Relationship between risk premium and volatility in a two-regime market: evidence from the UK

Abstract

This paper examines the intertemporal relation between excess stock returns and volatility within c two-regime framework in the UK We extend previous research by examining the relation between these two variables in regimes that are dependent on movements in stock market prices and movements of various macroeconomic variables. The market is divided into two broad categories of rising and falling markers. We find that regardless of the model used there is evidence of a positive relation between expected volatility and realised excess return in rising markets. However in the case of falling markets we report indirect evidence of the positive risk-return relation when the exogenous separation method is used. These results are consistent with the behaviour of rational investors implying that while modelling this relation the effect of the various macroeconomic changes taking place in the economy must be taken into account.