Risk-Return Relation in Stock Returns under Economic Constraints

We obtain new methodological and empirical perspectives on the fundamental risk-return tradeoff in stock returns by imposing economic and asset pricing motivated constraints on the equity premium. In contrast to highly ambiguous past empirical findings, these constraints result in a nonlinear model implying a bounded and positive risk-return relationship. Our empirical results show that the positive risk-return relation in the U.S. data is statistically significant over the mean return benchmark and the magnitudes of the risk aversion coefficients are slightly smaller than obtained without the constraints