Stock Market Risk and Return: An Equilibrium Approach

Empirical evidence that expected stock returns are weakly related to volatility at the market level appears to contradict the intuition that risk and return are positively related. We investigate this issue in a general equilibrium exchange economy characterized by a regime-switching consumption process with time-varying transition probabilities between regimes. When estimated using consumption data, the model generates a complex, non-linear and time-varying relation between expected returns and volatility, duplicating the salient features of the risk/return trade-off in the data. The results emphasize the importance of time-varying investment opportunities and highlight the perils of relying on intuition from static models.