Time-Varying Risk Premia and The Cross Section of Stock Returns

Abstract

This paper shows that the consumption-wealth ratio, realized stock market variance, and the stochastically detrended risk-free rate are strong predictors of stock market returns as well as returns on portfolios formed according to various sorting criteria. The Capital Asset Pricing Model (CAPM) and the Fama and French (1993) three-factor model fail to explain the dynamic pattern of stock portfolio returns tracked by the lagged forecasting variables. However, we cannot reject Campbell's (1993) Intertemporal CAPM, in which risk factors include a stock market return and variables forecasting stock market returns. We find that (1) the relative risk aversion coefficient is positive and statistically significant; (2) all the risk factors are significantly priced; (3) heteroskedasticity in stock returns has significant effects on asset prices. Also, shareholders tend to be more risk-averse towards value stocks than growth or glamour stocks. Therefore, in addition to stock market risk, a hedge for time-varying investment opportunities and possibly different risk attitudes are important to explain the cross section of stock returns.