What is the expected return on a stock?

Ian Martin and Christian Wagner have come up with something new (pdf), here is the abstract:

We derive a formula that expresses 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 the average stock. These components can be computed from index and stock option prices; the formula has no free parameters. We test the theory in-sample by running panel regressions of stock returns onto risk-neutral variances. The formula performs well at 6-month and 1-year forecasting horizons, and our predictors drive out beta, size, book-to-market, and momentum. Out-of-sample, we nd that the formula outperforms a range of competitors in forecasting individual stock returns. Our results suggest that there is considerably more variation in expected returns, both over time and across stocks, than has previously been acknowledged.

Here are some related slides; time will tell but this is possibly very important work.  And more slides, directly on this paper.

For the pointer I thank the excellent Samir Varma.

Addendum: And here are newer slides.


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