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Working Paper 2002-001A

"Understanding the Risk-Return Tradeoff in the Stock Market"
by Hui Guo

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 a 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.

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Category > Finance
Author > Hui Guo
Research Papers and Publications: JEL Code > G1