Does an intertemporal tradeoff between risk and return explain mean reversion in stock prices?

Chang Jin Kim, James C. Morley, Charles R. Nelson

Research output: Contribution to journalArticlepeer-review

19 Citations (Scopus)

Abstract

When volatility feedback is taken into account, there is strong evidence of a positive tradeoff between stock market volatility and expected returns on a market portfolio. In this paper, we ask whether this intertemporal tradeoff between risk and return is responsible for the reported evidence of mean reversion in stock prices. There are two relevant findings. First, price movements not related to the effects of Markov-switching market volatility are largely unpredictable over long horizons. Second, time-varying parameter estimates of the long-horizon predictability of stock returns reject any systematic mean reversion in favour of behaviour implicit in the historical timing of the tradeoff between risk and return.

Original languageEnglish
Pages (from-to)403-426
Number of pages24
JournalJournal of Empirical Finance
Volume8
Issue number4
DOIs
Publication statusPublished - 2001 Sept

Bibliographical note

Funding Information:
We have received helpful comments from Charles Engel, Dick Startz, Eric Zivot, participants in seminars at the Federal Reserve Bank of Dallas, the Federal Reserve Bank of St. Louis, Washington University, and the University of Washington, and two anonymous referees, but responsibility for any errors is entirely our own. Support from the National Science Foundation under grants SBR-9711301 and SES-9818789 and the Ford and Louisa Van Voorhis endowment at the University of Washington is gratefully acknowledged. This paper is based in part on Morley's (1999) doctoral dissertation at the University of Washington. Earlier drafts of the paper circulated under the title “Do Changes in the Market Risk Premium Explain the Empirical Evidence of Mean Reversion in Stock Prices?”

Keywords

  • G12
  • G14
  • Markov switching
  • Mean reversion
  • Time-varying parameter
  • Volatility feedback

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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