Smaller portfolio returns and the risk-return trade-off for the whole market

Jeffrey Dorfman () and Myung D. Park

Applied Financial Economics, 2014, vol. 24, issue 13, 853-869

Abstract: Empirical evidence on the risk-return trade-off in stocks has been conflicting. Several studies estimate a positive risk-return trade-off (see French et al ., 1987; Campbell and Hentschel, 1992) but other researchers find the opposite (see Nelson, 1991; Glosten et al ., 1993) and most of the results have been statistically insignificant regardless of the sign of the risk-return trade-off. Using bivariate GARCH-M models, we investigate (1) the risk-return trade-off for the market portfolio and (2) the relation between the expected return of individual portfolios and time-varying covariance with the market portfolio. Our bivariate models using individual portfolios yield results with positive, significant estimated risk-return trade-offs for the market portfolio and strong evidence of a positive relation between expected return and the time-varying covariance for individual portfolios. We also construct a robust estimate for the risk-return trade-off across model specifications using Bayesian model averaging and the resultant risk-return trade-off is estimated to be positive with high posterior probability.

Date: 2014
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DOI: 10.1080/09603107.2014.902154

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