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ON THE RATIONALITY OF COMMON STOCK RETURN VOLATILITY
Author(s) -
Ronn Ehud I.
Publication year - 1986
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.1540-6288.1986.tb01131.x
Subject(s) - econometrics , economics , stock (firearms) , volatility (finance) , conditional variance , conditional expectation , valuation (finance) , realized variance , mathematics , autoregressive conditional heteroskedasticity , finance , mechanical engineering , engineering
ABSTRACT This paper derives the relationship between the population unconditional variance of common stock returns and the variance of expected returns conditional on a well‐specified information set. As a consequence, a lower bound is obtained for the variance of common stock returns. The sample counterpart of this bound is then empirically tested against the sample variance of returns. The paper's main conclusion can be stated as follows: the observed volatility of real (inflation‐adjusted) common stock returns is not “irrationally” large. The paper admits of this conclusion because the point estimate of the lower‐bound variance derived in this model is actually larger than the point estimate of common stock return volatility. However, since these point estimates are found to have a statistically insignificant difference, equality of the two variances cannot be ruled out. Hence, “rationality” of common stock returns—as implied by a utility‐based valuation conditional on a specified information set—cannot be rejected.