Understanding the risk-return tradeoff in the stock market
Hui Guo ()
No 2002-001, Working Papers from Federal Reserve Bank of St. Louis
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) (search for similar items in EconPapers)
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