Risk-Return Tradeoff in U.S. Stock Returns over the Business Cycle

Abstract

In the empirical finance literature, findings on the risk-return tradeoff in excess stock market returns are ambiguous. In this study, I develop a new qualitative response (QR)-generalized autoregressive conditional heteroskedasticity-in-mean (GARCH-M) model combining a probit model for a binary business cycle indicator and a regime-switching GARCH-M model for excess stock market return with the business cycle indicator defining the regime. Estimation results show that there is statistically significant variation in the U.S. excess stock returns over the business cycle. However, consistent with the conditional intertemporal capital asset pricing model (ICAPM), there is a positive risk-return relationship between volatility and expected return independent of the state of the economy.