A New Approach to Risk-return Trade-off Dynamics via Decomposition

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This paper revisits the puzzling time series relation between risk premium and conditional volatility by proposing a flexible risk-return trade-off that allows for a variety of possible shapes and incorporates potential nonlinearities inherent in excess return dynamics. We derive this flexible risk-return relation using the decomposition approach of Anatolyev and Gospodinov (2010), which splits excess returns into the product of absolute returns and signs. Using this decomposition strategy, we study four major international financial markets. The empirical results support a significant and positive risk-return trade-off that is driven by conditional volatility, market timing and the interdependence between the two components, which is generically related to return skewness.

Journal of Economic Dynamics and Control
David T. Frazier
DECRA Fellow and Associate Professor in Econometrics and Statistics

My research interests include simulation-based statistical theory and inference, approximate Bayesian analysis, forecasting and scoring rules.