Stock market risk and return: an equilibrium approach

Empirical evidence that expected stock returns are weakly relatedto volatility at the market level appears to contradict theintuition that risk and return are positively related. We investigatethis issue in a general equilibrium exchange economy characterizedby a regime-switching consumption process with time-varyingtransition probabilities between regimes. When estimated usingconsumption data, the model generates a complex, non-linearand time-varying relation between expected returns and volatility,duplicating the salient features of the risk/return trade-offin the data. The results emphasize the importance of time-varyinginvestment opportunities and highlight the perils of relyingon intuition from static models.