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Uncovering the Risk–Return Relation in the Stock Market


  • HUI GUO,


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    • Guo is at the Research Department, Federal Reserve Bank of St. Louis, and Whitelaw is at the Stern School of Business, New York University and the NBER. This paper was formerly circulated under the title “Risk and Return: Some New Evidence.” We thank N.R. Prabhala for providing the implied volatility data and an anonymous referee, the editor, Rick Green, and seminar participants at the Federal Reserve Bank of New York, the University of Illinois, Urbana-Champaign, the University of Texas, Austin, Vanderbilt University, the Australian Graduate School of Management, and the University of Queensland for helpful comments. Financial support from the C. V. Starr Center for Applied Economics is gratefully acknowledged by the first author. The views expressed in this paper are those of the authors and do not necessarily reflect the official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.


There is ongoing debate about the apparent weak or negative relation between risk (conditional variance) and expected returns in the aggregate stock market. We develop and estimate an empirical model based on the intertemporal capital asset pricing model (ICAPM) that separately identifies the two components of expected returns, namely, the risk component and the component due to the desire to hedge changes in investment opportunities. The estimated coefficient of relative risk aversion is positive, statistically significant, and reasonable in magnitude. However, expected returns are driven primarily by the hedge component. The omission of this component is partly responsible for the existing contradictory results.

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