The Relation between Expected Returns, Realized Returns and Firm Risk Characteristics


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Abstract

Existing literature employs two approaches to assess the validity of alternative proxies for firm specific expected return. The first approach assesses validity by examining the association between the proxy for expected return and realized returns, while the second approach focuses on the association between the proxy and firm-specific risk characteristics (e.g. market beta). The results of these two streams of literature are mixed. We contribute to this research by investigating the reliability of the proxies for expected return employed in extant research using a two-pronged approach that includes both the association between expected and realized returns and the association between expected returns and firm-specific risk proxies. We reconcile our results to the conflicting results previously documented, and document that only two of these proxies (rDIV and rPEG) are associated with firm-specific risk characteristics in a theoretically predictable manner and provide explanatory power in a realized return analysis, after the appropriate controls are included. Finally, we provide substantial evidence that realized returns do not serve as a proxy for expected returns without including controls for expected cash flow and return news.
 
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Paolo Perego
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