Stock Market Risk and Return:

An Equilibrium Approach
Robert F. Whitelaw
Empirical evidence that expected stock returns are weakly related to volatility at the
market level appears to contradict the intuition that risk and return are positively related.
We investigate this issue in a general equilibrium exchange economy characterized by a
regime-switching consumption process with time-varying transition probabilities between
regimes. When estimated using consumption data, the model generates a complex, non-
linear and time-varying relation between expected returns and volatility, duplicating the
salient features of the risk/return trade-off in the data. The results emphasize the impor-
tance of time-varying investment opportunities and highlight the perils of relying on
intuition from static models.
Understanding the risk/return trade-off is fundamental to equilibrium asset
pricing. In this context, the stock market is one of the most natural starting
points since it serves as a proxy for the wealth portfolio that is studied in
nance theory. It is perhaps surprising, therefore, that there is still a good deal
of controversy around the issue of how to measure risk at the market level.
Recent empirical studies [e.g., Glosten, Jagannathan, and Runkle (1993),
Whitelaw (1994), and Boudoukh, Richardson, and Whitelaw (1997)] doc-
ument two puzzling results with regard to the intertemporal relation between
equity risk and return at the market level.
1
First, they provide evidence of a
weak, or even negative, relation between conditional expected returns and the
conditional volatility of returns.
2
Second, they document signicant time vari-
ation in this relation. Specically, in a modied GARCH-M framework using
post-World War II monthly data, Glosten, Jagannathan, and Runkle (1993)
nd that the estimated coefcient on volatility in the expected return regres-
sion is negative. In a similar dataset, when both conditional moments are
estimated as functions of predetermined nancial variables, Whitelaw (1994)
My thanks to an anonymous referee, the editor, Ravi Jagannathan, Kobi Boudoukh, Kent Daniel, Wayne
Ferson, John Heaton, Anthony Lynch, Matt Richardson, and seminar participants at UCLA, Duke University,
University of Minnesota, Northwestern University, University of Southern California, the 1997 AFA meetings,
and the 1996 Utah Winter Finance Conference for helpful comments. Address correspondence to Robert F.
Whitelaw, NewYork University, Stern School of Business, 44 West 4th St., Suite 9-190, NewYork, NY 10012,
or email: rwhitela@stern.nyu.edu.
1
These articles extend earlier work on the subject by Campbell (1987) and French, Schwert, and Stambaugh
(1987), among many others.
2
Similar results are also reported in Nelson (1991), Pagan and Hong (1991), and Harrison and Zhang (1999).
However, Harrison and Zhang (1999) show that at longer horizons (i.e., 12 years) there is a signicantly
positive relation between expected returns and conditional volatility. The shorter horizon phenomenon is also
present in international data. For example, De Santis and Imrohoroglu (1997) nd a signicant positive relation
in only 2 countries out of a sample of 14 emerging and 3 developed markets, and Ang and Bekaert (1999)
identify a low mean high volatility return regime using U.S., U.K., and German data.
The Review of Financial Studies Fall 2000 Vol. 13, No. 3, pp. 521547
2000 The Society for Financial Studies
The Review of Financial Studies/v 13 n 3 2000
nds that the long-run correlation between the tted moments is negative.
Moreover, the short-run correlation varies substantially from approximately
0.8 to 0.8 when measured over 17-month horizons. Finally, in a nonpara-
metric estimation using almost two centuries of annual data, Boudoukh,
Richardson, and Whitelaw (1997) nd that time variation in expected returns
and the variance of returns, as functions of slope of the term structure, do
not coincide.
These empirical results are especially interesting because they run counter
to the strong intuition of a positive relation between volatility and expected
returns at the market level that comes from such models as the dynamic
CAPM [Merton (1980)]. Two questions arise naturally. First, are these results
consistent both with general equilibrium models and with the time series
properties of variables such as consumption growth which drive equity returns
in these models?
3
Second, what features are necessary to generate this coun-
terintuitive behavior of expected returns and volatility?
This article addresses these two questions in the context of a representative
agent, exchange economy [Lucas (1978)]. As such, the exercise is similar in
spirit to that of Cecchetti, Lam, and Mark (1990) and Kandel and Stambaugh
(1990), who attempt to duplicate various features of equity return data in an
equilibrium setting. Consumption growth is modeled as an autoregressive
process, with two regimes in which the parameters differ, an extension of
Hamilton (1989). The probability of a regime shift is modeled as a function
of the level of consumption growth, yielding time-varying transition prob-
abilities as in Filardo (1994). The parameters are estimated by maximum
likelihood using monthly consumption data over the period 19591996. The
stock market is modeled as a claim on aggregate consumption, and the quan-
tities of interest are the short-run and long-run relation between expected
equity returns and the volatility of returns.
The two-regime specication is able to identify the expansionary and con-
tractionary phases of the business cycle consistent with the NBER business
cycle dating. More important, the model generates results that are broadly
consistent with the empirical evidence. Expected returns and conditional
volatility exhibit a complex, nonlinear relation. They are negatively related in
the long run and this relation varies widely over time. The key features of the
specication are regime parameters that imply different means of consump-
tion growth across the regimes and state-dependent regime switching proba-
bilities. In marked contrast, a single-regime model calibrated to the same data
generates a strong positive, and essentially linear, relation between expected
returns and volatility.
In order to preserve tractability, the two-regime specication is kept simple.
As a consequence, the reduced form model, while providing insight into the
3
It is known that equilibrium models can generate a wide variety of relations between the mean and volatility
of returns [e.g., Abel (1988) and Backus and Gregory (1993)]. The question addressed in this article is whether
the more specic intertemporal patterns documented recently are consistent with economic data.
522
Stock Market Risk and Return
relation between risk and return, fails to match other features of the equity
return data. For example, the magnitude of the equity premium is much too
low. However, efforts to address this and other puzzles using tools such as
habit persistence [see, e.g., Campbell and Cochrane (1999)] are beyond the
scope of this article.
The major contribution of this article is in establishing the fact that the
recent empirical evidence is consistent with reasonable parameterizations
of a relatively simple equilibrium model. This nding adds credibility to
these empirical results, and the model also provides the relevant economic
intuition. Specically, the possibility of shifts between regimes that exhibit
different consumption growth processes increases volatility while simultane-
ously reducing the equity risk premium in certain states of the world. The
equity risk premium is a function of the correlation between equity returns
and the marginal rate of substitution. However, the marginal rate of substi-
tution depends only on next periods consumption growth, while the equity
return depends on the innite future via its dependence on the stock price
next period. In states in which a regime shift is likely, this divergence of
horizons weakens the link between market returns and the marginal rate of
substitution. As a result, the risk premium is low but the volatility of returns
is high.
Put slightly differently, regime shifts introduce large movements in the
investment opportunity set, and therefore induce a desire among investors
to hedge adverse changes [see Merton (1973)]. In some states of the world,
the market claim provides such a hedge. Specically, when a regime shift
is likely, its value is high and its expected return is low as a consequence.
These are also states of the world with high volatility, generating the required
negative relation between volatility and expected returns. In other states of
the world, regime shifts are less likely and the standard positive relation
dominates.
The remainder of the article is organized as follows. Section 1 develops the
asset pricing framework, provides the intuition behind the risk/return relation
in this setting, and describes the two-regime specication. In Section 2, we
estimate and analyze the two-regime model, contrasting the results to those
from a single-regime model. The expected return and volatility patterns are
analyzed and a sensitivity analysis is performed. Section 3 concludes.
1. Theory
1.1 The asset pricing framework
Consider a pure exchange economy with a single consumption good and
a representative agent whose utility function exhibits constant relative risk
aversion [Lucas (1978)]. The resulting pricing equation is
E
t

c
t +1
c
t

r
t +1

= 1, (1)
523
The Review of Financial Studies/v 13 n 3 2000
where c
t
is consumption, r
t +1
is the asset return, is the coefcient of risk
aversion, is the time preference parameter, and E
t
[] denotes the expectation
conditional on information available at time t . The expected return on any
asset in excess of the riskless rate (denoted r
f t
) is proportional to the negative
of the covariance of this return with the marginal rate of substitution (MRS),
that is,
E
t
[r
t +1
r
f t
] = r
f t
Cov
t
[m
t +1
, r
t +1
], . (2)
where m
t +1
(c
t +1
/c
t
)

is the MRS.
In this setting, it is standard to identify the stock market as the claim on the
aggregate consumption stream, that is, to equate aggregate consumption and
the aggregate stock market dividend [see, e.g., Mehra and Prescott (1985)
and Cecchetti, Lam, and Mark (1990)]. Consequently, the market return is
r
st +1
=
s
t +1
+c
t +1
s
t
=

c
t +1
c
t

(s
t +1
/c
t +1
) +1
s
t
/c
t
, (3)
and the price:dividend ratio is
s
t
c
t
=

s=1
E
t

c
t +s
c
t

. (4)
This model is not intended to capture all the complexities inherent in equity
returns. In fact, similar models have been rejected on the grounds that they
cannot match the observed equity premium or other features of the joint time
series of equity returns and consumption data.
4
Nevertheless, as will become
apparent, this model is both sufciently complex to produce insight into the
time variation of the mean and volatility of equity returns and sufciently
simple to preserve tractability.
It is not immediately clear how the expected excess equity return and
the conditional volatility of this return will be related in this framework.
Nevertheless, for many specications, the variance of the market return and
the covariance between the market return and the MRS will be closely linked.
Specically, for the stock market, Equation (2) can be rewritten as
E
t
[r
st +1
r
f t
] = r
f t
Vol
t
[r
st +1
]Vol
t
[m
t +1
]Corr
t
[m
t +1
, r
st +1
], (5)
where
Corr
t
[m
t +1
, r
st +1
] = Corr
t

c
t +1
c
t

c
t +1
c
t

(s
t +1
/c
t +1
) +1
s
t
/c
t

(6)
4
For early examples, see Hansen and Singleton (1982) and Mehra and Prescott (1985). Numerous attempts
have been made to modify the model to better t the data. These include introducing habit persistence and
durability [Constantinides (1990) and Ferson and Constantinides (1991)], time nonseparability of preferences
[Epstein and Zin (1989)], and consumption adjustment costs [Marshall (1993)].
524
Stock Market Risk and Return
and Vol
t
and Corr
t
are the conditional volatility and conditional correlation,
respectively. The conditional moments of returns will be positively related
(period by period) as long as the correlation between the MRS and the equity
return is negative. Holding the price:dividend ratio constant,
5
this condition
holds (for > 0) since
Corr
t

c
t +1
c
t

c
t +1
c
t

< 0.
The long-run relation between expected returns and volatility is less obvi-
ous because of potential time variation in the conditional correlation, the
conditional volatility of the marginal rate of substitution, and the riskless
rate. However, a negative long-run relation between the moments of equity
returns would generally require that time variation in the correlation offset
movements in the conditional volatility, that is, that the correlation be high
when volatility is low and vice versa. Again, this is impossible for xed
price:dividend ratios.
The only way to duplicate the salient features of the data (i.e., weak or neg-
ative short-run and long-run relations between expected returns and volatility)
is to formulate a model in which variation in the price:dividend ratio partially
offsets the variation in the dividend growth component of the equity return in
some states of the world. In other words, the price:dividend ratio must either
covary positively with the MRS or covary weakly, but be volatile enough to
reduce the overall correlation between the MRS and the return on equity. In
these states of the world, the magnitude of the correlation will be reduced,
and high volatility will no longer correspond to high expected returns.
For > 1, the price:dividend ratio is positively related to expectations
of the inverse of future consumption growth [see Equation (4)], that is,
the dominant effect is through the discount rate, not the growth in future
dividends. High expected consumption growth implies low price:dividend
ratios and vice versa. Therefore the price:dividend effect depends on the rela-
tion between consumption growth and expected future consumption growth.
For example, if high consumption growth today implies high expected con-
sumption growth in the future, then high consumption growth states will
be associated with low price:dividend ratios. Consequently, variation in the
price:dividend ratio offsets variation in dividend growth in the equity return,
and the correlation in Equation (5) is reduced.
There are two remaining issues. First, the magnitude of the variation in the
correlation must be sufciently large to offset variation in volatility. Second,
time variation in the short-run relation between expected returns and volatil-
ity (i.e., the existence of both positive and negative short-run correlations)
5
Of course, it may be difcult to imagine a world in which the price:dividend ratio is literally constant, yet
there is time variation in the moments of equity returns, since both depend on future consumption/dividend
growth. This thought experiment is intended simply to illustrate the intuition behind the standard risk/return
trade-off.
525
The Review of Financial Studies/v 13 n 3 2000
requires that the correlation be strongly time varying in some periods and
much less so in others. Both of these problems are difcult, if not impossible,
to overcome if consumption growth follows a simple ARMA process. The
correlation will vary little over time because the price:dividend ratio, which
is an expectation of future consumption growth, will be less variable than
consumption growth itself. Moreover, correlations will be relatively stable
because both the immediate and distant future depend on a limited number
of past values of consumption growth.
Can alternative specications of preferences achieve the desired result
even when consumption growth follows an ARMA process? Two popu-
lar generalizations, habit persistence [Constantinides (1990) and Ferson and
Constantinides (1991)] and recursive utility [Epstein and Zin (1989) and
Hung (1994)], have been investigated for their ability to match other fea-
tures of stock return data, particularly the magnitude and volatility of the
equity premium. Both approaches permit a separation between the intertem-
poral elasticity of substitution and the inverse of the relative risk aversion
coefcient; while under CRRA utility, these two quantities are equal. The
additional exibility may help in resolving the conict between a relatively
smooth consumption process and a large and variable equity premium, which
is at the heart of the equity premium puzzle [Mehra and Prescott (1985)],
although Kocherlakota (1990) argues that this exibility does not substan-
tially increase the explanatory power of the model.
The principle effects of these generalizations are on the volatility of the
MRS, not on the correlation between the MRS and equity returns, which is
the focus of this investigation. For example, under recursive utility, the MRS
depends on both consumption growth and the market return; consequently,
covariations with both these quantities determine the risk premium. Such a
specication provides little or no additional help in generating time-varying
conditional correlations between the MRS and the market return. Under habit
persistence, the MRS is modied to depend not on consumption growth but
on the growth of weighted differences in consumption, due to the dependence
of utility on past levels of consumption. Again, however, time-varying cor-
relations are not a natural feature of the model with standard consumption
processes. For example, Campbell and Cochrane (1999) use a model with
external habit persistence to match a wide variety of dynamic asset pricing
phenomena. Nevertheless, they still generate a monotonic, albeit nonlinear,
relation between expected returns and volatility. In many ways, the literature
on more general preferences is complementary to the work in this article.
Combining these preferences with the consumption process proposed in this
article may simultaneously address a variety of puzzles regarding stock mar-
ket returns.
1.2 Regime shifts
One simple and attractive way to overcome the problems outlined above is
to consider a model with regime shifts and transition probabilities between
526
Stock Market Risk and Return
regimes that are state dependent. For regimes that are sufciently far apart in
terms of the time-series behavior of consumption growth, the regime switch-
ing probability will control the conditional volatility of returns. That is, states
with a high probability of switching to a new regime will have high volatil-
ity. At the same time, however, increasing the probability of a regime switch
may decrease the correlation between equity returns and the marginal rate of
substitution, thus reducing the risk premium. This second effect will occur
because the price:dividend ratios, which depend on expected future con-
sumption growth, will be related to the regime not to short-run consumption
growth.
The idea of shifts in aggregate economic regimes has gathered increasing
empirical support in the literature [see Hamilton (1994, chap. 22) for a sur-
vey]. In general, this research provides evidence of multiple regimes within
the course of a single business cycle which then repeat in succeeding cycles.
For example, Hamilton (1989) develops and estimates a two-regime model
of the business cycle with constant switching probabilities. Filardo (1994)
extends this model to time-varying transition probabilities, and he shows that
allowing the probabilities to depend on economic state variables improves the
goodness-of-t. This article focuses on consumption data due to the nature of
the model, but GNP and industrial production, among other business cycle
variables, have also been shown to conform to regime shift specications.
Recent evidence [Sichel (1994)] even suggests the existence of more than
two regimes.
This type of model should not be confused with models of one-time struc-
tural shifts, such as those used to model interest rates during the Fed exper-
iment in 19791982. It also does not rely on extreme events that occur with
small probability, as in the peso problem [see, e.g., Bekaert, Hodrick, and
Marshall (1998) and Veronesi (1998)]. Moreover, we model the fundamental
process, consumption growth, rather than modeling asset prices or returns
directly. For example, Gray (1996), Bekaert, Hodrick, and Marshall (1998),
and Ang and Bekaert (1998) estimate regime-shift models for interest rates
and Ang and Bekaert (1999) estimate a model for stock returns. The approach
in this article is very different in that the fundamental economic process is
modeled in a regime-shift framework and asset returns are derived using
rational expectations. A similar approach is applied to the bond market in
Evans (1998) and Boudoukh et al. (1999). Given that agents rationally antic-
ipate regime shifts in the underlying process, the behavior of equity returns
can take on potentially complex, interesting, and realistic characteristics.
There are numerous possible specications, but for simplicity we con-
sider a two-regime model. In particular, we assume that, at any point in
time, the natural logarithm of consumption growth follows an autoregressive
process of order 1 [AR(1)] with normally distributed errors and a constant
variance. However, we also allow for the possibility of two different AR
regimes. The state process follows a specied AR until a regime switch is
527
The Review of Financial Studies/v 13 n 3 2000
triggered. This process then follows an AR with different parameters until
another switch occurs. In particular, using the notation g
t +1
ln(c
t +1
/c
t
),
the two-regime economy is parameterized as
g
t +1
=

a
1
+b
1
g
t
+
1t +1

1t +1
N(0,
2
1
) for I
t +1
= 1
a
2
+b
2
g
t
+
2t +1

2t +1
N(0,
2
2
) for I
t +1
= 2,
(7)
where I
t +1
indexes the regime. The evolution of this sequence of random
variables is governed by the regime transition probabilities
Pr[I
t +1
= 1, 2|
t
] = f (I
t
, g
t
),
that is, the probability of being in a given regime next period depends only
on the current regime and the underlying state variable. This function is
parameterized as
P
t +1
(1, 1) Pr[I
t +1
= 1|I
t
= 1, g
t
] =
exp(p
0
+p
1
g
t
)
1 +exp(p
0
+p
1
g
t
)
P
t +1
(1, 2) Pr[I
t +1
= 2|I
t
= 1, g
t
] = 1 P
t +1
(1, 1)
P
t +1
(2, 2) Pr[I
t +1
= 2|I
t
= 2, g
t
] =
exp(q
0
+q
1
g
t
)
1 +exp(q
0
+q
1
g
t
)
P
t +1
(2, 1) Pr[I
t +1
= 1|I
t
= 2, g
t
] = 1 P
t +1
(2, 2).
(8)
The parameterization of the regime switching model is a generalization of
the switching model in Hamilton (1989), which is also studied in the context
of stock returns in Cecchetti, Lam, and Mark (1990) and Hung (1994). It is
similar to the specications that Gray (1996) uses to estimate the process for
short-term interest rates and that Filardo (1994) uses to model the business
cycle dynamics of industrial production.
2. Empirical Results
2.1 Data
The model is estimated using monthly data on real, aggregate, chain-weighted
consumption of nondurable goods and services from the Basic Economics
database (series GMCNQ and GMCSQ). The monthly series starts in January
1959, but the late start date relative to the quarterly series is more than
compensated for by the higher frequency of the data. Using data from January
1959 to December 1996 yields 455 observations for consumption growth.
There are numerous issues with respect to the quality of the data, problems of
time aggregation, etc., which are beyond the scope of this article. Fortunately,
the implied intertemporal relation between expected returns and volatility is
relatively insensitive to the precise time-series properties of the data. This
issue is addressed in more detail in the sensitivity analysis later in the article.
528
Stock Market Risk and Return
Table 1
Descriptive statistics
Mean Std. Dev. Min. Max.
0.260 0.392 1.138 1.696
AR(1) Estimation
Constant g
t

g
t +1
0.322 0.239 0.381
(0.021) (0.046) (0.015)
Descriptive statistics for monthly log consumption growth (in percent) for the period February 1959December 1996. The AR(1)
is estimated using GMM, with heteroscedasticity-consistent standard errors in parentheses. denotes the residual standard
deviation.
Table 1 provides descriptive statistics for the monthly log consumption
growth data (in percent) over the sample period. Consumption growth varies
from a low of 1.138% to a high of 1.696%, with a mean of 0.260%. The
table also provides results from a generalized method of moments (GMM)
estimation [Hansen (1982)] of an AR(1) on the same data. Heteroscedasticity-
consistent standard errors are in parentheses, and the residual standard devi-
ation (denoted ) is also given. The coefcient indicates that consumption
growth is negatively autocorrelated, but that lagged consumption growth does
not explain a great deal of the variation in consumption growth. Note that the
residual standard deviation of 0.381% is only slightly lower than the sample
standard deviation of 0.392%. These results are broadly consistent with other
results in the literature that study consumption data.
2.2 Estimating a two-regime model
The two-regime model [Equations (7) and (8)] is estimated using the maxi-
mum likelihood methodology in Gray (1996). Using this approach, the model
is reparameterized in terms of the probability of being in a given state at time
t rather than in terms of the regime transition probabilities. This reparame-
terization allows for the construction of a recursive likelihood function much
like the one used for GARCH estimation.
6
The parameter values are chosen
to maximize this function in the standard manner.
Table 2 presents the parameter estimates from this estimation, with stan-
dard errors in parentheses. Note that the regimes have been denoted as
expansion and contraction, which coincides with the regime shift busi-
ness cycle literature given that the parameters imply regimes with mean con-
sumption growth of 0.323% and 0.146%. The parameters of both regimes
are estimated with good precision, and they are signicant at all conven-
tional levels. Table 2 also presents tests for the equality of the parameters
6
See the appendix of Gray (1996) for the details concerning construction of the likelihood function. Thanks to
Steve Gray for the estimation code that was modied for this application.
529
The Review of Financial Studies/v 13 n 3 2000
Table 2
Parameter estimates for the two-regime model
a
1
b
1

1
p
0
p
1
Expansion 0.422 0.307 0.383 3.986 2.783
(0.034) (0.066) (0.017) (0.749) (3.403)
a
2
b
2

2
q
0
q
1
Contraction 0.191 0.312 0.328 4.058 0.741
(0.036) (0.081) (0.020) (1.068) (2.989)
Test statistic 20.533 0.002 3.893
[0.000] [0.968] [0.048]
Parameter estimates for the two-regime AR(1) model of log consumption growth given in Equations (7) and (8). The model
is estimated by maximum likelihood using monthly data on the consumption of nondurable goods and services from February
1959 to December 1996. Standard errors are in parentheses. Test statistics for the equality of the parameters across the two
regimes are also reported, with p-values in brackets.
across the two regimes, with p-values in brackets. Both the mean and volatil-
ity of consumption growth are higher in expansions, but the level of mean
reversion is almost identical across the regimes. Clearly the model is able to
identify two distinct regimes within the time series of consumption data.
Of greatest interest are the parameters which control the regime shifts.
While the constants are positive and signicant, the coefcient on consump-
tion growth is positive in expansions and negative in contractions. The stan-
dard errors on both estimates are large, but the point estimates suggest that
regime persistence is positively related to consumption growth in expansions
and negatively related to consumption growth in contractions. To illustrate
the magnitude of this implied time variation, Figure 1 plots the regime shift
probabilities against log consumption growth. The graph shows P(1, 2) (solid
line) and P(2, 1) (dashed line)the probability of going from regime 1 to
regime 2 and vice versaas log consumption growth varies from 1.2% to
2.0%. The regime switch probabilities are relatively small for most reason-
able levels of consumption growth. For example, at the within-regime means
of the two regimes, P(1, 2) and P(2, 1), are 0.75% and 1.9%, respectively.
If the probabilities were constant at these levels, then the regime half-lives
would be approximately 92 months and 36 months, respectively. There is a
58% unconditional probability of being in an expansion and a 42% proba-
bility of being in a contraction.
Before proceeding to the implications of the estimated parameters for stock
market risk and return, we examine the estimation more closely since the
results that follow are sensitive to the parameter values (see Section 2.5).
First, note that the model is deliberately kept simple in order to illuminate
the underlying economic intuition. Such a reduced form model is unlikely
to capture all the complexities of the time series of consumption growth.
From an economic perspective, the two key questions are whether the data
truly indicate the existence of multiple regimes, and whether the transition
probabilities are time varying.
530
Stock Market Risk and Return
Figure 1
Regime-shift probabilities
The estimated probabilities of shifting from an expansion to a contraction [P(1, 2), solid line] and from a
contraction to an expansion [P(2, 1), dashed line] as a function of log consumption growth. The functions
are given in Equation (8), and the parameter estimates are in Table 2.
In partial answer to the rst question, Table 2 shows that the parameter
values are statistically different across the regimes. A direct test of a two-
regime model versus a single regime model is difcult because, under the null
hypothesis of a single regime, the regime shift parameters are not identied.
As a result, the likelihood ratio test does not have the standard chi-square
distribution. Nevertheless, this test statistic can be used informally to evalu-
ate the specication as in Gray (1996).
7
The statistic has a value of 19.93,
with a corresponding p-value of 0.000 under the
2
(3) distribution, which is
supportive of the two-regime specication. Note that this informal rejection
of the single-regime model is not due exclusively to the existence of different
conditional volatilities across the regimes. The test statistic for a two-regime
model with constant volatilities (i.e.,
1
=
2
) versus the single regime model
is 16.82, with a corresponding p-value of 0.000.
A different way to evaluate the goodness-of-t of the model is to examine
the precision with which it identies the regimes. Ideally the conditional
probability of being in either regime should be close to zero or one most of
the time, that is, the data should identify the state of the economy with a high
degree of certainty. In addition, the identied regimes and transitions should
7
A formal test can be constructed using a grid search over the nuisance parameters [see Hansen (1992)], but it
is prohibitively computationally intensive.
531
The Review of Financial Studies/v 13 n 3 2000
Figure 2
Regime identication and consumption growth
Panel A shows the estimated conditional probability of being in an expansion based on the two-regime model.
Panel B shows 9-month moving averages of consumption growth. In both graphs, vertical solid and dashed
lines mark NBER business cycle peaks and troughs, respectively.
correspond to economic intuition. Figure 2 presents evidence to this effect.
Panel A graphs the time series of Pr(I
t
= 1|
t 1
), that is, the conditional
probability of being in regime 1. For reference purposes, the NBER peaks
and troughs of the business cycle are marked by solid and dashed vertical
532
Stock Market Risk and Return
lines, respectively. While the probability series is not exceptionally smooth,
it identies the NBER cycles accurately, with two exceptions.
8
First, the estimation fails to pick up the recession of 1970. Second, the
model has difculty identifying the post-1991 period as an expansion. The
explanation for both results is clear when looking at the underlying consump-
tion growth data. Panel B shows 9-month moving averages (to smooth the
data) against the same NBER turning points. Consumption growth around
1970 shows no contraction-like behavior, hence the estimation fails to iso-
late this period. Similarly the recent expansion is weak by historical stan-
dards (with mean monthly consumption growth of 0.18% relative to 0.32%
in the ve previous expansions), so it is again difcult to identify. Overall
the regime-shift model performs excellently.
The issue of time-varying transition probabilities is somewhat less clear-
cut. While the point estimates in Table 2 are consistent with this interpreta-
tion, the standard errors are large. One explanation is that the reduced form
model may be too simple to fully capture the regime dynamics. For exam-
ple, Filardo (1994) provides strong evidence of state-dependent transition
probabilities in the cyclical process for industrial production using a more
elaborate model. When the transition probabilities are allowed to depend on
other exogenous variables such as the index of leading economic indicators,
constant transition probabilities can be rejected statistically. Moreover, the
resulting model provides a superior t to the data.
2.3 Risk and return
Using the pricing equations and the law of motion for consumption growth, it
is sometimes possible to calculate the conditional moments of equity returns
in closed form. For more complex, multiregime specications, closed-form
solutions are no longer available; therefore we employ a discrete state space
methodology that provides accurate numerical solutions. The continuous state
variable (consumption growth) is approximated by a variable that takes on
only a nite number of values. The dynamics are described by a transi-
tion matrix that gives the probabilities of moving between the various dis-
crete states. The details of the discretization methodology follow Tauchen
and Hussey (1991).
9
The key point, from the perspective of examining the
risk/return trade-off, is that the discrete approximation converges quickly to
the true model, and that the results are essentially identical to those from
the continuous state space model. Throughout the analysis we use nine con-
sumption growth states within each regime.
To analyze stock market risk and return we also need to specify the degree
of risk aversion and the time preference parameter. We use = 2 and =
0.997, and the sensitivity of the results to these parameters is addressed later.
8
The probability can easily be smoothed by constructing Pr(I
t
= 1|
T
), that is, the state probability given the
full dataset. The resulting series is less jagged, but it generates similar inferences.
9
Thanks to George Tauchen for the discrete approximation code that has been modied for this application.
533
The Review of Financial Studies/v 13 n 3 2000
The two-regime specication has a total of 18 states of the world, 9 within
each regime. The nine states in each regime are identical in terms of their
levels of consumption growth, but they differ with respect to their transition
probabilities, both because of the differing AR parameters and the differing
regime switching probabilities. Consequently the conditional expected risk
premium and the conditional volatility of returns can take on 18 different
values. Table 3 reports log consumption growth, the price:dividend ratio, the
risk premium, the volatility of returns, the probability of a regime shift, and
the unconditional probability for each state. The states are indexed from low-
est to highest consumption growth. For ease of interpretation, all the values
are annualized. The monthly risk premium and variance are multiplied by 12
and the price:dividend ratio is divided by 12. This latter adjustment makes
the magnitudes of the ratios comparable to P:E ratios calculated using annual
earnings. In addition, the risk premium is multiplied by 100 for presentation
purposes.
The conditional moments of returns exhibit dramatic nonmonotonicities as
shown in Figure 3, which graphs the risk premium and volatility for each of the
states. Expansion states are marked by circles and contraction states are marked
by squares. The most notable feature of Figure 3 is the weak relation between
volatility and the risk premium. In the contractionary regime, the risk premium
and volatility are negatively related. In the expansion, a positive relation
holds for states 59, but even in this limited set the relation is nonlinear.
Table 3
Risk and return in a two-regime model
E
t
[r
st +1
r
f t
] Vol
t
[r
st +1
]
State g
t
s
t
/c
t
(%100) (%) P
t
(i, j) Probability
Expansion
1 1.406 15.148 1.859 7.529 48.139 0.003
2 0.905 14.959 0.586 6.046 18.726 0.251
3 0.473 14.889 2.766 4.023 6.471 3.400
4 0.069 14.873 3.594 2.696 2.201 14.253
5 0.323 14.879 3.762 1.977 0.751 22.549
6 0.715 14.892 3.648 1.605 0.253 14.183
7 1.118 14.909 3.380 1.386 0.083 3.363
8 1.551 14.930 2.968 1.212 0.025 0.247
9 2.051 14.959 2.333 1.024 0.006 0.003
Contraction
1 1.406 15.507 2.966 1.755 0.606 0.001
2 0.905 15.526 2.880 1.904 0.876 0.212
3 0.473 15.541 2.817 2.072 1.203 3.999
4 0.069 15.554 2.736 2.261 1.616 15.674
5 0.323 15.566 2.626 2.477 2.148 16.530
6 0.715 15.576 2.478 2.727 2.852 4.937
7 1.118 15.585 2.273 3.018 3.808 0.389
8 1.551 15.592 1.981 3.365 5.171 0.004
9 2.051 15.597 1.531 3.799 7.324 0.000
State-by-state values for log consumption growth, the price:dividend ratio, the risk premium, the volatility of stock returns, the
probability of a regime shift, and the unconditional state probability in a two-regime model based on the parameter values in
Table 2. All values except for consumption growth are annualized.
534
Stock Market Risk and Return
Figure 3
Risk and return in a two-regime model
State-by-state values of the conditional equity risk premium (times 100) and the conditional volatility of equity
returns (both in percent, annualized) for a two-regime model. The model parameters are given in Table 2.
Expansion and contraction states are marked by circles and squares, respectively.
These results are in marked contrast to those generated from a single-
regime model. Figure 4 shows the the state-by-state volatility and risk pre-
mium for the model based on the AR(1) estimates in Table 1 (marked by
triangles). The graph shows a strong, positive, and essentially linear relation
between the risk premium and the volatility of returns. This result coincides
with the intuition of the risk/return trade-off at the market level in a dynamic
CAPM setting [see Merton (1980)]. The other major differences between the
two models are the increase in the variability of the risk premium and the
higher volatility associated with the two-regime model.
The unconditional relation is difcult to ascertain from the graph due to
the differing probabilities associated with each state. For example, state 5 in
the expansion has an unconditional probability of 22.5%, while states 1 and
9 in both regimes have probabilities of less than 0.01%. A more accurate
idea of the unconditional relation between the expected risk premium and
the volatility is given by the correlation between these conditional moments
of returns. For this model, the unconditional correlation is 0.481, which
coincides with the empirical results in Glosten, Jagannathan, and Runkle
(1993) and Whitelaw (1994). Both of these articles report a negative relation
between conditional expected returns and conditional volatility. The analysis
here shows that this negative relation is consistent with both general equilib-
rium and the fundamental time-series properties of consumption growth.
535
The Review of Financial Studies/v 13 n 3 2000
Figure 4
Risk and return in two single-regime models
State-by-state values of the conditional equity risk premium (times 100) and the conditional volatility of equity
returns (both in percent, annualized) for the individual regimes within the two-regime model, assuming zero
probability of a regime shift, and for the single-regime model. The parameters for the two-regime and single-
regime models are given in Tables 2 and 1, respectively. Expansion states are marked by circles, contraction
states are marked by squares, and the single-regime states are marked by triangles.
It is tempting to attribute this negative relation between the mean and
volatility of returns to the extreme values observed in certain states of the
world. For example, states 1 and 2 in the expansion have high regime-shift
probabilities, high volatilities, and low expected returns. Note, however, that
the unconditional probability of those states is small so they contribute little
to the unconditional moments. One way to verify this conjecture is to set the
transition probabilities to zero in the four most extreme consumption growth
states in each regime (states 1, 2, 8, and 9). The resulting unconditional
correlation is 0.498, little different from the previous result. In other words,
the observed behavior is not being driven by the tails of the distribution.
How can the relatively straightforward two-regime specication generate
such striking results? One perspective on the role of regime shifts can be
gained by looking at the two regimes individually, as if they were each
single-regime economies. In other words, consider the expansion or contrac-
tion with zero probability of a regime shift. Figure 4 graphs the state-by-state
levels of the risk premium and the volatility for these two economies. Again,
expansion states are marked by circles and contraction states are marked by
squares. For comparison purposes, the single-regime premium and volatility
are also plotted (marked by triangles). As expected, each regime individually
bears a strong resemblance to the single-regime economy. If there are no
536
Stock Market Risk and Return
regime switches, then there is a strong positive relation between the risk pre-
mium and the volatility in both regimes. The differences in the levels of risk
premiums and volatilities across the three economies is due to the differences
in the conditional volatility and autocorrelation of consumption growth. As
the parameters change, so do the volatility and the risk premium. However,
it is clearly not the parameters of the individual regimes but the existence of
time-varying probabilities of regime shifts that creates the complex dynamics
in the two-regime economy as plotted in Figure 3.
To understand these dynamics better, we start with the results underlying
Figure 4. Table 4 presents the state-by-state values of the price:dividend
ratio, the equity risk premium, and the volatility of stock returns for these
two economies. Note that consumption growth in each state is identical to
the values given in Table 3. The only difference between the tables is that the
regime shift probabilities have been set to zero in the latter table. As a result,
price:dividend ratios are low and positively related to consumption growth
in the expansion, and high and positively related to consumption growth in
the contraction. It is this simple feature that generates the key results. The
market claim may act as a hedge against shifts in investment opportunities,
that is, shifts from one regime to the other. Relative to dividends, prices are
high when investment opportunities are poor, and vice versa.
What happens when the possibility of a regime shift is introduced? Con-
sider state 5 in the expansion. The price:dividend ratio is 13.337 if there is
Table 4
Risk and return in single-regime models
E
t
[r
st +1
r
f t
] Vol
t
[r
st +1
]
State s
t
/c
t
(%100) (%)
Expansion
1 13.283 4.432 1.670
2 13.298 4.418 1.665
3 13.312 4.406 1.661
4 13.324 4.395 1.656
5 13.337 4.385 1.652
6 13.349 4.374 1.649
7 13.362 4.363 1.644
8 13.375 4.352 1.640
9 13.391 4.338 1.635
Contraction
1 18.586 3.296 1.439
2 18.608 3.237 1.424
3 18.627 3.225 1.419
4 18.645 3.217 1.416
5 18.663 3.209 1.412
6 18.680 3.201 1.409
7 18.698 3.194 1.405
8 18.717 3.187 1.402
9 18.740 3.190 1.400
State-by-state values for the price:dividend ratio, the risk premium, and the volatility of stock returns for the individual regimes
within the two-regime model, assuming zero probability of a regime shift. The parameter values are given in Table 2. All values
are annualized.
537
The Review of Financial Studies/v 13 n 3 2000
zero probability of ever entering a contraction. In Table 3, there is a 0.75%
probability of an immediate switch of regimes, and a positive probability that
a switch will occur in any subsequent period conditional on still remaining
in the expansion. Consequently, the new price:dividend ratio accounts for
the expectation that a switch to the contraction will occur, resulting in lower
consumption growth in the future. From Equation (4), lower consumption
growth implies a higher price:dividend ratio; therefore, permitting regime
shifts raises the price:dividend ratio from 13.337 to 14.879. A similar effect
occurs in each state in the expansion, but the magnitude depends on the
relative probability of a regime shift. In combination with the original con-
sumption growth effect, state-dependent probabilities lead to the U-shaped
pattern for the expansion states in Table 3. For states in the contraction,
the possibility of a shift to a high consumption growth regime lowers the
price:dividend ratios, but the pattern from Table 4 is preserved, albeit in a
weakened form.
The price:dividend ratio and consumption growth in each state, in turn,
determine the behavior of equity returns. The return is a combination of
two components: dividend (consumption) growth, and the change in the
price:dividend ratio [see Equation (3)]. Note rst that the variation in
price:dividend ratios, especially across the regimes, tends to be larger than the
variation in consumption growth. Table 3 is slightly deceptive in this respect
because log consumption growth is given in percent. The implications are
that the conditional volatility of returns is increasing in the probability of
a regime shift and that volatility is larger than in the single-regime models.
These patterns are clearly evident in the fth column of Table 3.
The second issue is the correlation between equity returns and the MRS
(see Section 1.1). In other words, does the market claim provide a hedge
against consumption risk? If this correlation is strong and negative, as in
the single-regime model, then expected returns will be positively related to
volatility. However, the magnitude of this correlation also depends on the
regime-shift probability. Recall that consumption growth and price:dividend
ratios are negatively correlated across regimes, that is, price:dividend ratios
are higher in the contraction than in the expansion. Consequently, a shift
from contraction to expansion results, on average, not only in higher con-
sumption growth and a lower MRS, but also in a lower price:dividend ratio
and a lower equity return. Equity returns and the MRS tend to be positively
correlated over regime transitions. This effect is sufcient to partially offset
the standard negative correlation between the MRS and dividend growth. As
a result, the correlation and the equity risk premium are low in states with
high regime-shift probabilities. For a sufciently high regime-shift probabil-
ity, the correlation between the MRS and the return on equity may be pos-
itive, yielding a negative risk premium. This extreme case occurs in state 1
of the expansion, with a regime-shift probability of more than 48%. While
the unconditional probability of being in this state is low, the model does
538
Stock Market Risk and Return
serve to illustrate the possibility of negative risk premiums at the stock mar-
ket level.
10
Given the positive relation between regime-shift probabilities and
volatility noted above, the net result is a negative relation between the equity
risk premium and the volatility of stock returns.
We are also interested in potential time variation in the relation between
the risk premium and volatility. In the context of the discrete economy, time
variation is equivalent to variation across different states of the world. The
most natural state-by-state measure is the conditional correlation between the
conditional expected risk premium and the conditional volatility. This corre-
lation captures both the sign and the magnitude of the relation between the
conditional moments. Of course, at time t , the conditional moments based on
time t information are known. Therefore we consider the correlation at time
t between the conditional expected risk premium and conditional volatility at
time t +1. For example, suppose the economy is in a particular state (out of
the 18 possible states) at time t . Next period (time t +1), the economy can
be in any of the 18 states (with different probabilities), with corresponding
conditional risk premiums and volatilities. The question we want to answer
is whether high risk premiums are associated with high volatilities in these
subsequent states. Conditional correlations will vary across states because
transition probabilities vary across states. These conditional correlations are
analogous to the short-run correlations between the estimated conditional
moments that are reported in the empirical literature.
The contrast between the single-regime model and the two-regime model
is equally apparent when considering these conditional correlations between
the risk premium and the volatility. For the single-regime model the condi-
tional correlations are 1.000 in every state. The short-run relation exhibits no
time variation. For the two-regime model, the conditional correlation is neg-
ative in every state of the world. These correlations are plotted in Figure 5.
Correlations in the expansion range from 0.99 in state 9 to 0.36 in state 3,
while those in the contraction range from 0.96 in state 1 to 0.37 in state 7.
These patterns in the two regimes result from a combination of the within-
regime transition probabilities, which look similar in both regimes, and the
regime switch probabilities, which vary inversely. The same effects that gen-
erate the long-run results discussed above are responsible for this short-run
behavior. The existence of time variation is consistent with results in the
empirical literature [see, e.g., Whitelaw (1994) and Boudoukh, Richardson,
and Whitelaw (1997)], but the absence of positive correlations is not. This
question is addressed in more detail in Section 2.5.
2.4 Other implications of the model
While the focus of this article is on the relation between the mean and volatil-
ity of stock market returns, it is interesting to investigate other implications of
10
Boudoukh, Richardson, and Whitelaw (1997) make a similar point in the context of a simple, four-state,
discrete economy.
539
The Review of Financial Studies/v 13 n 3 2000
Figure 5
Conditional correlations in a two-regime model
State-by-state values of the conditional correlation between the equity risk premium and the conditional
volatility of equity returns for a two-regime model. The model parameters are given in Table 2. The x-axis
gives the number of the state using the scheme in Table 3. Expansion and contraction states are marked by
circles and squares, respectively.
the model, both to consider further testable restrictions and to determine the
reasonableness of the parameterization. This latter concern is well founded
given that attempts to resolve the equity premium puzzle have sometimes led
to models that produce startlingly unrealistic interest rate processes. Such an
outcome is not totally surprising since a common approach is to attempt to
increase the volatility of the MRS [see Equation (5)], which also determines
the volatility of interest rates.
Intuitively, working on the correlation between current and future con-
sumption growth, as in this article, will have a less dramatic effect on interest
rates. This intuition is correct. The mean monthly real risk-free rate is essen-
tially the same in the two-regime model as in the single-regime model. As
expected, the volatility is somewhat higher (0.29% per month versus 0.19%
per month), but not unreasonably so. The patterns in the volatility of excess
returns are similar0.67% in the two-regime model and 0.46% in the single-
regime model. The ordering of the mean excess returns is reversed because
much of the induced regime risk is unpriced.
This relative similarity in unconditional moments contrasts markedly with
the dramatic differences in the conditional moments, as shown in Figures 3
and 4. Consequently it is in the conditional moments that we should look
for the strongest implications of the model. One interesting implication is
that the conditional moments of bond returns should exhibit patterns similar
540
Stock Market Risk and Return
to those seen in stock returns because the discount rate effect dominates the
dividend effect (see Section 1.1). Counter to the intuition of the liquidity
preference hypothesis, long-term bond returns should be volatile in periods
of low term premia associated with business cycle phase transitions. Evidence
in Boudoukh et al. (1999) is consistent with this prediction.
Finally, much of the evidence in the literature on the conditional moments
of bond and stock returns deals with predictability using various nancial
variables. In the two-regime model, there are only two relevant state vari-
ables: the level of consumption growth and the state of the economy. As a
result, such variables as price:dividend ratios (or equivalently dividend yields)
and interest rates have predictive power for both the mean and volatility
of stock and bond returns. Of equal importance are proxies for the cur-
rent and future state of the economy, especially around regime transitions.
While investigating possible variables is beyond the scope of this article, the
intuition is consistent with the use in the literature of such forward-looking
variables as the slope of the term structure or the credit yield spread.
2.5 Sensitivity analysis
The purpose of the sensitivity analysis is twofold: (1) to examine the robust-
ness of the results of the two-regime model to changes in the parameters and
(2) to nd the parameters that yield the desired long-run and short-run behav-
ior. For expositional clarity and brevity the discussion will focus primarily
on the unconditional and conditional correlations between the risk premium
and the volatility. These correlations conveniently summarize the direction
and strength of the relation between the conditional moments, at least in a
linear context.
Initially, consider the time preference parameter . Increasing toward 1
increases the magnitude of the negative correlations because the price:dividend
ratio is more sensitive to future consumption growth and hence more sen-
sitive to the regime. Decreasing has the opposite effect. At a value of
approximately 0.96, the unconditional correlation becomes positive and the
conditional correlations are both negative and positive. Of course, a monthly
value this low is difcult to justify.
In some ways, the effect of risk aversion is similar. As increases, the
magnitudes of the negative correlations also increase. The reverse is true as
decreases. At = 1, price:dividend ratios are constant across both regimes,
and the correlation becomes 1.000, unconditionally and conditionally. There
are intermediate values for which the unconditional correlation is negative
and the conditional correlations are both positive and negative. Of course,
raising the level of risk aversion also increases the magnitude of the risk
premium, but it has less plausible effects on the properties of interest rates.
With respect to the within-regime time-series properties of consumption
growth, there are six parameters and innumerable variations of these param-
eters that could be considered. We focus on three effects that illustrate how
541
The Review of Financial Studies/v 13 n 3 2000
the short-run and long-run behavior result from a delicate balance between
variation in consumption growth and variation in price:dividend ratios. First,
consider altering the degree of autocorrelation in both regimes by changing
b
1
and b
2
simultaneously. As these coefcients move toward zero, the short-
run and long-run correlations between the mean and volatility become more
negative because the current state of consumption growth has less inuence
on future expected consumption growth. When consumption growth is i.i.d.
in both regimes, the expected dividend growth component of expected equity
returns exhibits no within-regime variation. On the other hand, the varia-
tion in price:dividend ratios across regimes is still large. This cross-regime
variation dominates expected equity returns. Second, consider varying the
relative levels of mean consumption growth in the two states by changing
a
1
and a
2
. If the means are pushed further apart, the cross-regime variation
in price:dividend ratios increases, and the correlations become more nega-
tive. Again, the issue is the relative variation in consumption growth and
price:dividend ratios, especially across regimes. Third, think of changing the
conditional volatility of consumption growth. Increasing volatility pushes the
balance toward variation in consumption growth rather than price:dividend
ratios, and the correlations increase.
As a nal exercise, consider the critical role of the regime switch probabil-
ities. In many ways, this is the most important analysis because these param-
eters are identied less accurately in the estimation. Consequently, from a
statistical perspective, there is a wider range of plausible values, especially
for the coefcients on consumption growth p
1
and q
1
. The direct effects
of changes in the parameters are relatively straightforward. For example,
decreasing the constants p
0
and q
0
reduces regime persistence and increases
the probability of a regime shift in every state. Decreasing only one of
the constants reduces the unconditional probability of being in that regime.
Decreasing the coefcients on consumption growth has similar effects, that
is, reducing regime persistence and reducing the unconditional probability
of the regime. In addition, these coefcients also control the sensitivity of
regime-shift probabilities to the level of consumption growth. Large magni-
tudes, either negative or positive, generate larger variations across states.
The indirect effects on the moments of equity returns are less obvious
and depend on the levels of these and the other parameters. For example,
decreasing any of the parameters increases the probability of a regime shift,
but it does not necessarily increase volatility. There is an offsetting effect on
the distance between the price:dividend ratios across the regimes, as illus-
trated in Tables 3 and 4. The more persistent the regime, the more important
is the mean consumption growth level in that regime for determining the
price:dividend ratio. When regimes shifts are sufciently likely, the current
regime has little effect on the ratio. Of course, there is also an effect on the
risk premium and on the conditional and unconditional correlations. A nal
point worth noting is that almost all the signicant within-regime variation in
542
Stock Market Risk and Return
risk premiums and volatilities comes from the variability in the regime-shift
probabilities. If either of the coefcients on consumption growth is set to zero,
then all the points in that regime cluster in risk premium/volatility space. The
direction of this effect can be seen in Figure 3, wherein the states within the
contraction are more tightly clustered than those within the expansion.
Starting from the estimated parameter values, if either of the expansion
parameters p
0
and p
1
decrease, both the unconditional and conditional cor-
relations move upward toward zero. In contrast, decreasing the contraction
constant q
0
makes the correlation more negative. Finally, decreasing the coef-
cient q
1
has a small but positive effect on the correlations. The rst three
effects are all driven by the relative probability of the two regimes. Moving
the weight more toward the contraction increases the correlation between the
risk premium and the volatility. In the nal case, this effect is offset by the
negative effect associated with increasing variation across the states within
the contraction.
Perhaps the easiest way to illustrate the complexity of the interactions and
the magnitude of the effects is to look at a single interesting example. Table 5
gives the state-by-state values for the regime-shift parameters p
0
= 3.5,
p
1
= 0.5, q
0
= 3.0, and q
1
= 1.4. All the parameters have been reduced,
so both regimes are less persistent. However, the unconditional probability
of being in an expansion is increased to 71%. The effects on the moments of
equity returns are quite dramatic. The risk premium/volatility patterns have
Table 5
Risk and return in a two-regime model
E
t
[r
st +1
r
f t
] Vol
t
[r
st +1
]
State (%100) (%) P
t
(i, j) Probability
t
Expansion
1 3.880 1.981 5.747 0.004 0.816
2 3.959 1.925 4.532 0.306 0.668
3 4.015 1.879 3.684 4.137 0.441
4 4.057 1.839 3.031 17.350 0.156
5 4.089 1.803 2.505 27.481 0.109
6 4.113 1.771 2.069 17.322 0.295
7 4.132 1.740 1.697 4.123 0.400
8 4.145 1.712 1.372 0.304 0.445
9 4.154 1.683 1.071 0.004 0.440
Contraction
1 2.611 1.229 0.691 0.001 0.841
2 2.646 1.334 1.383 0.149 0.703
3 2.656 1.464 2.505 2.785 0.539
4 2.612 1.630 4.325 10.887 0.353
5 2.496 1.842 7.256 11.461 0.134
6 2.293 2.105 11.928 3.415 0.139
7 2.004 2.407 19.242 0.268 0.455
8 1.695 2.704 30.381 0.003 0.727
9 1.580 2.893 46.798 0.000 0.884
State-by-state values for the risk premium, the volatility of stock returns, the probability of a regime shift, the unconditional
state probability, and the conditional correlation in a two-regime model based on the AR parameter values in Table 2 and the
regime-shift parameters p
0
= 3.5, p
1
= 0.5, q
0
= 3.0, and q
1
= 1.4. All values are annualized.
543
The Review of Financial Studies/v 13 n 3 2000
changed in both regimes, and the overall variation in these moments has
been reduced, especially for the expansion. The unconditional correlation is
now weak and positive, taking on a value of 0.05. Finally, there has been
a dramatic shift in the conditional correlations. These correlations exhibit
extreme time variation, achieving both high positive and high negative values.
From the above analysis, four conditions emerge as necessary to gener-
ate a weak or negative unconditional correlation and large time variation in
the conditional correlation between the risk premium and the volatility of
stock returns. First, the AR parameters of the regimes must be sufciently
far apart to generate signicant cross-regime variation in expected consump-
tion growth. Second, risk aversion must be high enough to generate corre-
sponding variation in price:dividend ratios. Third, regime-shift probabilities
must be relatively small to preserve the distinction between the regimes.
Finally, these probabilities must also be state dependent to generate mean-
ingful time variation in the conditional correlations. However, given these
conditions, there are numerous parameterizations that will generate results
that are broadly consistent with the empirical evidence, but in direct contra-
diction to the standard risk/return intuition.
3. Conclusion
This article shows that a two-regime exchange economy, estimated using
consumption growth data, is able to duplicate two interesting features of
the empirical relation between expected returns and volatility at the mar-
ket level. Specically, the model generates a negative unconditional relation
between these moments of returns and substantial time variation in this rela-
tion. This article demonstrates not only that a negative and time-varying
relation between expected returns and volatility is consistent with rational
expectations, but also that such a relation is consistent with aggregate con-
sumption data in a representative agent framework.
These insights into the risk/return relation at the market level may be a
precursor to a better understanding of asset pricing in a variety of markets.
For example, the large changes in investment opportunities implied by the
regime-shift model and the implied hedging demands are also likely to have
strong implications for bond prices and returns. Moreover, given the some-
what surprising results at the market level, the model may have interesting
implications for the cross-section of expected equity returns, a topic that has
been studied extensively in the literature.
An important implication of the results is that empirical models that impose
a strong, often linear, relation between expected returns and volatility, such
as GARCH-M, need to be employed with caution. The time-series behavior
implied by the model in this article is inconsistent with many of these empir-
ical specications. One potential correction is to model expected returns in
a multifactor framework, with conditional volatility as one of the factors
544
Stock Market Risk and Return
and other factors proxying for changes in the investment opportunity set
[e.g., Scruggs (1998)]. Another promising approach is to model both expec-
ted returns and volatility nonparametrically, as functions of predetermined
nancial variables, thus allowing the data to tell the story [e.g., Boudoukh,
Richardson, and Whitelaw (1997)].
Given the importance of regime shifts to the results, further research in this
area is clearly warranted. The sensitivity of the results to changes in the prob-
ability structure of regime shifts is both good and bad news in this respect.
On the negative side, this sensitivity means that it is difcult to extract strong
implications from models with parameters that are not estimated precisely.
On the positive side, the time-series properties of equity returns may provide
a powerful information set with which to estimate these parameters.
Moreover, further research is needed on the interaction between asym-
metric consumption processes and alternative preferences such as recursive
utility. Hung (1994), for example, shows that a simple Markov model in
combination with nonexpected utility can match the unconditional moments
of equity returns and interest rates when the dividend process of the stock
market is permitted to differ from the aggregate consumption process.
Throughout the article we have dealt with real equity returns. In contrast,
the empirical literature works with nominal returns. Obviously, if ination
is constant, then all the results will carry through. More generally, adding
stochastic ination does not qualitatively affect the results as long as it has
no real effects. The intuition behind this result is that ination, while inu-
encing the nominal marginal rate of substitution and equity returns, does not
affect price:dividend ratios. Consequently, the dominant cross-regime dynam-
ics are preserved. However, it would be worthwhile to estimate a multiregime
model that permits a link between ination and consumption growth and
in which ination is allowed to inuence regime-shift probabilities. Such a
model presents a number of challenges, not the least of which is the fact
that the time series of ination appears to exhibit not only business cycle
dynamics but also structural shifts.
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