Risk and Return: An Equilibrium Approach

Recent empirical evidence suggests, counterintuitively, that expected stock returns are negatively related to the volatility of stock returns at the market level, and that this relation varies substantially over time. This paper investigates this relation in a general equilibrium nominal exchange economy estimated using consumption growth and inflation data. Surprisingly, perhaps, a two regime specification is able to duplicate the salient features of the expected return/volatility relation. Within each regime, the state variables follow a VAR(1), and the probability of a regime shift depends on the level of inflation. In this model, the unconditional correlation between expected returns and volatility is -0.3. Moreover, conditional correlations range from -0.7 to 1.0, depending on the state of the world as described by the levels of consumption growth and inflation. These results highlight the perils of relying on intuition from static models. They also have important implications for the empirical modeling of returns and investment performance evaluation. Finally, the results demonstrate that volatility can be an extremely poor measure of priced risk at the market level