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Upper Bounds on Return Predictability

Published online by Cambridge University Press:  21 April 2017

Dashan Huang  and
Guofu Zhou
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Abstract

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Can the degree of predictability found in data be explained by existing asset pricing models? We provide two theoretical upper bounds on the R2 of predictive regressions. Using data on the market portfolio and component portfolios, we find that the empirical R2s are significantly greater than the theoretical upper bounds. Our results suggest that the most promising direction for future research should aim to identify new state variables that are highly correlated with stock returns instead of seeking more elaborate stochastic discount factors.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 52 , Issue 2 , April 2017 , pp. 401 - 425
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2017 

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