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New Forecasts of the Equity Premium

  • Christopher Polk
  • Samuel Thompson
  • Tuomo Vuolteenaho

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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10406.

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Date of creation: Apr 2004
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Publication status: published as Polk, Christopher, Samuel Thompson and Tuojmo Vuolteenaho. "Cross-Sectional Forecasts Of The Equity Premium," Journal of Financial Economics, 2006, v81(1,Jul), 101-147.
Handle: RePEc:nbr:nberwo:10406
Note: AP
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