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The Risk-Return Tradeoff and Leverage Effect in a Stochastic Volatility-in-Mean Model

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  • Institut for Økonomi
We study the risk premium and leverage effect in the S&P500 market using the stochastic
volatility-in-mean model of Barndor¤-Nielsen & Shephard (2001). The Merton (1973, 1980)
equilibrium asset pricing condition linking the conditional mean and conditional variance of
discrete time returns is reinterpreted in terms of the continuous time model. Tests are per-
formed on the risk-return relation, the leverage effect, and the overidentifying zero intercept
restriction in the Merton condition. Results are compared across alternative volatility proxies,
in particular, realized volatility from high-frequency (5-minute) returns, implied Black-Scholes
volatility backed out from observed option prices, model-free implied volatility (VIX), and
staggered bipower variation. Our results are consistent with a positive risk-return relation and
a significant leverage effect, whereas an additional overidentifying zero intercept condition is
rejected. We also show that these inferences are sensitive to the exact timing of the chosen
volatility proxy. Robustness of the conclusions is verified in bootstrap experiments.
UdgiverInstitut for Økonomi, Aarhus Universitet
Antal sider25
StatusUdgivet - 2010

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