What is the Expected Return on a Stock?

91 Pages Posted: 28 Apr 2016 Last revised: 9 Mar 2018

Ian Martin

London School of Economics & Political Science (LSE) - Department of Finance

Christian Wagner

Copenhagen Business School

Multiple version iconThere are 2 versions of this paper

Date Written: March 5, 2018

Abstract

We derive a formula that expresses the expected return on a stock in terms of the risk-neutral variance of the market and the stock's excess risk-neutral variance relative to the average stock. These quantities can be computed from index and stock option prices; the formula has no free parameters. We run panel regressions of realized stock returns onto risk-neutral variances, and find that the theory performs well at 6-month, 1-year, and 2-year forecasting horizons. The formula drives out beta, size, book-to-market and momentum, and outperforms a range of competitors in forecasting stock returns out of sample. Our results suggest that there is considerably more variation in expected returns, both over time and across stocks, than has previously been acknowledged.

Keywords: Equity Returns, Cross-Sectional Asset Pricing, Risk-Neutral Variance, Idiosyncratic Volatility, Equity Options

JEL Classification: G11, G12, G13

Suggested Citation

Martin, Ian and Wagner, Christian, What is the Expected Return on a Stock? (March 5, 2018). Available at SSRN: https://ssrn.com/abstract=2771464 or http://dx.doi.org/10.2139/ssrn.2771464

Ian W. R. Martin

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/martiniw/

Christian Wagner (Contact Author)

Copenhagen Business School ( email )

Department of Finance
Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

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