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

44 Pages Posted: 11 Dec 2018

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: December 2018

Abstract

We propose testing asset-pricing models using multi-horizon returns (MHR). MHR serve as powerful source of conditional information that is economically important and not data-mined. We apply MHR-based testing to linear factor models. These models seek to construct the unconditionally mean-variance efficient portfolio. We reject all state-of-the-art models that imply high maximum Sharpe ratios in a single-horizon setting. Thus, the models do a poor job in accounting for the risk-return trade-off at longer horizons. Across the different models, the mean absolute pricing errors associated with MHR are positively related to the magnitude of maximal Sharpe ratio in the single-horizon setting. Model misspecification manifests itself in strong intertemporal dynamics of the factor loadings in the SDF representation. We suggest that misspecification of the dynamics of loadings arises from the common approach towards factor construction via portfolio sorts.

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

JEL Classification: C51, G12

Suggested Citation

Chernov, Mikhail and Lochstoer, Lars A. and Lundeby, Stig, Conditional Dynamics and the Multi-Horizon Risk-Return Trade-Off (December 2018). CEPR Discussion Paper No. DP13365. Available at SSRN: https://ssrn.com/abstract=3298772

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

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

Lars A. Lochstoer

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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