Asymmetric Loss Functions and the Rationality of Expected Stock Returns

45 Pages Posted: 21 Mar 2006 Last revised: 23 Dec 2019

See all articles by Kevin Aretz

Kevin Aretz

Alliance Manchester Business School

Söhnke M. Bartram

Warwick Business School - Department of Finance; Centre for Economic Policy Research (CEPR)

Peter F. Pope

Bocconi University; London School of Economics and Political Science

Date Written: October 13, 2009

Abstract

We combine the innovative approaches of Elliott, Komunjer, and Timmermann (2005) and Patton and Timmermann (2007) with a block bootstrap to analyze whether asymmetric loss functions can rationalize the S&P 500 return expectations of individual forecasters from the Livingston Surveys. Although the rationality of these forecasts has often been rejected, earlier studies rely on the assumption that positive and negative forecast errors of identical magnitude are equally important to forecasters. Allowing for homogenous asymmetric loss, our evidence still strongly rejects forecast rationality. However, if we allow for variation in asymmetric loss functions across forecasters, we not only find significant differences in preferences, but we can also often no longer reject forecast rationality. Our conclusions raise serious doubts about the homogeneous expectations assumption often made in asset pricing, portfolio construction and corporate finance models.

Keywords: financial markets, general loss functions, GMM block bootstrapping, Livingston Survey, price forecasting

JEL Classification: G11, G12, G15

Suggested Citation

Aretz, Kevin and Bartram, Söhnke M. and Pope, Peter F., Asymmetric Loss Functions and the Rationality of Expected Stock Returns (October 13, 2009). International Journal of Forecasting, Vol. 27, No. 2, pp. 413-437, April-June 2011, WBS Finance Group Research Paper No. 61, Available at SSRN: https://ssrn.com/abstract=889323 or http://dx.doi.org/10.2139/ssrn.889323

Kevin Aretz (Contact Author)

Alliance Manchester Business School ( email )

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HOME PAGE: http://www.kevin-aretz.com

Söhnke M. Bartram

Warwick Business School - Department of Finance ( email )

Coventry, CV4 7AL
United Kingdom
+44 (24) 7657 4168 (Phone)
+1 425 952 1070 (Fax)

HOME PAGE: http://go.warwick.ac.uk/sbartram/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Peter F. Pope

Bocconi University ( email )

Dept of Accounting
Milan, 20136
Italy

London School of Economics and Political Science ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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