What is the Expected Return on a Stock?

Ian Martin, Christian Wagner

Research output: Working paperResearch

Abstract

We derive a formula that expresses the expected return on a stock in terms of the risk-neutral variance of the market and the stock’s excess risk-neutral variance relative to the average stock. These components can be computed from index and stock option prices; the formula has no free parameters. We test the theory in-sample by running panel regressions of stock returns onto risk-neutral variances. The formula performs well at 6-month and 1-year forecasting horizons, and our predictors drive out beta, size, book-to-market, and momentum. Out-of-sample, we find that the formula outperforms a range of competitors in forecasting individual stock returns. Our results suggest that there is considerably more variation in expected returns, both over time and across stocks, than has previously been acknowledged.
We derive a formula that expresses the expected return on a stock in terms of the risk-neutral variance of the market and the stock’s excess risk-neutral variance relative to the average stock. These components can be computed from index and stock option prices; the formula has no free parameters. We test the theory in-sample by running panel regressions of stock returns onto risk-neutral variances. The formula performs well at 6-month and 1-year forecasting horizons, and our predictors drive out beta, size, book-to-market, and momentum. Out-of-sample, we find that the formula outperforms a range of competitors in forecasting individual stock returns. Our results suggest that there is considerably more variation in expected returns, both over time and across stocks, than has previously been acknowledged.
LanguageEnglish
Place of PublicationLondon
PublisherThe London School of Economics and Political Science, LSE
Number of pages69
StatePublished - Nov 2016
SeriesFinancial Markets Group Discussion Paper
Number760
ISSN0956-8549

Cite this

Martin, I., & Wagner, C. (2016). What is the Expected Return on a Stock? London: The London School of Economics and Political Science, LSE. Financial Markets Group Discussion Paper , No. 760
Martin, Ian ; Wagner, Christian. / What is the Expected Return on a Stock?. London : The London School of Economics and Political Science, LSE, 2016. (Financial Markets Group Discussion Paper ; No. 760).
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Martin, I & Wagner, C 2016 'What is the Expected Return on a Stock?' The London School of Economics and Political Science, LSE, London.

What is the Expected Return on a Stock? / Martin, Ian; Wagner, Christian.

London : The London School of Economics and Political Science, LSE, 2016.

Research output: Working paperResearch

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Martin I, Wagner C. What is the Expected Return on a Stock? London: The London School of Economics and Political Science, LSE. 2016 Nov.