Working Paper: NBER ID: w10406
Authors: Christopher Polk; Samuel Thompson; Tuomo Vuolteenaho
Abstract: If investors are myopic mean-variance optimizers, a stock's expected return is linearly related to its beta in the cross section. The slope of the relation is the cross-sectional price of risk, which should equal the expected equity premium. We use this simple observation to forecast the equity-premium time series with the cross-sectional price of risk. We also introduce novel statistical methods for testing stock-return predictability based on endogenous variables whose shocks are potentially correlated with return shocks. Our empirical tests show that the cross-sectional price of risk (1) is strongly correlated with the market's yield measures and (2) predicts equity-premium realizations especially in the first half of our 1927-2002 sample.
Keywords: Equity Premium; CAPM; Cross-sectional Price of Risk; Stock Return Predictability
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cross-sectional price of risk (G19) | expected equity premium (G12) |
| cross-sectional price of risk (G19) | market yield measures (E43) |
| market conditions (P42) | expected returns on equities (G12) |
| cross-sectional beta premium (C46) | future excess returns on CRSP value-weight index (G12) |
| cross-sectional price of risk (G19) | market price levels (E30) |
| cross-sectional price of risk (G19) | equity premium realizations (G12) |
| cross-sectional beta premium (C46) | predictability of returns (G17) |
| cross-sectional beta premium consistency (C46) | pricing of risk stability (G19) |