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Title: Conditional dynamics and the multi-horizon risk-return trade-off

Author(s): Mikhail Chernov, Lars Lochstoer and Stig Lundeby

Publication Date: December 2018

Keyword(s): linear factor models, multi-horizon returns and Stochastic discount factor

Programme Area(s): Financial Economics

Abstract: We propose testing asset-pricing models using multi-horizon returns (MHR). MHR effectively generate a new set of test assets that are endogenous to the model and that identify a broad set of possible conditional misspecifications. We apply MHR-based testing to prominent linear factor models and show that these models typically do a poor job of pricing longer-horizon returns, with pricing errors of similar magnitude as the risk premiums they were designed to explain. We trace the errors to the conditional factor dynamics. Explicitly incorporating factor timing in the models often makes mispricing worse, posing a challenge for future research.

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Bibliographic Reference

Chernov, M, Lochstoer, L and Lundeby, S. 2018. 'Conditional dynamics and the multi-horizon risk-return trade-off'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13365