On the Stock Market Variance-Return or Price Relations : A Tale Of Two Variances

Stock market variance-return or price relations are sometimes negative and sometimes positive. We explain these puzzling findings using a model with two ("bad" and "good") variances. In the model, conditional equity premium depends positively on bad variance and negatively on good variance. Market prices, which correlate negatively with discount rates, decrease with bad variance and increase with good variance. Because market variance is the sum of bad and good variances, its relation to conditional equity premium or market prices can be negative or positive, depending on relative importance of two variances. Our empirical results support model's main implications