Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models

56 Pages Posted: 2 Jun 2016 Last revised: 28 Feb 2018

Christian Schlag

Goethe University Frankfurt - Research Center SAFE

Michael Semenischev

University of Muenster - Finance Center Muenster

Julian Thimme

Goethe University Frankfurt - House of Finance

Date Written: January 30, 2018

Abstract

In asset pricing models with state variables excess returns on arbitrary assets are typically 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 criteria for the market prices of risks a model has to satisfy to produce expected return patterns in line with the data.

Keywords: Asset pricing, cross-section of stock returns, long-run risks, predictability

JEL Classification: G12, E44, D81

Suggested Citation

Schlag, Christian and Semenischev, Michael and Thimme, Julian, Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models (January 30, 2018). Available at SSRN: https://ssrn.com/abstract=2788117 or http://dx.doi.org/10.2139/ssrn.2788117

Christian Schlag

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

Michael Semenischev

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 22854 (Phone)
+49 251 83 22690 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=2986

Julian Thimme (Contact Author)

Goethe University Frankfurt - House of Finance ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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