a time-varying conditional heteroskedasticity and correlation structure.

Keywords: Stock returns, asymmetry

JEL Classification: C32, G12, E44

Suggested Citation

Smith, Peter N. and Sorensen, Steffen and Wickens, Michael, The Asymmetric Effect of the Business Cycle on the Relation between Stock Market Returns and Their Volatility (January 2006). University of York, Discussion Paper No. 2006/03. Available at SSRN: https://ssrn.com/abstract=676383 or http://dx.doi.org/10.2139/ssrn.676383

Peter N. Smith (Contact Author)

University of York - Department of Economics and Related Studies ( email )

Heslington
York 010 5DD
United Kingdom
+44 1904 433 765 (Phone)
+44 1904 433 759 (Fax)

Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA) ( email )

ANU College of Business and Economics
Canberra, Australian Capital Territory 0200
Australia

Steffen Sorensen

Moody's Investor Services

New York, NY 10007
United States

Michael Wickens

University of Cardiff; Centre for Economic Policy Research (CEPR) ( email )

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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