Measuring and Modeling Variation in the Risk-Return Trade-off

Martin Lettau, Sydney Ludvigson

    Research output: Chapter in Book/Report/Conference proceedingChapter

    Abstract

    This chapter reviews what is known about the time-series evolution of the risk-return trade-off for stock market investment and presents some new empirical evidence. Financial markets are often hard to understand. Stock prices are highly volatile and difficult to predict, requiring that market participants and researchers devote significant resources to understanding the behavior of expected returns relative to the risk of stock market investment. Understanding the time-series properties of the Sharpe ratio is crucial to the development of theoretical models capable of explaining observed patterns of stock market predictability and volatility. The behavior of the Sharpe ratio over time is fundamental for assessing whether stocks are safer in the long run than they are in the short run, as increasingly advocated by popular guides to investment strategy. Only if the Sharpe ratio grows more quickly than the square root of the horizon-so that the standard deviation of the return grows more slowly than its mean-stocks are safer investments in the long run than they are in the short run. Such a dynamic pattern is not possible if stock returns are unpredictable, i.i.d. random variables. Thus, understanding the time series, behavior of the Sharpe ratio not only provides a benchmark for theoretical progress but also has profound implications for investment professionals concerned with strategic asset allocation.

    Original languageEnglish (US)
    Title of host publicationHandbook of Financial Econometrics, Vol 1
    PublisherElsevier Inc.
    Pages617-690
    Number of pages74
    ISBN (Print)9780444508973
    DOIs
    StatePublished - 2010

    Fingerprint

    Sharpe ratio
    Risk-return trade-off
    Modeling
    Stock market
    Short-run
    Random variables
    Resources
    Stock prices
    Empirical evidence
    Expected returns
    Investment strategy
    Benchmark
    Stock returns
    Financial markets
    Standard deviation
    Strategic asset allocation
    Predictability

    ASJC Scopus subject areas

    • Economics, Econometrics and Finance(all)

    Cite this

    Lettau, M., & Ludvigson, S. (2010). Measuring and Modeling Variation in the Risk-Return Trade-off. In Handbook of Financial Econometrics, Vol 1 (pp. 617-690). Elsevier Inc.. https://doi.org/10.1016/B978-0-444-50897-3.50014-6

    Measuring and Modeling Variation in the Risk-Return Trade-off. / Lettau, Martin; Ludvigson, Sydney.

    Handbook of Financial Econometrics, Vol 1. Elsevier Inc., 2010. p. 617-690.

    Research output: Chapter in Book/Report/Conference proceedingChapter

    Lettau, M & Ludvigson, S 2010, Measuring and Modeling Variation in the Risk-Return Trade-off. in Handbook of Financial Econometrics, Vol 1. Elsevier Inc., pp. 617-690. https://doi.org/10.1016/B978-0-444-50897-3.50014-6
    Lettau M, Ludvigson S. Measuring and Modeling Variation in the Risk-Return Trade-off. In Handbook of Financial Econometrics, Vol 1. Elsevier Inc. 2010. p. 617-690 https://doi.org/10.1016/B978-0-444-50897-3.50014-6
    Lettau, Martin ; Ludvigson, Sydney. / Measuring and Modeling Variation in the Risk-Return Trade-off. Handbook of Financial Econometrics, Vol 1. Elsevier Inc., 2010. pp. 617-690
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