Investment-Based Expected Stock Returns
36 Pages Posted: 16 Oct 2009
Date Written: October 15, 2009
We derive and test q-theory implications for cross-sectional stock returns. Under constant returns to scale, stock returns equal levered investment returns, which are tied directly to firm characteristics. When we use GMM to match average levered investment returns to average observed stock returns, the model captures the average stock returns of portfolios sorted by earnings surprises, book-to-market equity, and capital investment. When we try to match expected returns and return variances simultaneously, the variances predicted in the model are largely comparable to those observed in the data. However, the resulting expected return errors are large.
Keywords: q-theory, the cross-section of expected returns, investment-based asset pricing, stock return volatility, structural estimation
JEL Classification: D21, D92, E22, E44, G12, G14, G31, G32, G35
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