The enhanced risk premium factor model and expected returns

Javier Estrada

Abstract

ABSTRACT

The predictability of the equity risk premium is a central and controversial issue in finance. The risk premium factor model is a recent and novel approach to forecasting the equity risk premium and the level and price earnings ratio of the equity market. This paper aims to overcome the main limitation of, and therefore improve upon, this novel approach. The enhanced risk premium factor model proposed here to forecast the market return is clearly supported by the evidence. Furthermore, a model that articulates the same variables considered in the framework proposed, but that imposes no specific functional form to relate them, produces very highly correlated and unbiased forecasts of the market return.