Stock returns and volatility in two regime markets: international evidence

This paper examines the intertemporal relationship between stock returns and volatility within a two regime framework in five countries namely the UK, USA, Germany, Japan and Italy. We extend previous research by examining the relationship between these two variables in regimes that are dependent on factors both exogenous and endogenous to the model. The exogenous separator is the sign of the observed risk premium while the endogenous separator is the sign of the risk premium predicted by different macroeconomic variables. In a regime characterized by positive risk premium, excess returns and expected volatility are positively associated while there exists a negative relation between unexpected volatility and excess returns. This, in itself, is proof of an ex ante positive relationship between risk and return. In the endogenous model, we find that regardless of the regime, there is a positive relation between expected volatility and expected return and a negative relationship between unexpected volatility and excess return. These results are consistent with the behavior of rational investors implying that while modelling this relationship the effect of the economic environment under which rational investors make investment decisions must be taken into account. The results are qualitatively similar for all countries in the sample.