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Understanding the Risk-Return Relation: The Aggregate Wealth Proxy Actually Matters

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  • Scott Cederburg
  • Michael S. O’Doherty

Abstract

The ICAPM implies that the market’s conditional expected return is proportional to its conditional variance and that the reward-to-risk ratio equals the representative investor’s coefficient of relative risk aversion. Prior studies examine this relation using the stock market to proxy for aggregate wealth and find mixed results. We show, however, that stock-based tests suffer from low power and lead to biased estimates of the risk-return tradeoff when stocks are an imperfect market proxy. Tests designed to mitigate this bias by incorporating a more comprehensive measure of aggregate wealth produce large, positive estimates of the risk-aversion coefficient around seven to nine. Supplementary materials for this article are available online.

Suggested Citation

  • Scott Cederburg & Michael S. O’Doherty, 2019. "Understanding the Risk-Return Relation: The Aggregate Wealth Proxy Actually Matters," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 37(4), pages 721-735, October.
    • Handle: RePEc:taf:jnlbes:v:37:y:2019:i:4:p:721-735
    DOI: 10.1080/07350015.2017.1419140
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    Cited by:

    1. Tan, Zhengxun & Xiao, Binuo & Huang, Yilong & Zhou, Li, 2021. "Value at risk and return in Chinese and the US stock markets: Double long memory and fractional cointegration," The North American Journal of Economics and Finance, Elsevier, vol. 56(C).

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