On the (Im)Possibility of Estimating Expected Return from Risk-Neutral Variance
45 Pages Posted: 18 Apr 2019 Last revised: 30 May 2024
Date Written: May 28, 2024
Abstract
I investigate the possibility of estimating expected return on a stock using only risk-neutral variance of return and reach a negative conclusion. The formula is not viable because: (i) its coefficients are indeterminate;(ii) its identification rests on assumption of constant stock-specific intercepts which is rejected empirically; (iii) its approximation error, when the relative risk aversion exceeds one, has the same order of magnitude as the expected excess return it is intended to estimate; (iv) its identification requires one-factor structure (high correlation) of stocks' conditional idiosyncratic variances which is rejected empirically.
Keywords: cross-section of expected returns, risk-neutral distribution
JEL Classification: G12
Suggested Citation: Suggested Citation