Risk Horizon and Expected Market Returns

Abstract

This paper tackles the issue of expected market return inside an equilibrium risk-return framework that accounts of the incomplete information on returns distribution and investors' preferences. Only moments up to order four of unknown unconditional distribution can be observed, and the model does not impose that moments preference should hold. Using Chebyshev-type inequalities, an intuitive risk measure, risk horizon, is introduced with reference to the speed of convergence of an asset's mean return to its expectations. An arbitrage argument enables us to link this risk measure to the maturity of treasury securities and to calibrate the model parameters using US market data. The expected market return can be endogenously estimated inside this system. Tests of statistical and economic predictive ability for US stock excess returns provide significant evidence on the forecasting value of the estimates.