The Asymmetric Effect of the Business Cycle on the Equity Premium (This is an extensively revised version of earlier paper No. 06/04)

Peter Smith, Steffen Sorensen () and Michael Wickens

Discussion Papers from Department of Economics, University of York

Abstract: We examine the relation between US stock market returns and the US business cycle for the period 1960 - 2003 using a new methodology that allows us to estimate a time-varying equity premium. We identify two channels in the transmission mechanism. One is through the mean of stock returns via the equity risk premium, and the other is through the volatility of returns. We provide support for previous findings based on simple correlation analysis that the relation is asymmetric with downturns in the business cycle having a greater negative impact on stock returns than the positive effect of upturns. We also obtain a new result, that demand and supply shocks affect stock returns differently. We find that negative supply shocks are a very important source of increases in the risk premium. Our model of the relation between returns and their volatility encompasses the CAPM and the results demonstrate the importance of allowing for a time-varying price of volatility risk. The model is implemented using a multi-variate GARCH-in-mean model with an asymmetric time-varying conditional heteroskedasticity and correlation structure.

Keywords: Equity returns; risk premium; asymmetry (search for similar items in EconPapers)
JEL-codes: C32 C51 E44 G12 (search for similar items in EconPapers)
Date: 2007-05
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Persistent link: https://EconPapers.repec.org/RePEc:yor:yorken:07/11

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