Conditional Dynamics and the Multi-Horizon Risk-Return Trade-Off

59 Pages Posted: 24 Dec 2018 Last revised: 7 Aug 2020

See all articles by Mikhail Chernov

Mikhail Chernov

UCLA Anderson

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Stig H.R. Lundeby

Norwegian School of Economics (NHH)

Multiple version iconThere are 3 versions of this paper

Date Written: January 30, 2020

Abstract

We propose testing asset-pricing models using multi-horizon returns (MHR). MHR effectively generate a new set of test assets that are endogenous to the model and that identify a broad set of possible conditional misspecifications. We apply MHR-based testing to prominent linear factor models and show that these models typically do a poor job of pricing longer-horizon returns, with pricing errors of similar magnitude as the risk premiums they were designed to explain. We trace the errors to the conditional factor dynamics. Explicitly incorporating factor timing in the models often makes mispricing worse, posing a challenge for future research.

Keywords: multi-horizon returns, linear factor models, stochastic discount factor

JEL Classification: G12, C51

Suggested Citation

Chernov, Mikhail and Lochstoer, Lars A. and Lundeby, Stig, Conditional Dynamics and the Multi-Horizon Risk-Return Trade-Off (January 30, 2020). Available at SSRN: https://ssrn.com/abstract=3296130 or http://dx.doi.org/10.2139/ssrn.3296130

Mikhail Chernov

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Lars A. Lochstoer (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Stig Lundeby

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

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