Expected Return and Conditional Asset Pricing : A New Testing Approach

Traditional tests of conditional asset pricing models are performed under the assumption of rational expectations and presume that the use of realized returns as a proxy for expected returns is acceptable. This paper turns the tables and asks what realized returns we would observe, given the pricing model. Based on this idea, we develop a new approach for testing conditional asset pricing models. The new approach implies a testable model that links the realized returns to changes in the risk-free rates, expected dividends and risk premium. This approach is used to test the Merton (1973, 1980) model and a long-standing risk-return trade-off puzzle: the price of market risk, lambda, has often turned out to be small, even negative and often insignificant. The empirical model implied by the new approach suggests that estimating lambda requires that we take into account changes in the conditional variance and its long-term persistence. We compare the price of market risk estimates from the new and the traditional testing approaches. We use both conventional measures of variance, such as (asymmetric) GARCH estimates as well as new measures based on forward-looking option market implied volatilities and MIDAS estimation. Tests are conducted using US stock market data. The re-sults give strong support for the new testing approach; the lambda estimates from the new approach are consistently significant, positive, more stable, and higher than those estimated using the traditional approach