Time-Varying Risk-Return Tradeoff in the Stock Market

Forthcoming at JMCB

45 Pages Posted: 8 Aug 2006 Last revised: 29 Oct 2012

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Zijun Wang

Texas A&M University

Jian Yang

University of Colorado at Denver - Business School

Date Written: April 1, 2012

Abstract

Using a semiparametric estimation technique, we show that the risk-return tradeoff and the Sharpe ratio of the stock market increases monotonically with the consumption wealth ratio (CAY) across time. While early studies have commonly interpreted such a finding as evidence of the countercyclical variation in aggregate relative risk aversion (RRA), we argue that it mainly reflects changes in investment opportunities for two reasons. First, we fail to reject the null hypothesis of constant RRA after controlling for CAY as a proxy for the hedge against changes in the investment opportunity set. Second, by contrast with habit formation models but consistent with ICAPM, we find that loadings on the conditional stock market variance scaled by CAY are negatively priced in the cross-sectional regressions. For illustration, we replicate the countercyclical stock market risk-return tradeoff using simulated data from Guo's (2004) limited stock market participation model, in which RRA is constant and CAY is a proxy for shareholders' liquidity conditions.

Keywords: Habit Formation, Time-Varying Risk Aversion, Countercyclical Sharpe Ratio, Limited Stock Market Participation, Illiquidity Premium, ICAPM, Conditional CAPM, Nonparametric and Semiparametric Models

JEL Classification: G12, C14

Suggested Citation

Guo, Hui and Wang, Zijun and Yang, Jian, Time-Varying Risk-Return Tradeoff in the Stock Market (April 1, 2012). Forthcoming at JMCB, Available at SSRN: https://ssrn.com/abstract=923148 or http://dx.doi.org/10.2139/ssrn.923148

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

Jian Yang

University of Colorado at Denver - Business School ( email )

1250 14th St.
Denver, CO 80204
United States

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