Time-Varying Risk-Return Tradeoff in the Stock Market
Forthcoming at JMCB
45 Pages Posted: 8 Aug 2006 Last revised: 29 Oct 2012
Date Written: April 1, 2012
Using a semiparametric estimation technique, we show that the risk-return tradeoff and the Sharpe ratio of the stock market increases monotonically with the consumption wealth ratio (CAY) across time. While early studies have commonly interpreted such a finding as evidence of the countercyclical variation in aggregate relative risk aversion (RRA), we argue that it mainly reflects changes in investment opportunities for two reasons. First, we fail to reject the null hypothesis of constant RRA after controlling for CAY as a proxy for the hedge against changes in the investment opportunity set. Second, by contrast with habit formation models but consistent with ICAPM, we find that loadings on the conditional stock market variance scaled by CAY are negatively priced in the cross-sectional regressions. For illustration, we replicate the countercyclical stock market risk-return tradeoff using simulated data from Guo's (2004) limited stock market participation model, in which RRA is constant and CAY is a proxy for shareholders' liquidity conditions.
Keywords: Habit Formation, Time-Varying Risk Aversion, Countercyclical Sharpe Ratio, Limited Stock Market Participation, Illiquidity Premium, ICAPM, Conditional CAPM, Nonparametric and Semiparametric Models
JEL Classification: G12, C14
Suggested Citation: Suggested Citation