Is there a Positive Risk-Return Tradeoff? A Forward-Looking Approach to Measuring the Equity Premium

Abstract

This article revisits the puzzling time-series relation between risk and return on the stock market portfolio. It replaces the standard ex post mean returns with forward-looking calculations of the equity risk premium derived from the classic Gordon stock valuation model. The article estimates the equity premium for several industrialised markets and finds that conditional market risk is significantly priced in the context of asset pricing theory both in the short- and long-run using various specifications for volatility. Findings herein lend credible support for the presence of a positive intertemporal risk-return relation and suggest that perhaps ex post realised returns are unjustifiably used to make ex ante inferences regarding expected returns and to motivate asset pricing tests.