Does Aggregate Relative Risk Aversion Change Countercyclically over Time? Evidence from the Stock Market

Hui Guo, Zijun Wang, Jian Yang
2006 Social Science Research Network  
Stock market risk-return tradeoff changes countercyclically and sometimes may even become negative. The negative tradeoff, which poses a challenge to the explanation based solely on timevarying relative risk aversion (RRA), may reflect investment opportunity changes for three reasons. First, after controlling for changing investment opportunities, we find that RRA is always positive and fail to reject the null hypothesis of constant RRA. By contrast, investment opportunities always have
more » ... always have significant effects on expected returns even if allowing for timevarying RRA. Second, the interaction term of conditional market variance with the (countercyclical) conditioning variable is negatively priced in the cross-section of stock returns, and its explanatory power is similar to that of Fama and French's (1996) HML factor. Lastly, we replicate the observed countercyclical risk-return tradeoff using simulated data from a limited participation model, in which RRA is constant and shareholders' liquidity conditions are an important determinant of the conditional equity premium.
doi:10.2139/ssrn.923148 fatcat:gnqcrsx2jrapdmuebyaahnjvsa