On the relationship between the conditional mean and volatility of stock returns: A latent VAR approach

We model the conditional mean and volatility of stock returns as a latent VAR process to study their contemporaneous and intertemporal relationships in a flexible statistical framework and without relying on exogenous predictors. We find a strong and robust negative correlation between the innovations to the conditional moments leading to pronounced countercyclical variation in the Sharpe ratio. We document significant lead-lag correlations between the moments that also appear related to business cycles. Finally, we show that although the conditional correlation between the mean and volatility is negative, the unconditional correlation is positive due to these lead-lag correlations. (C) 2003 Elsevier B.V. All rights reserved.