What is the Expected Return on a Stock?

71 Pages Posted: 7 Nov 2016

See all articles by Ian Martin

Ian Martin

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

Christian Wagner

WU Vienna University of Economics and Business; Vienna Graduate School of Finance (VGSF)

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: expected returns, forecast, implied volatility, risk premia, risk-neutral variance

JEL Classification: E22, E44, G10, G12, G17, G31, G32

Suggested Citation

Martin, Ian W. R. and Wagner, Christian, What is the Expected Return on a Stock? (November 2016). CEPR Discussion Paper No. DP11608, Available at SSRN: https://ssrn.com/abstract=2865878

Ian W. R. Martin (Contact Author)

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

United Kingdom

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

Christian Wagner

WU Vienna University of Economics and Business ( email )

Welthandelsplatz 1
Vienna, Wien 1020
Austria

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

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