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
Date Written: January 30, 2018
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: Suggested Citation