Measuring the Time-Varying Risk-Return Relation from the Cross-Section of Equity Returns.” Working Paper

We use the structure imposed by Mertons (1973) ICAPM to obtain monthly estimates of the market-level risk-return relationship from the cross-section of equity returns. Our econometric approach sidesteps the speci\u85cation of time-series models for the conditional risk premium and volatility of the market portfolio. We show that the risk-return relation is mostly positive but varies considerably over time. It covaries positively with counter-cyclical state variables. The relationship between the risk premium and hedge-related risk also exhibits strong time-variation, which supports the empirical evidence that aggregate risk aversion varies over time. Finally, the ICAPMs two components of the risk premium show distinctly di¤erent cyclical properties. The volatility component exhibits a counter-cyclical pattern whereas the hedging component is less related to the business cycle and falls below zero for extended periods. This suggests the market serves an important hedging role for long-term investors. We thank Jules van Binsbergen, seminar participats at the Vienna Symposium on Asset Management, and an anonymous referee for helpful comments