The impact of global financial market uncertainty on the risk-return relation in the stock markets of G7 countries

Geoffrey Loudon

Studies in Economics and Finance, 2017, vol. 34, issue 1, 2-23

Abstract: Purpose - This paper aims to investigate the effect of global financial market uncertainty on the relation between risk and return in G7 stock markets. Design/methodology/approach - Market uncertainty is quantified using a probability-based measure derived from a regime-switching model in which the state transition probabilities are time-varying in response to leading economic indicators. Time variation in the risk return relation is estimated using a GARCH-M model. Findings - While the regime-switching model successfully distinguishes between crisis and normal states, there remains substantial variability through time in the level of uncertainty about which state prevails. Results show that a strong negative relation exists between this uncertainty and the reward-to-variability ratio across all G7 stock markets. This finding is qualitatively consistent at both monthly and weekly horizons. Originality/value - Extant evidence on the risk-return relation is conflicting. Most papers assume the relation is time constant. Allowing the reward-to-variability ratio to vary through time in response to return regime uncertainty increases the understanding of asset pricing. It also has important implications for asset allocation decisions by investors.

Keywords: Risk and return; Regime-switching; Asset pricing; Market uncertainty; G12; G13 (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eme:sefpps:sef-05-2013-0069

DOI: 10.1108/SEF-05-2013-0069

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