A new approach to risk-return trade-off dynamics via decomposition |
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Institution: | 1. Ladislaus von Bortkiewicz Chair of Statistics, C.A.S.E. – Center for Applied Statistics and Economics, Humboldt-Universität zu Berlin, Unter den Linden 6, 10099 Berlin, Germany;2. LeBow College of Business, Drexel University, Gerri LeBow Hall, 3220 Market Street, Philadelphia, PA 19104, USA;3. Sim Kee Boon Institute for Financial Economics, Singapore Management University, 50 Stamford Road, 178899 Singapore, Singapore |
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Abstract: | This paper revisits the puzzling time series relation between risk premium and conditional volatility by proposing a flexible risk-return trade-off that allows for a variety of possible shapes and incorporates potential nonlinearities inherent in excess return dynamics. We derive this flexible risk-return relation using the decomposition approach of Anatolyev and Gospodinov (2010), which splits excess returns into the product of absolute returns and signs. Using this decomposition strategy, we study four major international financial markets. The empirical results support a significant and positive risk-return trade-off that is driven by conditional volatility, market timing and the interdependence between the two components, which is generically related to return skewness. |
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Keywords: | Absolute return and sign Copulas Nonlinear dependence Return skewness and asymmetry Asset pricing International financial markets |
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