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Modeling Expected Stock Returns for Long and Short Horizons

Shmuel Kandel and Robert Stambaugh

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: Expected returns over long and short horizons are modeled using two approaches: an equilibrium asset pricing model and a vector autoregression (VAR). Empirical properties of returns that are consistent with the equilibrium model’s implications include (i) an annual "equity premium" of about six percent (ii) a U-shaped pattern of autocorrelations of returns with respect to investment horizon for the R-squared in projections of stock returns on predetermined financial variables. Parameters estimated in a monthly VAR for returns and these financial variables also imply autocorrelations, R-squared values, and conditional expected returns that are close to those computed with actual long-horizon returns. Simulations indicate that such a VAR is a reasonable approximation to the equilibrium model for representing the properties short- and long-horizon returns.

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