State-dependent intertemporal risk-return tradeoff: Further evidence

Abstract

We suggest that the intertemporal risk-return tradeoff is not necessarily positive but rather state dependent. We further explore the state dependent risk-return relation by examining how the positive risk-return relation is distorted in response to various market conditions, including extreme price changes, differing levels of investor sentiment, the introduction of stock options, and throughout business cycles. The tendency for uninformed investors to be optimistic (pessimistic) in response to good (bad) market news cause overpricing (underpricing), and the resulting trade activity of arbitrageurs that distorts the positive risk-return tradeoff, is documented consistently across these environments. We find that the attenuation (reinforcement) of the positive risk-return relation under investors’ optimistic (pessimistic) expectations is stronger in high (low) sentiment periods, in the presence of extreme returns, in the period after stock options became available, and during expansionary periods. We argue that the asymmetric intertemporal risk-return relation is a consequence of rational arbitrageurs’ trading to exploit mispricing through the selling of overpriced stocks conditional on good news and buying underpriced stocks conditional on bad news.