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Journal of Financial Econometrics Advance Access published online on August 31, 2007
Journal of Financial Econometrics, doi:10.1093/jjfinec/nbm012
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Copyright © The Author 2007. Published by Oxford University Press.
The online version of this article has been published under an open access model. Users are entitled to use, reproduce, disseminate, or display the open access version of this article for non-commercial purposes provided that: the original authorship is properly and fully attributed; the Journal and Oxford University Press are attributed as the original place of publication with the correct citation details given; if an article is subsequently reproduced or disseminated not in its entirety but only in part or as a derivative work this must be clearly indicated. For commercial re-use, please contact journals.permissions@oxfordjournals.org

Components of Market Risk and Return

John M. Maheu and Thomas H. McCurdy
     University of Toronto

Address correspondence to Thomas H. McCurdy, Joseph L. Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, ON M5S 3E6, 416-978-3425, and Associate Fellow, CIRANO, or e-mail: tmccurdy{at}rotman.utoronto.ca


  Abstract

This article proposes a flexible but parsimonious specification of the joint dynamics of market risk and return to produce forecasts of a time-varying market equity premium. Our parsimonious volatility model allows components to decay at different rates, generates mean-reverting forecasts, and allows variance targeting. These features contribute to realistic equity premium forecasts for the U.S. market over the 1840–2006 period. For example, the premium forecast was low in the mid-1990s but has recently increased. Although the market's total conditional variance has a positive effect on returns, the smooth long-run component of volatility is more important for capturing the dynamics of the premium. This result is robust to univariate specifications that condition on either levels or logs of past realized volatility (RV), as well as to a new bivariate model of returns and RV.

KEYWORDS: volatility components, long-run market risk premium, realized volatility

The authors thank the editor, René Garcia, two anonymous referees, Hakan Bal, Harjoat Bhamra, Chris Jones, Mark Kamstra, Raymond Kan, Benoit Perron, Daniel Smith, participants at the May 2005 CIREQ-CIRANO Financial Econometrics Conference, the 2005 NFA annual meetings, and seminar participants at Simon Fraser University and McMaster University for very helpful comments, as well as Bill Schwert for providing U.S. equity returns for the period 1802–1925. They are also grateful to SSHRC for financial support. An earlier draft of this paper was titled "The long-run relationship between market risk and return."

Received January 18, 2007; revised May 16, 2007; accepted June 20, 2007


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