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What is the Expected Return on a Stock?

68 Pages Posted: 28 Apr 2016 Last revised: 3 Nov 2016

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: November 2016

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 components can be computed from index and stock option prices; the formula has no free parameters. We test the theory in-sample by running panel regressions of stock returns onto risk-neutral variances. The formula performs well at 6-month and 1-year forecasting horizons, and our predictors drive out beta, size, book-to-market, and momentum. Out-of-sample, we find that the formula outperforms a range of competitors in forecasting individual stock returns. 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? (November 2016). 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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