The impact of global financial market uncertainty on the risk-return relation in the stock markets of G7 countries

Purpose This paper aims to investigate the effect of global financial market uncertainty on the relation between risk and return in G7 stock markets. Design/methodology/approach Market uncertainty is quantified using a probability-based measure derived from a regime-switching model in which the state transition probabilities are time-varying in response to leading economic indicators. Time variation in the risk return relation is estimated using a GARCH-M model. Findings While the regime-switching model successfully distinguishes between crisis and normal states, there remains substantial variability through time in the level of uncertainty about which state prevails. Results show that a strong negative relation exists between this uncertainty and the reward-to-variability ratio across all G7 stock markets. This finding is qualitatively consistent at both monthly and weekly horizons. Originality/value Extant evidence on the risk-return relation is conflicting. Most papers assume the relation is time constant. Allowing the reward-to-variability ratio to vary through time in response to return regime uncertainty increases the understanding of asset pricing. It also has important implications for asset allocation decisions by investors.