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

44 Pages Posted: 11 Dec 2018 Last revised: 10 Feb 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: December 2018

Abstract

We propose testing asset-pricing models using multi-horizon returns (MHR). A correctly specified stochastic discount factor prices the cross-section of returns at all horizons. We show that MHR are informative about the model's conditional implications. Different from typical conditioning variables, MHR-implied conditioning variables are endogenous to the model. Further, MHR are economically important as they explicitly test the model's ability to take present values of streams of risky cash flows that accrue at different horizons, a core concept in financial economics. 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. We find that strong and, surprisingly, pro-cyclical time-variation in the pricing kernel's factor loadings and implied prices of risk is needed to jointly price returns at multiple horizons in these models.

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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