Unemployment, Inflation, and Common Stock Returns

THIS PAPER INVESTIGATES whether there exist risk premia for common stock returns associated with unemployment and inflation. Over the last decade, there have been large fluctuations in both macroeconomic and financial variables. The main purpose of this paper is to provide some empincal insight into the effects of this recent macroeconomic activity on mean common stock returns. Merton [71 showed that economy-wide state variables that affect investors' earnings opportunities can affect equilibrium secunty returns. In Merton's intertemporal setting, the anticipated return on a security is a linear function of the return on the zero-beta portfolio and a set of state variable betas, where each reflects the security's systematic movement with respect to the associated state variable. While Merton used an equilibrium setting, Ross [91 developed a similar pricing relationship from arbitrage conditions. In both cases, the slope coefficients in the expected return equations are the pnces of systematic risk associated with the factors. They reflect the risk premium for an asset whose return is perfectly correlated with the respective factor and is uncorrelated with the other factors. Brock [4] has extended Merton's and Ross's analysis to a production economy, and is able to derive asset