What is the Expected Return on a Stock?

Abstract

We derive a formula for 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 that of the average stock. These quantities can be computed from index and stock option prices; the formula has no free parameters. The theory performs well empirically both in and out of sample. Our results suggest that there is considerably more variation in expected returns, over time and across stocks, than has previously been acknowledged.

Stock return expectations in the credit market

“…We build our approach on a model suggested by Martin and Wagner (2016) that links stock return expectations and risk-neutral idiosyncratic (or rather individual) stock return variances (SVIX indexes). While Martin and Wagner (2016) uses option-implied variances we instead use credit default swap (CDS) implied variances backed out using the methodology described in Byström (2015Byström ( , 2016. In addition to reflecting stock market expectations among the market participants in the credit market rather than those in the equity market, our approach has the advantage of allowing for a much longer-term focus than the equity market.…”

“…In addition to reflecting stock market expectations among the market participants in the credit market rather than those in the equity market, our approach has the advantage of allowing for a much longer-term focus than the equity market. If one uses ordinary call-and put-options, like Martin and Wagner (2016), the available option maturities limit the horizon of the expectation or forecast to a maximum of twelve, or perhaps twenty-four, months. Martin and Wagner (2016), indeed, looks at horizons between one and twelve months.…”

“…If one uses ordinary call-and put-options, like Martin and Wagner (2016), the available option maturities limit the horizon of the expectation or forecast to a maximum of twelve, or perhaps twenty-four, months. Martin and Wagner (2016), indeed, looks at horizons between one and twelve months. If one instead uses credit default swaps to back out the implied stock return variances then the available horizons are much longer.…”

“…Since our approach builds directly on the theoretical results in Martin and Wagner (2016) it shares the nice feature of not relying on parameter estimations. No historical stock price-or credit spread observations are needed.…”

The Quanto Theory of Exchange Rates

“…(To streamline the discussion, this description is an oversimplification and strengthening of the condition we actually need to hold for our approach to work, which is based on a general identity presented in Result 1.) This approach has been shown by Martin (2017) and Martin and Wagner (2018) to be successful in forecasting returns on the stock market and on individual stocks, respectively.…”