On Estimating the Expected Return on the Market: An Exploratory Investigation

Abstract

The expected return on the market is a number frequently required for the solution of many investment and corporate finance problems.However, by comparison with other financial variables, there has been relatively little academic research on estimating this expected return.The current practice for estimating the expected return on the market is to take the historical average of realized excess returns on the market and add, :It to'the current observed inte're~t: rate.While th;i:smodel does explicitly relfect the dependence of the market experience return ,on the interest rate, it does not take into account the effect of changes in the level of risk associated with the market.Three models of equilibrium expected market returns which do reflect this dependence are analyzed in this paper.Estimation procedures are derived which incorporate the prior restriction that equilibrium expected excess returns on the market must be positive.The parameters of the models are estimated using realized return data for the period 1926-1978.The principal conclusions from this exploratory investigation are: ~irst, in estimating models of the expected return on the market, the nonnegativity restriction of the expected excess return should be explicitly included as part of the specification.Second, estimators which use realized return time series should be adjusted for heteroscadasticity.