ABSTRACT Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.

ABSTRACT There is ongoing debate about the apparent weak or negative relation between risk (conditional variance) and expected returns in the aggregate stock market. We develop and estimate an empirical model based on the intertemporal capital asset pricing model (ICAPM) that separately identifies the two components of expected returns, namely, the risk component and the component due to the desire to hedge changes in investment opportunities. The estimated coefficient of relative risk aversion is positive, statistically significant, and reasonable in magnitude. However, expected returns are driven primarily by the hedge component. The omission of this component is partly responsible for the existing contradictory results.

We propose a consumption-based model to explain puzzling unstable (i.e., sometimes positive and sometimes negative) relations between stock market variance with both stock market risk premia and prices. In the model, market risk premia depend positively (negatively) on fear (euphoria) variance. Market prices, which decrease with discount rates, correlate negatively (positively) with fear (euphoria) variance. Because it is the sum of fear and euphoria variances, the market variance may correlate positively or negatively with expected returns and prices, depending on the relative importance of the two variances. Our empirical results support the model’s key assumptions and many novel implications.

There is mixed evidence of a positive relationship between the stock market risk and return. We reexamine this critical implication of asset pricing theory using fresh data from China's stock market, which is largely segmented from the rest of the global financial market. Using formal variable selection methods and a comprehensive set of predictor variables, we identify conditional market variance, scaled market prices, and inflation as crucial determinants of equity premiums. The estimated simple risk-return relationship exhibits downward omitted variable bias, which underlines the importance of considering multiple factors to explain the variation in equity premiums. We cannot wholly attribute the three-factor conditional equity premium model to data mining, as Guo, Sanni, and Yu (2022) select the same model for the U.S. stock market. These findings challenge existing asset pricing models and provide valuable guidance for future theoretical research.

We investigate the international transmission of inflation among G-7 countries using data-determined vector autoregression analysis, as advocated by Swanson and Granger [Swanson, N., Granger, C., 1997. Impulse response functions based on a causal approach to residual orthogonalization in vector autoregressions. Journal of the American Statistical Association 92, 357–367]. Over the period 1973–2003, we find that unexpected changes in US inflation have large effects on inflation in other countries, although they are not always the dominant international factor. Similarly, shocks to some other countries also have a statistically and economically significant influence on US inflation. Moreover, our evidence indicates that US inflation has become less vulnerable to foreign shocks since the early 1990s, mainly because of the diminished influence from Germany and France.

We uncover a positive stock market risk-return tradeoff after controlling for the covariance of market returns with the value premium. Fama and French (1996) conjecture that the value premium proxies for investment opportunities; therefore, by ignoring it, early specifications suffer from an omitted variable problem that causes a downward bias in the risk-return tradeoff estimation. We also document a positive relation between the value premium and its conditional variance, and the estimated conditional value premium is strongly countercyclical. The latter evidence supports the view that value is riskier than growth in bad times, when the price of risk is high.