Analyzing the Time-Varying Stock Market Risk-Return Relation

We analyze the stock market risk-return relation over the period from 1927 to 2005. We empirically implement the Intertemporal Capital Asset Pricing Model (ICAPM) using a cross-section of stock and bond portfolios, and allow for the market price of risk to be time-varying. We show that including bond portfolios in the estimation not only significantly changes the time-series estimates of the market price of risk, but also makes the correlation between conditional stock-market variance and the variance component of expected market return positive.