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Keywords:

  • S&P 500;
  • implied volatility index;
  • GARCH-M;
  • risk-return relation

ABSTRACT

A strong and positive risk-return relation for the S&P 500 market index is uncovered when the implied volatility index is allowed for in the conditional variance equation. This result holds for five alternative Generalised Autoregressive Heteroscedasticity (GARCH) specifications and irrespective of the conditional distribution. Monte Carlo evidence suggests that if implied volatility is not included while it should be, then the risk-return relation is more likely to be negative or weak. Copyright © 2012 John Wiley & Sons, Ltd.