Working Paper

Understanding the risk-return tradeoff in the stock market

Abstract: We find that past stock market variance forecasts excess stock market returns and that its predictive ability is greatly enhanced if the consumption-wealth ratio is also included in the forecasting equation. While the risk-return tradeoff is found negative if we use the latter as the instrumental variable for the conditional moments, the former suggests positive one. We argue that the consumption-wealth ratio is closely related to the hedge component of excess returns as in Merton's (1973) intertemporal capital asset pricing model: market risk is indeed positively priced if we control for the hedge component.

Keywords: Stock market; Hedging (Finance);

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2002

Number: 2002-001