Working Paper

Uncovering the risk-return relation in the stock market

Abstract: There is an ongoing debate about the apparent weak or negative relation between risk (conditional variance) and expected returns in the aggregate stock market. We develop and estimate an empirical model based on the ICAPM that separately identifies the two components of expected returns?the risk component and the component due to the desire to hedge changes in investment opportunities. The estimated coefficient of relative risk aversion is positive, statistically significant, and reasonable in magnitude. However, expected returns are driven primarily by the hedge component. The omission of this component is partly responsible for the existing contradictory results.

Keywords: Stock market; Econometric models; Asset pricing;

Status: Published in Journal of Finance, June 2006, 61(3), pp. 1433-63

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2005

Number: 2001-001