Expected Returns and Risk in the Stock Market

58 Pages Posted: 27 Feb 2019

See all articles by Michael J. Brennan

Michael J. Brennan

University of California, Los Angeles (UCLA) - Finance Area

Alex P. Taylor

Alliance Manchester Business School

Date Written: February 9, 2019

Abstract

We present new evidence on the predictability of aggregate market returns by developing two new prediction models, one risk-based, and the other purely statistical. The pricing kernel model expresses the expected return as the covariance of the market return with a pricing kernel that is a linear function of portfolio returns. The discount rate model predicts the expected return directly as a function of weighted past portfolio returns. These models provide independent evidence of predictability, with R2 of 16-19% for 1-year returns. We show that innovations in the pricing kernel are associated with the cash flow component of the market return.

Keywords: Predictability, Expected Market Returns, Risk

JEL Classification: G12, G14

Suggested Citation

Brennan, Michael John and Taylor, Alex P., Expected Returns and Risk in the Stock Market (February 9, 2019). Available at SSRN: https://ssrn.com/abstract=3331573 or http://dx.doi.org/10.2139/ssrn.3331573

Michael John Brennan

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825 3587 (Phone)
310-206 8419 (Fax)

Alex P. Taylor (Contact Author)

Alliance Manchester Business School ( email )

Crawford House
Oxford Road
Manchester M13 9PL
United Kingdom

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