On the (Im)Possibility of Estimating Expected Return from Risk-Neutral Variance

46 Pages Posted: 18 Apr 2019 Last revised: 1 Nov 2023

See all articles by Valery Polkovnichenko

Valery Polkovnichenko

Board of Governors of the Federal Reserve System

Date Written: October 31, 2023

Abstract

I investigate the possibility of estimating expected return on a stock using only risk-neutral variance of return and reach a negative conclusion. The formula is not viable because: (i) its coefficients are indeterminate;(ii) its identification rests on assumption of constant stock-specific intercepts which is rejected empirically; (iii) its approximation error, when the relative risk aversion exceeds one, has the same order of magnitude as the expected excess return it is intended to estimate; (iv) its identification requires one-factor structure (high correlation) of stocks' conditional idiosyncratic variances which is rejected empirically.

Keywords: cross-section of expected returns, risk-neutral distribution

JEL Classification: G12

Suggested Citation

Polkovnichenko, Valery, On the (Im)Possibility of Estimating Expected Return from Risk-Neutral Variance (October 31, 2023). Available at SSRN: https://ssrn.com/abstract=3357656 or http://dx.doi.org/10.2139/ssrn.3357656

Valery Polkovnichenko (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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