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The Asymmetric Effect of the Business Cycle on the Equity Premium (This is an extensively revised version of earlier paper No. 06/04)

Author

Listed:
  • Peter N Smith
  • Steffen Sorensen
  • Mike Wickens

Abstract

We examine the relation between US stock market returns and the US business cycle for the period 1960 - 2003 using a new methodology that allows us to estimate a time-varying equity premium. We identify two channels in the transmission mechanism. One is through the mean of stock returns via the equity risk premium, and the other is through the volatility of returns. We provide support for previous findings based on simple correlation analysis that the relation is asymmetric with downturns in the business cycle having a greater negative impact on stock returns than the positive effect of upturns. We also obtain a new result, that demand and supply shocks affect stock returns differently. We find that negative supply shocks are a very important source of increases in the risk premium. Our model of the relation between returns and their volatility encompasses the CAPM and the results demonstrate the importance of allowing for a time-varying price of volatility risk. The model is implemented using a multi-variate GARCH-in-mean model with an asymmetric time-varying conditional heteroskedasticity and correlation structure.

Suggested Citation

  • Peter N Smith & Steffen Sorensen & Mike Wickens, 2007. "The Asymmetric Effect of the Business Cycle on the Equity Premium (This is an extensively revised version of earlier paper No. 06/04)," Discussion Papers 07/11, Department of Economics, University of York.
    • Handle: RePEc:yor:yorken:07/11
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    References listed on IDEAS

    as
    1. Wickens, Michael R. & Smith, Peter N, 2002. "Macroeconomic Sources of FOREX Risk," CEPR Discussion Papers 3148, C.E.P.R. Discussion Papers.
    2. P N Smith & S Sorensen & M R Wickens, "undated". "Macroeconomic Sources of Equity Risk," Discussion Papers 03/13, Department of Economics, University of York.
    3. repec:cup:macdyn:v:5:y:2001:i:4:p:621-46 is not listed on IDEAS
    4. Chauvet, Marcelle & Potter, Simon, 2001. "Nonlinear Risk," Macroeconomic Dynamics, Cambridge University Press, vol. 5(4), pages 621-646, September.
    5. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Equity returns; risk premium; asymmetry;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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