52 CFA Digest February 2008

The Risk Return Tradeoff in the Long Run:

18362003
Christian Lundblad
Journal of Financial Economics
vol. 85, no. 1 (July 2007):123150
Although the riskreturn trade-off is fundamental to finance,
the empirical literature has offered mixed results. The author
extends the sample considerably and analyzes nearly two
centuries of both U.S. and U.K. market returns and finds a
positive and statistically significant riskreturn trade-off in line
with the postulated theory.

Previous attempts at studying the riskreturn trade-off have typically

used the past 5075 years of data along with the popular generalized
autoregressive conditional heteroscedasticity in-mean (GARCH-M)
framework. The evidence suggests that the relationship is weak at best
and is particularly sensitive to the volatility specification. The author
argues that within the GARCH-M framework, one needs a very large
amount of data to successfully detect the riskreturn trade-off.
The author starts with a Monte Carlo analysis on the small sample
distribution of the riskreturn trade-off coefficient. In the simulation,
expected returns are driven by conditional volatility by construction
and realized return variation is calibrated to be nearly unrelated to
volatility (as in the real data). This analysis is done for the GARCH-M
and TARCH (threshold ARCH) specifications. It is conducted for
simulated sample sizes of 500, 2,000, and 5,000. The author considers
sensitivity of the results to the level of return volatilitythe volatility
of return volatilityand the persistence of return. He then considers
whether one can improve the precision by using high-frequency data
rather than long data spans.
Returns from 1836 to 1925 are obtained from data compiled by
Schwert (Journal of Business, 1990), and for the 19262003 period,
Christian Lundblad is at the University of North Carolina at Chapel Hill. The
summary was prepared by Yazann S. Romahi, CFA, JPMorgan Asset Management.

2008, CFA Institute

Equity Investments 53

CRSP value-weighted portfolio returns for the NYSE, Amex, and

NASDAQ markets are used. Data are also obtained for the United
Kingdom from Global Financial Data.
In analyzing the historical data, the author uses the same framework
but with a number of different variance specifications: GARCH,
EGARCH, TARCH, and QGARCH. The latter three specifications
enable the evaluation of the importance of leverage-effect asymmetry
and its implication for the empirical riskreturn trade-off. Time
variation of the riskreturn trade-off is also examined. In particular,
the relationship with the development of the financial market (market
capitalization/GDP), macroeconomic liquidity (M3/GDP), recessions, and the overall state of the economy (foreign trade [exports plus
imports/GDP] and size of government [GOV/GDP]) are considered.
The author finds that with a sample size of 500 and with the risk
return trade-off coefficient known to be 2, 19 percent (22 percent)
of the time for the GARCH (TARCH) specification, the estimated
coefficient is negative. If the sample size is increased to 2,000, this
figure falls dramatically, to 3 percent (7 percent), and it falls to less
than 1 percent for 5,000 observations. Moreover, the author finds
that the conditional probability of estimating a negative coefficient
over a short period when the longer sample yields a correct positive
estimate is 28 percent.
The author also finds that the ability to detect the riskreturn tradeoff is closely linked to the magnitude and volatility of return volatility.
Doubling (halving) return volatility yields a negative estimate 35
percent (6 percent) of the time instead of 19 percent. Doubling
volatility of volatility results in a negative estimate only 5 percent of
the time. By analyzing the different frequencies, the author finds that
the distribution of the estimate is almost identical, suggesting that
going to higher frequencies yields no improvement whereas longer
data spans yield significant improvement.
In examining the historical U.S. long-term data, the author finds a
positive trade-off, with the risk premium ranging from 5.2 percent to
7.1 percent for all four volatility specifications examined. When
considering individual subperiods, given the small sample size, a
number of the estimates are negative, including the postwar period.
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54 CFA Digest February 2008

For robustness, U.K. data are also considered. The postwar period for
the United Kingdom yields a positive but statistically insignificant
estimate. This suggests that the negative postwar result obtained for
the U.S. data is a result of sampling error. Over the long period, he
finds the result to be around 2, as in the U.S. data.
The exploratory evidence suggests that the riskreturn trade-off is
related to recessions, the overall size of the equity market, external
trade, and government spending.
Keywords: Equity Investments: fundamental analysis and valuation models;
Investment Theory: CAPM, APT, and other pricing theories; Risk Measurement and
Management: equity portfolios

2008, CFA Institute