Predictability and the Cross-section of Expected Returns

Download or read book Predictability and the Cross-section of Expected Returns written by Christian Schlag and published by . This book was released on 2020 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: Many modern macro finance models imply that excess returns on arbitrary assets are predictable via the price-dividend ratio and the variance risk premium of the aggregate stock market. We propose a simple empirical test for the ability of such a model to explain the cross-section of expected returns by sorting stocks based on the sensitivity of expected returns to these quantities. Models with only one uncertainty-related state variable, like the habit model or the long-run risks model, cannot pass this test. However, even extensions with more state variables mostly fail. We derive conditions under which models would be able to produce expected return patterns in line with the data and discuss various examples.