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What is the expected return on a stock?

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  • Martin, Ian
  • Wagner, Christian

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.

Suggested Citation

  • Martin, Ian & Wagner, Christian, 2016. "What is the expected return on a stock?," LSE Research Online Documents on Economics 118957, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:118957
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    File URL: http://eprints.lse.ac.uk/118957/
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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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