The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support to international institutions.
The Outreach and Education function engages, empowers and educates the Second District communities that the Bank serves, especially civic leaders, students, educators, small business owners, policymakers and the general public. It furthers the Bank's commitment to the region by listening to the communities we serve and leveraging our unique attributes to positively impact school and university programs, as well as analysis and research.
This paper proposes a flexible framework for analyzing the joint time series properties of the level and volatility of expected excess stock returns. An unobservable dynamic factor is constructed as a nonlinear proxy for the market risk premia with its first moment and conditional volatility driven by a latent Markov variable. The model allows for the possibility that the risk-return relationship may not be constant across the Markov states or over time. We find a distinct business cycle pattern in the conditional expectation and variance of the monthly value-weighted excess return. Typically, the conditional mean decreases a couple of months before or at the peak of expansions, and increases before the end of recessions. On the other hand, the conditional volatility rises considerably during economic recessions. With respect to the contemporaneous risk-return dynamics, we find an overall significantly negative relationship. However, their correlation is not stable, but instead varies according to the stage of the business cycle. In particular, around the beginning of recessions, volatility increases substantially, reflecting great uncertainty associated with these periods, while expected returns decrease, anticipating a decline in earnings. Thus, around economic peaks there is a negative relationship between conditional expectation and variance. However, toward the end of a recession, expected returns are at their highest value as an anticipation of the economic recovery, and volatility is still very high in anticipation of the end of the contraction. That is, the risk-return relation is positive around business cycle troughs. This time-varying behavior also holds for non-contemporaneous correlations of these two conditional moments.