Question

4. Suppose there is a positive risk-return tradeoff. That is, expected excess market returns increase with conditional market variance. When stock market variance increases unexpectedly, would the stock market price increases, decreases, or stay put?

Answer 1

When stock market variances increase suddenly, it means that risk has significantly spiked and since there is a positive risk reward tradeoff, there will be higher chances to make Higher Return.

But in reality, when the risk associated with the particular stock spikes, the market price of the security decreases as the risk Is being factored into the market price.

Therefore, In reality when there is variances in stock market price will seem to go downward and that will provide with a greater opportunity for making excess returns.