The Risk-Return Tradeoff and Leverage Effect in a Stochastic Volatility-in-Mean Model

Bent Jesper Christensen and Petra Posedel Šimović ()

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We study the risk premium and leverage effect in the S&P500 market using the stochastic volatility-in-mean model of Barndor¤-Nielsen & Shephard (2001). The Merton (1973, 1980) equilibrium asset pricing condition linking the conditional mean and conditional variance of discrete time returns is reinterpreted in terms of the continuous time model. Tests are performed on the risk-return relation, the leverage effect, and the overidentifying zero intercept restriction in the Merton condition. Results are compared across alternative volatility proxies, in particular, realized volatility from high-frequency (5-minute) returns, implied Black-Scholes volatility backed out from observed option prices, model-free implied volatility (VIX), and staggered bipower variation. Our results are consistent with a positive risk-return relation and a significant leverage effect, whereas an additional overidentifying zero intercept condition is rejected. We also show that these inferences are sensitive to the exact timing of the chosen olatility proxy. Robustness of the conclusions is verified in bootstrap experiments.

Keywords: Financial leverage effect; implied volatility; realized volatility; risk-return relation; stochastic volatility; VIX (search for similar items in EconPapers)
JEL-codes: G13 L12 (search for similar items in EconPapers)
Pages: 25
Date: 2010-09-01
New Economics Papers: this item is included in nep-bec, nep-cfn, nep-fmk and nep-rmg
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