The non-linear trade-off between return and risk: a regime-switching multi-factor framework

TL;DR

This paper introduces a regime-switching multi-factor model revealing that the positive risk-return trade-off is prominent during low volatility periods but not during high volatility, highlighting non-linear dynamics in financial markets.

Contribution

It develops a novel regime-switching multi-factor framework that captures non-linear risk-return relationships and different risk premium dynamics across volatility regimes.

Findings

Positive risk-return trade-off during low volatility periods

No significant trade-off during high volatility periods

Distinct risk premium patterns in different volatility regimes

Abstract

This study develops a multi-factor framework where not only market risk is considered but also potential changes in the investment opportunity set. Although previous studies find no clear evidence about a positive and significant relation between return and risk, favourable evidence can be obtained if a non-linear relation is pursued. The positive and significant risk-return trade-off is essentially observed during low volatility periods. However, this relationship is not obtained during periods of high volatility. Also, different patterns for the risk premium dynamics in low and high volatility periods are obtained both in prices of risk and market risk dynamics.