Publication Type

Working Paper

Publication Date

11-2013

Abstract

This paper investigates whether return predictability can be explained by existing asset pricing models. Using different assumptions, I develop two theoretical upper bounds on the R-square of the regression of stock returns on predictive variables. Empirically, I find that the predictive R-square is significantly larger than the upper bounds, implying that extant asset pricing models are incapable of explaining the degree of return predictability. The reason for this inconsistency is the low correlation between the excess returns and the state variables used in the discount factor. The finding of this paper suggests the development of new asset pricing models with new state variables that are highly correlated with stock returns.

Keywords

Return predictability, predictive regression, stochastic discount factor

Discipline

Business Administration, Management, and Operations

Research Areas

Finance

Share

COinS