Department of Economics and Business Economics

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

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  • School of Economics and Management
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.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages25
Publication statusPublished - 2010

    Research areas

  • Financial leverage effect, implied volatility, realized volatility, risk-return relation, stochastic volatility, VIX

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