The Risk-Return Tradeoff Among Equity Factors

Abstract

We examine the time-series risk-return trade-off among equity factors. We obtain a positive trade-off for profitability and investment factors. Such relationship subsists conditional on the covariance with the market factor, which represents consistency with Merton's ICAPM. Critically, we obtain an insignificant risk-return relationship for the market factor. The factor risk-return trade-off tends to be weaker among international equity markets. The out-of-sample forecasting power (of factor variances for future own returns) tends to be economically significant for the investment and profitability factors. Our results suggest that the risk-return trade-off is stronger within segments of the stock market than for the whole.

Keywords: Asset pricing, risk-return trade-off, ICAPM, realized volatility, profitability and investment factors

JEL Classification: G11, G12, G17