Abstract
One of central questions to macroeconomics and finance has been whether macroeconomic factors are useful predictors for expected stock returns. The general consensus is somewhat surprising in that financial factors, rather than macroeconomic factors, have predictive power on stock returns. Such predictability of financial factors is justified on the ground that those factors can act as a proxy for future business conditions and undiversifiable risk. Hence, they should be priced in terms of expected returns. However, as suggested by Campbell, S., and F. Diebold. 2009. “Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence.” Journal of Business & Economic Statistics 27 (2): 266–278, such a justification can be puzzling because macroeconomic factors are likely to have a closer and more direct link to future business conditions than financial factors. In this paper, we will attempt to solve this puzzling problem by accounting for market volatility when measuring the relationship between stock returns and macroeconomic factors. As a result, we propose a unified framework in which the three components of macroeconomic factors, market volatility, and stock returns are jointly embedded.
Acknowledgments
We would like to thank Bruce Mizrach (the Editor), an Associate Editor, and two anonymous referees for their insightful comments and suggestions on an earlier draft of this article. This work was supported by the 2015 Research Fund of the University of Seoul for Yunmi Kim.
Appendix
For maximum likelihood estimation of our proposed model in (17)–(22), we derive the following (log) likelihood function:
where
where
References
Beaudry, P., and F. Portier. 2004. “An Exploration into Pigou’s Theory of Cycles.” Journal of Monetary Economics 51 (6): 1183–1216.10.1016/j.jmoneco.2003.10.003Search in Google Scholar
Beaudry, P., and B. Lucke. 2010. “Letting Different Views about Business Cycles Compete.” NBER Macroeconomics Annual 24 (1): 413–456.10.1086/648305Search in Google Scholar
Beaudry, P., and F. Portier. 2014. “News-Driven Business Cycles: Insights and Challenges.” Journal of Economic Literature 52 (4): 993–1074.10.1257/jel.52.4.993Search in Google Scholar
Bollerslev, T., and H. Zhou. 2006. “Volatility Puzzles: A Simple Framework for Gauging Return-Volatility Regressions.” Journal of Econometrics 131 (1): 123–150.10.1016/j.jeconom.2005.01.006Search in Google Scholar
Campbell, J. 1999. “Asset Prices, Consumption, and the Business Cycle.” In Handbook of Macroeconomics, Volume 1, edited by J. B. Taylor and M. Woodford, 1231–1303. North-Holland: Amsterdam.10.1016/S1574-0048(99)10032-6Search in Google Scholar
Campbell, J., and R. Shiller. 1988. “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors.” Review of Financial Studies 1: 195–228.10.1093/rfs/1.3.195Search in Google Scholar
Campbell, J., and L. Hentschel. 1992. “No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns.” Journal of Financial Economics 31: 281–331.10.1016/0304-405X(92)90037-XSearch in Google Scholar
Campbell, S., and F. Diebold. 2009. “Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence.” Journal of Business & Economic Statistics 27 (2): 266–278.10.1198/jbes.2009.0025Search in Google Scholar
Chen, N. F., R. Roll, and S. Ross. 1986. “Economic Forces and the Stock Market.” Journal of Business 59: 383–403.10.1086/296344Search in Google Scholar
Diebold, F. X., J. H. Lee, and G. C. Weinbach. 1994. “Regime Switching with Time-Varying Transition Probabilities.” In Non-stationary Time Series Analysis and Cointegration, 283–302. Oxford: Oxford University Press.Search in Google Scholar
Fama, E., and K. French. 1989. “Business Conditions and Expected Returns on Stocks and Bonds.” Journal of Financial Economics 25: 23–49.10.1016/0304-405X(89)90095-0Search in Google Scholar
Filardo, A. J. 1994. “Business-Cycle Phases and Their Transitional Dynamics.” Journal of Business & Economic Statistics 12 (3): 299–308.Search in Google Scholar
Flannery, M. J., and A. A. Protopapadakis. 2002. “Macroeconomic Factors Do Influence Aggregate Stock Returns.” Review of Financial Studies 15 (3): 751–782.10.1093/rfs/15.3.751Search in Google Scholar
French, K., W. Schwert, and R. Stambaugh. 1987. “Expected Stock Returns and Volatility.” Journal of Financial Economics 19: 3–30.10.1016/0304-405X(87)90026-2Search in Google Scholar
Glosten, L., R. Jagannathan, and D. Runkle. 1993. “On the Relation Between the Expected Value and the Volatility of the Nominal Excess Return on Stocks.” Journal of Finance 48: 1779–1801.10.1111/j.1540-6261.1993.tb05128.xSearch in Google Scholar
Hamilton, J. D., and G. Lin. 1996. “Stock Market Volatility and the Business Cycle.” Journal of Applied Econometrics 11: 573–593.10.1002/(SICI)1099-1255(199609)11:5<573::AID-JAE413>3.0.CO;2-TSearch in Google Scholar
Kim, Y., and C. R. Nelson. 2014. “Pricing Stock Market Volatility: Does it Matter whether the Volatility is Related to the Business Cycle?” Journal of Financial Econometrics 12 (2): 307–328.10.1093/jjfinec/nbt014Search in Google Scholar
Kim, C.-J., J. Morley, and C. R. Nelson. 2004. “Is There a Positive Relationship between Stock Market Volatility and the Equity Premium?” Journal of Money, Credit, and Banking 36: 339–360.10.1353/mcb.2004.0055Search in Google Scholar
Lettau, M., and S. Ludvigson. 2001. “Consumption, Aggregate Wealth, and Expected Stock Returns.” Journal of Finance 56: 815–849.10.1111/0022-1082.00347Search in Google Scholar
Lewellen, J. 1999. “The Time-Series Relations among Expected Return, Risk, and Book-to-Market.” Journal of Financial Economics 54: 5–43.10.1016/S0304-405X(99)00030-6Search in Google Scholar
McQueen, G., and V. Roley. 1993. “Stock Prices, News, and Business Conditions.” Review of Financial Studies 6: 683–707.10.1093/rfs/5.3.683Search in Google Scholar
Pearce, D. K., and V. V. Roley. 1985. “Stock Prices and Economic News.” Journal of Business 58: 49–67.10.1086/296282Search in Google Scholar
Ross, S. A. 1976. “The Arbitrage Theory and Capital Asset Pricing.” Journal of Economic Theory 13: 341–360.10.1016/0022-0531(76)90046-6Search in Google Scholar
Schwert, G. W. 1981. “The Adjustment of Stock Prices to Information About Inflation.” Journal of Finance 36 (1): 15–29.10.1111/j.1540-6261.1981.tb03531.xSearch in Google Scholar
Sims, C. A. 1980. “Macroeconomics and Reality.” Econometrica 48 (1): 1–48.10.2307/1912017Search in Google Scholar
Stock, J., and M. W. Watson. 2001. “Vector Autoregressions.” Journal of Economic Perspectives 15 (4): 101–115.10.1257/jep.15.4.101Search in Google Scholar
Turner, C., R. Startz, and C. R. Nelson. 1989. “A Markov Model of Heteroscedasticity, Risk, and Learning in the Stock Market.” Journal of Financial Economics 25: 3–22.10.1016/0304-405X(89)90094-9Search in Google Scholar
Yu, J. 2005. “On Leverage in a Stochastic Volatility Model.” Journal of Econometrics 127: 165–178.10.1016/j.jeconom.2004.08.002Search in Google Scholar
Supplementary Material
The online version of this article offers supplementary material (DOI: https://doi.org/10.1515/snde-2016-0151).
©2019 Walter de Gruyter GmbH, Berlin/Boston
