Conditional Dynamics and the Multi-Horizon Risk-Return Trade-Off
59 Pages Posted: 24 Dec 2018 Last revised: 7 Aug 2020
Date Written: January 30, 2020
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: Suggested Citation