Is Value Premium a Proxy for Time-Varying Investment Opportunities : Some Time Series Evidence

This paper tests the conjecture that the value premium constructed from the cross-section of stocks proxies for investment opportunities by investigating whether it helps explain the puzzling empirical risk-return tradeoff in the stock market across time. In contrast with many early authors, we find that, in the U.S. data, the stock market return is positively and significantly related to its conditional variance after controlling for its covariance with the value premium. The covariance, which is negatively correlated with stock variance, is positively and significantly priced as well. Thus, by ignoring the effect of time-varying investment opportunities on the stock market return, the early specification might suffer from an omitted variables problem, which generates a downward bias in the estimate of the risk-return relation. Also, consistent with recent investment-based equilibrium models, we document a novel finding of a positive and significant relation between the value premium and its conditional variance over the post 1963 period. Moreover, we find qualitatively the same results for the world market as well as most of the other G7 countries. Our empirical evidence suggests that the value premium is a proxy for investment opportunities