FIN-03-021 |
NYU Stern School of Business |
July 2003
Hui Guo and Robert F. Whitelaw
ABSTRACT
There is an ongoing debate in the literature about the apparent weak or negative relation
between risk (conditional variance)and return (expected returns)in the aggregate stock market.
We develop and estimate an empirical model based on the ICAPM to investigate this relation.Our
primary innovation is to model and identify empirically the two components of expected returns –the
risk component and the component due to the desire to hedge changes in investment opportunities.
We also explicitly model the e .ect of shocks to expected returns on ex post returns and use implied
volatility from aded options to increase estimation e .ciency.As a result,the coe .cient of relative
risk aversion is estimated more precisely,and we .nd it to be positive and reasonable in magnitude.
Although volatility risk is priced,as theory dictates,it conibutes only a small amount to the
time-variation in expected returns.Expected returns are driven primarily by the desire to hedge
changes in investment opportunities.It is the omission of this hedge component that is responsible
for the conadictory and counter-intuitive results in the existing literature.
Hui Guo
Institution: Research Department,Federal Reserve Bank of St.Louis (P.O.Box 442,St.Louis,Missouri 63166)
Email: hui.guo@stls.frb.org
Robert F. Whitelaw
Institution: Stern School of Business, New York University, 44 West 4th Seet, New York, NY 10012
Telephone: (212) 998-0338
Fax: (212) 995-4233
Email: rwhitela@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~rwhitela
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