The risk-return relationship in the South Africa stock market - African ...

model and data is presented in section 3. Section 4 discusses the empirical results,while section 5 concludes.2 Literature reviewAssuming rational, risk-averse investors, the Sharpe (1964) and Lintner (1965)Capital Asset Pricing Model (CAPM) implies a positive, linear relationship betweenthe expected market risk and returns. Merton (1973) estimated a variant of thetraditional CAPM called the Intertemporal Capital Asset Pricing Model (ICAPM).Similar to the CAPM, the ICAPM implies a positive, linear relationship between theaggregate market return and the market risk premium of the market. This assetpricing model can be summarised by the following equation:E JW ww2wftrm, t1 rf. t1 Etm,t1 Etmf , t1JwJw J [1] where E r r is the conditional market return between period t and t 1.t m, t1f , t1is the rate of return on the stock market index andE r t m, t1r f , t1is the rate of returnon risk-free asset.E2t m , t 1is the conditional variance of the market return or the riskcomponent.E is the covariance of the market return with investmenttmf , t1opportunities or the hedge component. W ( t 1)is wealth and F(t 1) is the vector ofstate variables that describe wealth such thatJ ( W ( t 1),F(t 1),t 1) is the indirectutility function of wealth. JJwwwWis positive if investors are risk averse.is the measure of risk aversion or price of risk andAssuming that investors have a recursive (power) utility function and the rates ofreturn are independent and identically distributed, Merton (1980) agues that relativerisk aversion is constant such that that the hedge component is negligible. Inparticular, Guo and Neely (2006) argue that investment opportunities are sluggish,such that their impact on stock returns is almost constant in the short term. Thismakes the case for the exclusion of the hedge component and the use of high2