Is Value Premium a Proxy for Time-Varying Investment Opportunities: Some Time Series Evidence

FRB of St. Louis Working Paper No. 2005-026B

65 Pages Posted: 17 Mar 2005

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Zijun Wang

Texas A&M University

Robert Savickas

George Washington University - School of Business - Department of Finance

Jian Yang

University of Colorado at Denver - Business School

Date Written: April 2006

Abstract

This paper tests the conjecture that the value premium constructed from the cross-section of stocks proxies for investment opportunities by investigating whether it helps explain the puzzling empirical risk-return tradeoff in the stock market across time. In contrast with many early authors, we find that, in the U.S. data, the stock market return is positively and significantly related to its conditional variance after controlling for its covariance with the value premium. The covariance, which is negatively correlated with stock variance, is positively and significantly priced as well. Thus, by ignoring the effect of time-varying investment opportunities on the stock market return, the early specification might suffer from an omitted variables problem, which generates a downward bias in the estimate of the risk-return relation. Also, consistent with recent investment-based equilibrium models, we document a novel finding of a positive and significant relation between the value premium and its conditional variance over the post 1963 period. Moreover, we find qualitatively the same results for the world market as well as most of the other G7 countries. Our empirical evidence suggests that the value premium is a proxy for investment opportunities.

Keywords: CAPM, ICAPM, Fama and French Three Factors, Stock Market Return Predictability, Realized Volatility, and GARCH, Value Premium

JEL Classification: G1

Suggested Citation

Guo, Hui and Wang, Zijun and Savickas, Robert and Yang, Jian, Is Value Premium a Proxy for Time-Varying Investment Opportunities: Some Time Series Evidence (April 2006). FRB of St. Louis Working Paper No. 2005-026B, Available at SSRN: https://ssrn.com/abstract=682781 or http://dx.doi.org/10.2139/ssrn.682781

Hui Guo (Contact Author)

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/

Zijun Wang

Texas A&M University ( email )

Langford Building A
798 Ross St.
College Station, TX 77843-3137
United States

Robert Savickas

George Washington University - School of Business - Department of Finance ( email )

Funger Hall, Suite 501R
2201 G Street, N.W.
Washington, DC 20052
United States
202-994-8936 (Phone)
202-994-5014 (Fax)

HOME PAGE: http://savickas.net/

Jian Yang

University of Colorado at Denver - Business School ( email )

1250 14th St.
Denver, CO 80204
United States

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