Predictive Regressions Based on Ex Ante Index

Futures Market Information

Junhua Zhong

JOB MARKET PAPER
November 26, 2013
Abstract
The index futures market allows for accurate measure of expected dividends from
the aggregate stock market. This paper uses the dividend information exclusively
extracted from the S&P 500 futures market to construct the implied dividend yield,
implied capital gains and novel measures of cash ow characteristics such as equity
duration and convexity as improved predictors for excess market returns. For the
period from April 1982 to December 2008, the implied dividend yield, equity du-
ration and convexity have substantial predictive power for equity premium, both
in-sample and out-of-sample, over both short- and long-horizon. The implied divi-
dend yield outperforms the historical dividend yield which has severe limitations in
forecasting returns. The equity duration and convexity negatively predict the excess
returns, which is in line with the ndings of a downward sloping term structure of
equity premium documented in Binsbergen, Brandt and Koijen (2012). Given the
insight that implied dividend yield and implied duration are actually the two dier-
ent versions of the same type of measure, this paper highlights the important role
of cash ow characteristics in the determination of time-varying expected returns.
Keywords: return predictability, index futures.
JEL Classication: G11, G12, G14, E44

Department of Financial Economics, Norwegian Business School (Email: junhua.zhong@bi.no; Tel:

0047 4641 0521). I am grateful to Richard Priestley, Ilan Cooper, Paulo Maio, Amit Goyal, Bruno
Gerard, Chunyu Yang, and Benjamin Holcblat for valuable comments. I would like to thank my dis-
cussant Bjrn Hansson and participants at NFN Research Workshop (Oslo, 2012), Second International
Conference on Futures and Derivative Markets (Beijing, 2013), and BI CAPR brown bag seminar for
helpful comments and suggestions. I am also grateful for Robert Bliss for providing some of the data
used in this study.
1 Introduction
Whether equity returns are predictable is one of the most debated issues in the nance
literature. More and more empirical ndings of return predictability suggest that the ex-
pected rate of equity return is time-varying (for example, Lettau and Ludvigson (2001),
Cooper and Priestley (2009) and Maio (2012)). This research often adopts a direct way
of testing time-varying expected returns, i.e., by explicitly forecasting excess returns
with predetermined conditioning variables.
Recent research ferrets out new powerful predictors which are based on solid the-
oretic models (Cooper and Priestley (2009)) or better characterize investors behavior
in reality (Maio (2012)). One variation of these attempts is to forecast the returns (or
return volatility) by exploring the forward-looking information from derivative markets.
This methodology has been gradually adopted in the literature of predictive regressions.
1
In particular, information on expected aggregate dividends can be extracted from in-
dex derivatives prices. This is because pay-os of options contracts are based on the
ex-dividend prices. If the pricing of index futures and options are correct, they should
reect the expected aggregate dividend growth suciently well. Since the index futures
and option markets are highly liquid, the information about market-anticipated divi-
dend growth and the future expected return is quickly impounded into the futures and
option prices. Therefore, index derivatives prices provide a convenient way of uncovering
the expected dividends for the aggregate market. For example, Binsbergen, Brandt and
Koijen (2012) use the put-call parity ensured by the absence of arbitrage opportunities
and data from index options markets to uncover the prices of the short-term asset (dis-
counted value of short term dividend ows) from the aggregate stock market. They nd
that the term structure of equity premium is downward-sloping. They also suggest to
create the same type of short-term assets by using futures contracts. As an implemen-
tation, Buraschi and Carnelli (2012) construct short term expected risk premium from
dividend prices implied by index futures.
1
For example, Hong and Yogo (2012) show that movements in commodity market open interest
predict commodity returns, bond returns and even movements in the short rate. Giamouridis and
Skiadopoulos (2009) provide a survey for this approach to measurement.
1
This paper generalizes the methodology represented by Binsbergen, Brandt and
Koijen (2012) to allow for justiable measures of expected market capital return and
aggregate dividend payment. The primary impetus is to decompose the excess stock
market return for a given holding period into two components: the dividend yield and
the capital gains, assuming lump-sum dividends payment from the market index port-
folio. Then I implement the change of numeraire method to get their counterparts
under an equivalent forward measure. I show that under the appropriate forward mea-
sure, the forward price of the dividend yield can be precisely replicated by discount
bonds and the forward price of a given market portfolio. By taking advantage of this
property, expected return components, such as the implied dividend yield (IDY) and
implied capital gains (ICG), can be imputed from the data of both index futures prices
and forward interest rates. By feeding the IDY and ICG into the predictive regressions,
I nd that IDY is a reliable predictor of future returns for both short- and long-horizons.
Encompassing tests also show that IDY has superior predictive performance relative to
competing variables such as the historical dividend price ratio, earnings price ratio and
term spreads. However, ICG has rather poor predictive power for future returns.
Moreover, the framework proposed in this paper also allows for imputing the accu-
mulative value of dividend strips over any given horizon. Measure of cash ow charac-
teristics of the aggregate equity market for dierent horizons, such as modied duration
(DUR) and convexity (CON), can therefore be obtained by interpolating the dividend
ows implied from the futures market, if the terminal payment (spot price at the end
of the holding period) is regarded as another form of cash ow. These measures of cash
ow characteristics are novel in that they are hardly paid attention to in the context of
equity market, as opposed to the xed income asset markets where the notion of dura-
tion and convexity are widely adopted. I nd out that the duration and convexity for
the aggregate market negatively predict the expected returns, which is in line with the
downward sloping term structure of expected returns found by Binsbergen, Brandt and
Koijen (2012). Since equity duration directly measures the timing of dividends and can
be intuitively interpreted as the rst-order eect to prices with respect to the variation
of discount rates, the empirical evidence documented in this paper provides new insights
to the time-variation of expected returns, and sheds light on the importance of cash ow
2
characteristics of equity market.
Replacing the historical dividend price ratio with implied dividend yield in return
forecasting is motivated by the limitation of historical dividend yield in predicting ex-
pected returns or dividend growth rates. Dividend growth is aected by abrupt shifts
of technology and the business cycle. It is also subject to a choice of corporate pol-
icy. For example, Chen, Da and Priestley (2012) show that dividend smoothing due
to management decision profoundly reduces the dividend growth predictability in the
postwar period. Their nding provides a sound explanation for the inability of historical
dividend price ratio in predicting dividend growth rates which is one of two components
of dividend price ratio. More importantly, the predictive power of historical dividend
price ratio is hampered by its intrinsic components. The accounting equality provided
by Campbell and Shiller (1988) indicates that the log dividend price ratio is determined
by two osetting processes: the expected dividend growth rates and the expected re-
turns. An observed log dividend price ratio is high when dividends grow slowly and/or
stock returns are expected to be high. Consistent with this interpretation, the historical
dividend price ratio per se has long been recognized as a noisy predictor for expected
returns due to the presence of time-varying expected dividend growth rates (Campbell
and Shiller (1988); Fama and French (1988); Menzly, Santos and Veronesi (2004)). This
problem is even more severe when expected returns and expected dividend growth are
positively correlated as shown in Lettau and Ludvigson (2005). To tackle this problem,
attempts have been made to adjust the historical dividend price ratio so that the com-
ponent due to expected returns can be isolated from that caused by changing forecasts
of dividend growth. For example, Lacerda and Santa-Clara (2012) use a simple average
of past dividend growth rates as a proxy for expected dividend growth rates. They
take into account the changes in forecasts of dividends when forecasting returns with
the historical dividend price ratio. The historical dividend price ratio corrected for the
variation of expected dividend growth is more volatile and has substantially improved
predictive power for returns.
By performing associated comprehensive analysis of return predictability, I show
that the risk premium is highly predictable by using the implied predictive variables,
3
both in-sample and out-of-sample. In particular, the implied variables have better per-
formance in long-horizon regressions than the popular competing explanatory variables.
The empirical results in this paper survive through a battery of tests, in light of the
concern on the strength of the statistical evidence on return predictability. For ex-
ample, Goyal and Welch (2008) among many others cast doubts on the credibility of
return predictability ndings. The main concern is that many apparently promising
predictors are unable to beat a naive historical-mean model out-of-sample. Predictive
models require out-of-sample validation. Furthermore a lot of predictive variables are
subject to the criticism that they are spurious due to the possibility of data-mining.
In-sample estimates are instable indicating that there is no return predictability during
some particular data periods, i.e., sample period matters for the evidence on return
predictability. Financial variables such as the dividend price ratio and value factors are
found to have long term predictability for the equity returns. Return predictability over
long horizon is still questionable since long-horizon coecients are biased (Boudoukh,
Richardson and Whitelaw (2008)).
What can we gain from using IDY instead of the conventional historical dividend
price ratio? Why is IDY a better predictor than the historical one? An interpretation
to IDY which does not apply to the historical dividend price ratio is that IDY in fact
measures the ratio of present value of short-term dividend strips over the present value
of entire dividend strips innitely into the future. The higher IDY, the higher the por-
tion of dividends on S&P 500 to be realized in the immediate future. In this paper,
I show that the reciprocal of IDY essentially measures the Macaulay duration of the
market asset, since the price/dividend ratio is the measure of Macaulay duration based
on Gordons constant growth model. The point estimates in this paper indicate that the
higher the sensitivity of market price to discount rates, the lower the expected return
there would be.
The main contributions in this paper have the following three aspects: (1) The
framework proposed in this paper generalizes the methodology which utilizes the infor-
mation in derivatives market to analyze the aggregate equity returns. The IDY and
ICG calculated from index futures prices and treasury bond yields are shown to be
4
unbiased estimates for the dividend yield and capital gains of the same holding period
under some forward measure. Within this framework, not only the dividend yield but
also the capital gains can be implied from the observable futures prices. (2) The cash
ow characteristics, such as modied duration and convexity calculated from imputed
dividend ows are shown to have signicant predictive power for total returns especially
over long horizons. (3) I also show that ignoring the risk premium components and
naively using the futures price as the measure of market-anticipated future spot price
tends to underpredict the future capital returns.
My framework is dierent from Golez (2012) who also utilizes the dividends implied
from index derivatives markets to predict market returns. The construction of predictive
instruments in this paper only requires the data on index futures prices and bond yields.
Golez (2012) shows that market returns are strongly predictable by historical dividend
price ratio corrected by implied dividend growth rates to account for the variation of ex-
pected dividend growth rates. However, the predictability documented in Golez (2012)
depends heavily on the simultaneous use of options and futures in estimating the im-
plied dividend growth rates. That is, information about dividends in his paper can be
useful for predicting returns on the underlying asset only if markets are suciently inte-
grated. Even though extraction of implied dividends simultaneously from index options
and futures can circumvent the use of proxies for the implied interest rates, it leads to
a shorter data period and introduces more noise to the measure of forward rates, and
is therefore redundant and inecient. To the contrary, using treasury bond yields data
has several advantages: (1) It ensures a comprehensive data period which covers all his-
torical data of S&P 500 futures prices (prior to year 2009); (2) The treasury bond yields
are obtained from highly liquid U.S. bonds market, therefore more accurate than the
implied interest rates; (3) The usage of bond yields can be rigorously justied within the
algebraic framework in this paper. Additionally, the algebraic framework in my paper
is model-free and does not require the assumption that expected returns and expected
dividend growth rates follow a rst-order autoregressive process.
The rest of the paper is organized as follows: Section 2 presents the framework for
the risk premium decomposition. Section 3 describes the data and how the proposed
5
predictive instruments are constructed. Section 4 discusses and evaluates the estimation
results for predictive regressions. Section 5 concludes.
2 Decomposition of equity risk premium
In this section, I show that under some appropriate forward martingale measure, the
equity premium can be decomposed precisely into two components: one for the capital
gains and the other for dividend yield. The assumption required is merely that the
dividends from holding the S&P 500 index portfolio are reinvested at forward rates and
paid out to investors in a lump-sum manner at the end of the given holding period.
Importantly, the variables that replicate these two components are all observable from
the derivatives markets for the S&P 500 index and the treasury bond market. This
determines the appropriate predictive instruments in Section 3.
2.1 Notation and settings
Consider an arbitrary multi-period setting from time t to T. The terminal of a time
horizon, tagged by T, is the maturity date of a particular future contract, t +n, where
n is the time to maturity. An investor carries out a strategy of buying a share of S&P
500 index portfolio at spot price S
t
and selling the underlying asset at time t + n. He
receives cash at amount of S
t+n
plus the dividends D
t+n
. Even though in practice, the
S&P 500 pays dividends almost continuously, in the setting of this paper, the dividend
ows are assumed to arrive at the end of the holding period in a lump-sum manner.
D
t+n
represents the cumulative value of the dividends paid out on the portfolio during
the period, assuming it is reinvested at the forward rate of interest from the date of
payout until time t + n.
2
The dividend payout is still stochastic because the amount,
its timing, and the reinvestment rate are all uncertain as of time t. By imposing such
a restriction, the lump-sum dividends can be regarded as a contingent claim at time
2
This set-up is based on Cornell and French (1983). In their paper, the forward pricing model for
the equity index is given by (using the notation in this paper)
f(t, T) = S
t
e
r(t,T)(Tt)

_
T
t
E[D(w)]e
f(t,w,T)(Tw)
dw (1)
where E[D(w)] is the expected dividend ow conditional on all the information available at time t; the
dividend ow is stochastic but independent of the market return. f(t, w, T) is the forward rate at time
t for a loan that will be made at time w and that will mature at time T.
6
t + n. The ex-dividend price S
t+n
dened in this way only tracks the capital value of
the portfolio and it is arbitrarily separated from the dividends ows generated before
maturity for the purpose of convenience.
The savings account with a risk-free rate of return is used to relate amounts of money
available at dierent dates. In order to have one dollar in the money-market account at
time T, investors need to have
1
B
t,T
= e

_
T
t
r(s)ds
(2)
dollars in the account at time t T, assuming an instantaneously compounded risk-free
rate r(t). This discount factor is stochastic: it is not known with certainty at time t. The
price of a discount bond to mature at time T is denoted by P
t,T
. The forward interest
rates can be calculated by the prices of zero coupon bonds with dierent horizons. For
example, the forward rates between time t and T are given by the logarithm of
1
P
t,T
=
P
0,t
P
0,T
. (3)
Under the assumption of no arbitrage opportunities, there exists an equivalent mar-
tingale measure Q such that the discounted bond price process, P
t,T
/B
0,t
t T is
a Q-martingale and P
T,T
= 1 for all T > 0. In addition, the following relationship
between discount bond prices and savings account holds,
P
t,T
= E
Q
_
e

_
T
t
r(t,s)ds

t
_
= E
Q
_
1
B
t,T

t
_
(4)
where
t
represents the information set at time t.
Denote the future prices of the index with maturity at time t as F
()
t
and the
corresponding forward prices f
()
t
, = 0, 1, , n. Suppose E
Q
[|S
t+
|] < . Then the
futures price process is given by
F
()
t
= E
Q
[ S
t+
|
t
] (5)
7
namely, the futures prices are martingales under the measure Q.
3
2.2 Decomposition of excess equity returns under the forward measure
As in Ferreira and Santa-Clara (2011), the total return of the stock market index can
be decomposed into a dividend yield and a capital gains component:
1 +R
tT
= 1 +CG
T
+DY
T
=
S
T
S
t
+
D
T
S
t
. (6)
where R
tT
denotes the return obtained from time t to T, CG
T
is the capital gain,
DY
T
is the dividend yield. D
T
is the dividend per share during the return period. In
the index futures market, investors are able to observe the S
T
best anticipated by the
market in the form of futures price. Since the pay-os of futures contracts are based
on the ex-dividend price of the underlying asset, assuming the market is perfect, the
information of both the future dividend yields and capital gains can be recovered.
The following proposition derives the equivalence between the ex ante risk-neutral
expectation of the excess dividend yield and the excess capital gain and their counter-
parts under the equivalent forward measure.
Proposition 1 Assuming the dividends are paid out to the investors in a lump-sum
way at the end of holding period, T, under some forward martingale measure Q
T
, the
time t forward price of excess capital gains over period [t, T] is P
t,T

_
f
(Tt)
t
S
t
1
_
. The
forward price of the dividend yield is 1 P
t,T

f
(Tt)
t
S
t
.
Proof. Assuming the absence of arbitrage opportunities, there exists some appropriate
risk-neutral measure, Q, under which futures prices are martingales. By change of
numeraire to discount bonds that mature at time T, an equivalent probability measure
Q
T
Q can be dened by
dQ
T
dQ

t
=
1
P
t,T
B
t,T
, (7)
3
For rigorous proofs, see Filipovic (2009).
8
so that,
E
Q
t
_
1/P
t,T
B
t,T
_
= E
Q
T
t
(1). (8)
The expected excess holding period return over horizon [t, T] under Q equals one,
E
Q
t
_
S
T
+D
T
S
t
B
t,T
_
= 1. (9)
The excess total capital return under Q is given by
E
Q
t
_
S
T
S
t
B
t,T
_
=
P
t,T
S
t
E
Q
T
t
(S
T
) (10)
The forward price of the contingent claim S
T
, under the forward measure, is given by
f
(Tt)
t
= E
Q
T
t
(S
T
).
The forward price of the excess capital gains is given by
E
Q
t
_
S
T
S
t
S
t
B
t,T
_
=
P
t,T
S
t
E
Q
T
t
(S
T
) E
Q
t
_
P
t,T
P
t,T
B
t,T
_
= P
t,T
_
f
(Tt)
t
S
t
1
_
(11)
Subtracting equation(10) from equation(9) gives the expected dividend yield under
the measure Q
T
,
E
Q
t
_
D
T
S
t
B
t,T
_
= 1 P
t,T

f
(Tt)
t
S
t
(12)
The above proposition shows that the right hand sides of equation (11) and equation
(12) are the unbiased estimates for the excess capital gains and excess dividend yield
respectively. It provides a new insight to the equity premium of a given holding period.
That is, by assuming a lump-sum arrival of dividends and the absence of arbitrage, the
equity premium for a given holding period can be precisely replicated by the observable
prices (i.e. f
(Tt)
t
, P
t,T
and S
t
) from bonds and derivative markets. Moreover, they
9
can be estimated separately under the condition that there exists accordingly a forward
market for the underlying asset.
The proposition has several implications. Firstly, it justies that the value of divi-
dends in the future can be synthetically created by using forward contracts and taking
advantage of the cost-of-carry parity as suggested by Binsbergen, Brandt and Koijen
(2012)
4
. Proposition 1 indicates that if D
T
is dened to be the accumulative value of
dividend ows at the contract expiration date T, the forward price has to fall by the
time T value on the dividends that are paid over the life of the contract, so that the
following formula holds,
f
(Tt)
t
= S
t
e
_
T
t
r(t,s)ds
E
Q
T
t
(D
T
), (14)
where r(t, s) denotes the instantaneously compounded risk-free rate. This cost-of-carry
parity is no more than a future value version of equation(12), and consistent with the
same version of parity from Cornell and French (1983) (see equation (1)). To see this,
rearranging equation (14) and taking expectations of both sides under the Q-measure:
E
Q
t
_
_
D
T
S
t
e
_
T
t
r(t,s)ds
_
_
= 1 E
Q
t
_
_
f
(Tt)
t
S
t
e
_
T
t
r(t,s)ds
_
_
= 1 P
t,T

f
(Tt)
t
S
t
(15)
The last equality is due to equation (4).
The interpretation to the forward pricing formula in equation (14) is as follows: an
investor who short sells one unit of the index portfolio at S
t
, goes long in the future
market for the same unit at a delivery price of f
(Tt)
t
, and invests this amount of money
4
Binsbergen, Brandt and Koijen (2012) propose a way of synthetically creating the short-term asset
(the present value of the cash ows within some specic nite maturity) by using future contracts. Their
version of the cost-of-carry formula for equity futures is given by
P
t,T
= S
t
e
r
t,T
(Tt)
F
t,T
(13)
In fact, the price F
t,T
should be interpreted as a forward price. By accepting some specication error,
as in this paper, we can substitute the forward price with futures price, even though theoretically their
pricing formulas are dierent, reecting the fact that futures contracts are settled daily and forward
contracts are not settled until the contract matures. The main insight they exploit in their paper (as
we do in this paper) is that payos of derivatives contracts with S&P 500 index as the underlying asset
are based on the ex-dividend price, which helps to recover the present value of the short-term asset.
10
into the bond market. The investor has to return the index unit to the broker plus the
dividends generated within the period [t, T]. This self-nancing strategy should bring
about zero prot to the investor so that the cost-of-carry parity holds. The only dier-
ence between the spot-forward parity in equation (14) and the Binsbergen, Brandt and
Koijens version in equation (13) is that the latter gives the present-value of all cash
ows but the former gives the future value of the same quantities.
The implied dividend yield in equation (12) can be interpreted as the ratio of present
value of short-term dividend strips over the present value of entire dividend strips in-
nitely into the future. The higher IDY, the higher the portion of dividends on S&P
500 to be realized in the immediate future. The reciprocal of IDY essentially measures
the Macaulay duration of the market asset, as the price/dividend ratio is equivalent
to Macaulay duration based on Gordons constant growth model. Gordons constant
growth model provides a crude measure of the intrinsic value of a stock, based on a
future series of dividends that grow at a constant rate. The present value of the innite
series of future dividends can be expressed as
S
t
=
D
t+1
r g
, (16)
where D
t+1
is the expected dividend paid in one period, r is the required rate of return
and g is the constant dividend growth rate. Taking rst-order derivative with respect
to r gives the Macaulay duration which measures the sensitivity of prices to variation
of r:
DUR
Gordon
=
S
t
/S
t
r
=
S
t
D
t+1
. (17)
Note that the historical dividend yield is measured as the realized dividend as of time
t scaled by the spot price S
t
, which is not the value of the dividends to be realized one
period ahead at time t + 1. The implied dividend yield provides information on the
dividend growth rate which does not exist in the historical dividend price ratio.
Secondly, Proposition 1 also provides the unbiased estimate for excess capital gains
conditional on the information set at time t and under the risk-neutral measure. This
11
estimate allows us to examine the eects of expected dividend yields and capital gains
on the equity premia simultaneously, which is abstracted from Binsbergen, Brandt and
Koijen (2012). Binsbergen, Brandt and Koijen only focus on the dividend strips analy-
sis and do not consider the capital gains in the equity holding period return separately.
Moreover, the dividend yields and capital gains are negatively correlated, which is en-
sured by Proposition 1. That is, when the future aggregate dividend yields are high
(low), the future capital gains should be low (high), which is consistent with the nd-
ings by Malliaropulos and Priestley (2011).
3 Data and estimation strategies
Given the analytical framework in the previous section, several predictors can be con-
structed by observable futures quotes and discount bonds. I rst briey introduce the
data, then discuss the construction of relevant predictors.
3.1 Data
The daily data of future prices on the S&P 500 is from the Chicago Mercantile Exchange
(CME). The sample period is from 1982M4 to 2008M12. Futures on S&P 500 have been
traded since April 21, 1982. Initially, there are only four contracts available for trading,
with the longest horizon of only 4 quarters. From June 17, 1983, 5th and 6th contracts
began to be traded. The horizon of future contracts was gradually extended to 6 quar-
ters. On May 27, 1997, CME further extended the horizon to 2 years and there has
been as many as 8 types of contracts ever since. However, sometimes the contract with
farthest horizon is not available, which makes the data set incomplete. In this paper, I
narrow down the data set to the rst four contracts, as they are the most actively traded,
have substantial amount of open interest, and therefore ensure the most comprehensive
time series observation in the data set.
Futures prices are normally higher than the current level of the index by an amount
equal to the interest rate on risk-free securities minus the dividend yield on the in-
dex portfolio. However, it is often observed that in stock index future markets spot
12
prices rise above prices for future delivery, which is known as price backwardation or
priced at a discount. The future prices might be much lower than the fair value
calculated by current information based on interest rates and dividend ows. There-
fore, the calculated implied dividend yields shown in Section 3.2 are sometimes negative.
Figure 1 illustrates the time convention of the futures contracts. The six knots (rep-
resenting the contracts from Front to 6th) are determined by the last trading days
for the S&P 500 index futures over all horizons available at time t. Usually, the last
trading day is the third Thursday of a particular month in March, June, September
and December consecutively. For example, from June 17, 1983, the most far-reaching
last trading day is 6 quarters ahead. This horizon of 1.5 years is divided into 6 intervals
quarter by quarter. The longest maturity for all futures is time-varying and cyclical. As
we can see in Figure 1, at time t + t, the farthest last trading day is 1.5 t years
ahead. This longest maturity will be back to 1.5 years when the new sixth contracts be-
gin to be traded. Note that in the following empirical analysis, the horizons of left hand
side variables such as overlapping or non-overlapping excess stock returns and dividend
growth rates are regular, while the maturities of farthest futures contracts are irregular
and time-varying.
To deal with this time-varying maturity problem, I set the longest horizon to be 12
months and interpolate the futures prices for every month-end so that the whole spec-
trum of futures prices are available for that particular trading day
5
. To interpolate the
futures prices instead of the calculated implied dividend yields as in Golez (2012) is more
reasonable. Because the within-year dividend yields are highly seasonal, to interpolate
between quarterly implied dividend yields directly might take on the risk of smoothing
the implied dividend yields.
5
The futures prices are interpolated using the shape-preserving monotone Hermite spline interpola-
tion. Denote the vector of spot and futures prices for S&P 500 available at time t as
Z
t
:= [S
t
, F
1
t
, F
2
t
, F
3
t
, F
4
t
]
with corresponding vector of time to maturities
Y
t
:= [0, y
1
, y
2
, y
3
, y
4
],
so that futures prices for every single day are available. The interpolation yields a 2 by y
4
matrix which
contains y
4
pairs of coordinates. Both the daily term structure and future prices interpolations are not
forward-looking, ensuring that all data points are contemporaneously observable.
13
I calculate the discount bond prices based on daily un-smoothed Fama-Bliss (UFB)
term structures.
6
Using UFB not only reduces the estimation error for the interest rates
as in Golez (2012) but also helps to attain a longer data set.
7
The yield to maturity at
time t for a discount bond maturing at time T is calculated as the sum of daily UFB
forward rates during the period [t, T], which are assumed to be constant during each
and every interval.
I use the SP500 index as a proxy for the aggregate market. The monthly S&P 500
index total returns are obtained from Standard & Poors website. All returns series
in this article are simple returns rather than log stock returns, because Campbell and
Thompson (2008) nd that all return forecasts tend to underpredict returns when log
returns are used.
The dividend yields are constructed from the realized SP 500 returns with and
without dividends:
D
t,t+1
S
t
= TR
t,t+1
CG
t,t+1
. (18)
I compare the predictive performance of the implied dividend yields, capital gains, eq-
uity duration and convexity and the cost of capital to a battery of forecasting variables
that have been proposed in the past literature, including the following: Historical divi-
dend yield (ldy); The term spread (tms, dierence between the yields on long-term and
short-term Treasury securities) data is from the website of the Federal Reserve Bank of
St. Louis; Book-to-market ratio (bm) is the value-weighted average of rm-level ratio
of book value to market value for the S&P 500 rms; Stock variance (svar) is the sum
of squared daily returns on the S&P 500 index; Ination rate (in) is the change in
6
The un-smoothed Fama-Bliss term structure is constructed according to Fama and Bliss (1987),
who use an iterative method to build up the discount rate function by computing the forward rate
necessary to price successively longer maturity bonds. Bliss (1996) compares the ve term structure
estimation methods (i.e., UFB, McCulloch cubic spline, Fisher-Nychka-Zeros cubic spline, extended
Nelson-Siegel and smoothed Fama-Bliss) using the parametric and non-parametric tests and nds that
the un-smoothed Fama-Bliss does best overall.
7
Golez (2012) combines the spot-forward parity and put-call parity and estimates the implied interest
rates and dividend yields jointly. This constraint reduces his sample size to the period starting from
year 1996.
14
CPI obtained from FRED; One-month T-bill rate (tbill ); Long term bond yield (lty)
is the 30-year U.S. treasury yield from WRDS. Net equity expansion (ntis) is the ratio
of new equity issuance to the sum of new equity and debt issuance; Sentiment index
(sent) is the rst principal component of six sentiment proxies. All monthly predictors
are computed as of the end of the month. The variables listed above whose resources
are not specied are all obtained from Amit Goyals website. The sample period for all
the time series mentioned above is selected to coincide with the coverage of the UFB
forward rates, namely from 1982M4 to 2008M12.
3.2 Predictive instruments
In Proposition 1, the proposed predictors are based on the observation of the forward
price of the market portfolio. Unfortunately, the forward prices for S&P 500 index
are not readily available. One option is to back out the forward prices from S&P 500
option prices.
8
In this paper, I use the futures quotes to approximate the forward prices.
According to Proposition 1, the implied dividend yield in excess the risk-free rates is
given by
IDY
t
= 1 P
t,T
F
(Tt)
t
S
t
. (20)
while the implied dividend yield including the risk-free rates is constructed by
IDYX
t
=
1
P
t,T

F
(Tt)
t
S
t
, (21)
8
Elaborately, the present value (as for time t) of forward prices, f
(n)
t
P
t,t+n
, can be calculated from
the S&P 500 index option market by put-call parity, which is given by
c
t,t+n
p
t,t+n
+ X P
t,t+n
= f
(n)
t
P
t,t+n
(19)
where X is the strike-price. The rationale of the above parity is as follows: if in the exchange-traded
markets, pairs of puts and calls with the same strike price are traded actively for a particular maturity
date, the put-call parity can be used to estimate the forward price of the index for that maturity date.
Once the forward prices of the index for a number of dierent maturity dates have been obtained, the
term structure of forward prices can be estimated (Hull, page 354, (2012)). This series of forecast indices
capture the information for the spot index at maturity anticipated by investors. As the forecasts are
model-free (based on put-call parity as opposed to other structural models), they provide high-quality
information regarding the dividend ows from index portfolios (see Binsbergen, Brandt and Koijen
(2012) and Golez (2012)).
15
where T represents the maturity date for the contract. By spline interpolation, T could
be any month-end in one year. IDY
t
is interpreted as the implied dividends during
period [t, T] accumulated to time T scaled by spot price at time t. Likewise, the implied
capital gains in excess the risk free rate is given by
ICG
t
= P
t,T
_
F
(Tt)
t
S
t
1
_
. (22)
which is directly from equation (11). The implied capital gains including risk-free rates
is constructed by
ICGX
t
=
F
(Tt)
t
S
t
1. (23)
By doing so, I obtain 12 time series for both IDY and ICG, each corresponding to
futures contracts with maturities from 1 to 12 months.
The market anticipated dividends for any given maturity (n) can be calculated, by
interpolating futures prices and taking advantage of the spot-forward parity in Eq (14).
If the futures prices are regarded as the target prices, the implied cost of capital can
be calculated by solving the following equation:
S
t
=
n

i=1
CF
i
(1 +ICC
t
)
i
+
F
(n)
t
(1 +ICC
t
)
n
, (24)
where the expected cash ow CF
i
are calculated as
CF
1
= S
t
/P
t,t+1
F
(1)
t
(25)
CF
i
= F
(i)
t
/P
t+i,t+i+1
F
(i+1)
t
(i > 1). (26)
The implied cost of capital equates the present value of all expected future dividends to
the current spot price. It contains the pricing information about both the dividend yield
and future dividend growth. My approach to calculating the implied cost of capital is
dierent from the residual income model promoted by Pastor, Sinha and Swaminathan
(2008). They use the accounting-based rm-level cash ow information from analyst
forecasts to calculate the implied cost of capital for each rm, and value-weight them to
16
get the aggregate cost of capital, assuming that short-run earnings growth converge, in
the long-run to the growth rate of the overall economy and the economic prots on new
investments to zero in the long-run. They show theoretically that ICC is an excellent
proxy of time-varying expected returns and use it empirically to detect the intertempo-
ral asset pricing relationship between expected returns and volatility. As pointed out by
Lewellen (2010), estimates of the implied cost of capital for individual rms are likely
to be both noisy and upward biased. My approach does not rely on the assumption
about the rms future cash ows: the implied cost of capital is directly inferred from
the implied dividend yields and the target prices from the index futures market, which
relieves the concern that the assumptions are somewhat arbitrary and the analyst fore-
casts tend to be systematically upward biased.
The ex ante measure of equity duration and convexity can be obtained, as long as the
estimated cash ows (dividend ows plus the spot price in the future) are available for
desired horizons. The equity duration and convexity are dened to be the rst and the
second order of the sensitivity of stock prices to changes in discount rate. The futures
market helps prole the anticipated pay-o streams with xed maturities. The rationale
is as follows: the holding period return for a particular horizon (e.g. from time t to T)
can be regarded as an investment on a stream of dividends {D

}
T
=t
plus the terminal
payment S
T
, both of which can be estimated from the index derivatives market. The
ex ante equity duration and convexity are dened as
DUR
t
= (1 +r)
1

=t
( t) w

(27)
CON
t
= (1 +r)
2

=t
(( t)
2
+ t) w

=
CF

/(1 +r)
t
S
t
, for t < T
w
T
=
(CF
T
+F
T
)/(1 +r)
Tt
S
t
, for = T
where r is the corresponding implied cost of capital and CF
t
are computed according
to equation (26). Thus, both duration and convexity measures are based on investors
expectations embodied in the parallel shift in the expected market returns. The calcula-
tion of both the implied cost of capital and the equity duration and convexity implicitly
17
assumes that the term structure of the discount rates is at and the variation of the
discount rate is parallel.
Table 1 provides the descriptive statistics for all variables in this article. Column Z
t
reports the Phillips and Perron (1988) test of the null hypothesis of a unit-root process.
In general, the explanatory variables are required to be stationary. Predictive regres-
sions based on non-stationary variables may lead to spurious results as the potential
signicant eects could be result of some underlying trend. Column KPSS in Table 1
also reports the Kwiatkowski-Phillips-Schmidt-Shin (KPSS) test for the null hypothesis
that an explanatory variable is level or trend stationary. We can see that the KPSS
statistics for all predictive variables are signicant at the level of 5% except for duration
and convexity measured over 3-month horizon, and the term spread. This indicates
that except for DUR3, CON3 and the term spread, most of the explanatory variables
are very stationary.
Figure 2 plots four selected variables IDY, ICG, DUR and CON over 12-month hori-
zon. On the left of Panel (a), the IDY gets quite stable since year 2001. It matches quite
well the realized dividend yield, with the 12-month moving sum of dividends from S&P
500 as the nominator. Panel (b) displays the time series of calculated equity duration and
convexity for 12-month horizon. By construction, they have similar time series patterns.
Figure 3 provides the 3d-plotting of the term structure of IDY, ICG, DUR and CON.
From Panel (a), we can see that the time-variation of IDY and ICG are much higher
when increasing the horizons. Except for the very beginning of the sample period, the
term structure of IDY is quite stable over time, but not the same case for ICG which has
apparent business cycle variation. Panel (b) shows that the duration of the aggregate
market is quite stable but still has high frequency variation. When the horizon increases,
the equity duration also increases linearly, but the convexity increases in a quadratic
way, which is consistent with theoretical predictions.
18
4 Predictive regressions
In this section, I forecast the total market returns over varying horizons with the implied
predictive variables proposed in the previous section on a monthly frequency. The
baseline specication is given as
rx
h
t+1
=
h
+
h
X
t
+
t+1
(28)
where rx
h
t+1
denotes the annualized h-horizon continuously compounded excess return.
9
X
i,t
denotes the vector of one-period lagged explanatory variables. The tted value of
this regression gives the expected return conditional on X
t
.
t+1
is a zero-mean distur-
bance term.
4.1 Short-horizon predictability
I start by assessing the in-sample (IS) predictive ability of the implied variables for
single period excess stock returns (h = 1). Table 2 reports the forecast results using
one-month excess returns on the S&P 500 index. For overlapping observations (when
horizon h > 1), the asymptotic standard errors are adjusted according to Newey and
West (1994), with h 1 moving average lags. In one-period return forecast, the returns
are non-overlapping. The standard errors are only adjusted for heteroskedasticity.
The chosen horizons for all four groups of implied predictors (IDY, ICG, DUR and
CON) are 3-, 6- and 12-month.
10
The results for other competing predictors are also
reported. The estimated coecient on IDY12 is positive, consistent with the case of
historical dividend yields, implying that higher implied dividend yields predicts higher
future expected returns. The t-statistic is above 2, and the R
2
is higher than that of
the actual dividend yield, ldy. The IDY3 (with 3-month horizon) has the highest R
2
among all the predictors. Ross (2005) shows that the regression R
2
has an upper bound
R
2
r
2
f
var(m
t
), (where r
f
is the gross risk-free rate and m
t
is the pricing kernel for
a given asset pricing model). According to Ross (2005) the R
2
bound is approximately
9
Dierent from Fama and French (1988) who focus on the CRSPVW and CRSPEW returns, in this
paper, I study the predictability of excess returns based on S&P 500 and CRSPVW.
10
The 12 after notation IDY stands for the horizon over which the IDY is calculated.
19
8% for monthly returns.
11
Fama and French (1988) report monthly R
2
of 1% or less for
predictive regressions using dividend-price ratio. Zhou (2010) also nd that the monthly
R
2
statistics are less than 1% using 10 popular economic variables from the literature.
Given these upper bounds for R
2
, we can see from Table 2 that the Ross (2005)s upper
bound is not binding for the implied dividend yields, but the bounds suggested by Fama
and French (1988) is violated. In fact, the IDYs explained the variation of the monthly
risk premium from the lowest 1.53% to the highest 2.71%, which is far better than the
0.91% for historical dividend yields and 0.76% for earnings price ratio.
While we nd an important role of IDY in predicting stock returns, the implied
capital gains calculated over various horizons are not statistically signicant. This is
also the same for duration and convexity for horizons less than 12-month. However, the
duration and convexity for one-year horizon (DUR12 and CON12) negatively predict
the excess returns, and their t-statistics are larger than 2. This ndings implies that the
timing of the dividends also plays a role in the determination of the time-varying risk
premium: the higher the duration of cash ows from the aggregate market, the lower
the future expected returns.
Except for the historical dividend yields, none of other competing predictors for
comparison are statistically signicant at 5% level. Panel B of Table 2 reports the same
kind of regressions as in Panel A, except using the CRSP value-weighted index as the
proxy for aggregate market portfolio. The predictive power for both IDY12 and ldy
deteriorates although they are still signicant at the 10% level, possibly because they
both are specic for S&P 500 index. However, the implied dividend yields over 3- and
6-month horizons and the aggregate duration for 12-month horizon remain signicant
at the level of 5%.
11
In Ross (2005), an annualized risk-free rate of 3.5% and annualized standard deviation of 20% for
the U.S. aggregate stock market are used. And the upper bound on market risk aversion is set to be
ve times the observed market risk aversion on asset returns.
20
4.1.1 Correcting for nite sample biases
The inference of return predictability may critically depend on the nite sample prop-
erties of the estimator (see Stambaugh (1999), Amihud and Hurvich (2004), Lewellen
(2004)). For example, under some circumstances bias will potentially inate the t-
statistic for

h
and distort the critical values. There are two sources of small-sample
problems that aect the estimation:
1. When both the regressand and the regressors display high level of skewness and
kurtosis.
2. Or when the regressors are highly persistent and contemporaneously correlated
with the regressand (Goetzmann and Jorion (1993), Goyal and Santa-Clara (2003)).
The most popular and economically sensible predictors are in general highly persistent
(e.g., IDY12, ICG12 as in Table 1), which leads to over-rejection of the null hypothesis
of no predictability using conventional critical values. Nevertheless, Campbell and Yogo
(2006) develop a pretest to determine when the conventional t-test leads to misleading
inferences. They nd that the t-test yields valid inference for the short-term interest
rate and the long-short yield spread, since their innovation has suciently low correla-
tion with the innovation to stock returns. So the persistence does not universally induce
biases in the inferences. And one needs to be careful in choosing ecient statistical tests
to detect predictability in stock returns.
Lewellen (2004) proposes an alternative methods to correct for the nite-sample
bias associated with predictive regressions. He shows that the small-sample distribution
studied by Stambaugh (1999) and Nelson and Kim (1993) can substantially understate
in some circumstances dividend yields predictive ability.
12
He provides a test of whether
the nancial ratios can predict aggregate stock returns. The key rationale of his method
is that the slope coecient in (28) cannot be estimated independently. Rather, the
information about the persistence of the predictor should be taken into account.
12
In multivariate regressions with the dividend yield being only a member of many independent
variables, the bias can no longer be signed in all cases, as noted by Stambaugh (1999).
21
In this section, I follow Kilian (1999), Goyal and Santa-Clara (2003), Lewellen (2004),
Goyal and Welch (2008), and Maio (2012) and assume the data generating process to
be
rx
t
= +x
t1
+
1,t
(29)
x
t
= +x
t1
+
2,t
(30)
where rx
t
is the excess stock return and x
t1
is the chosen predictor. I estimate these
two models separately using the same data set. The bias-adjusted estimator for is

adj
=

( ) (31)
where the true autoregressive coecient is assumed to be approximately one ( =
0.9999).
13
The estimated and

are based on the contemporaneous model regressing

1,t
on
2,t
(residuals in (29) and (30) respectively) which takes the form of

1,t
=
2,t
+
t
. (32)
Recollecting the above terms gives the adjusted slope coecient and its standard vari-
ance as

adj
=

( 0.9999) (33)
var(

)
adj
=
2

(X

X)
1
(2,2)
(34)
where X is the data matrix associated with the predictive regression (with the rst
column being a vector of ones).
2

is the estimated variance of the random error. The

subscript (2, 2) index the element on the second row and the second column of matrix
of (unscaled) covariances of the coecients, (X

X)
1
. Under the null, the adjusted
estimator truly follows a Student t distribution with (T 3) degrees of freedom.
The fth to ninth column of Table 2 reports the bias-adjusted estimator and the
associated autoregressive coecients (

) and slope estimate of regression in Equation

13
Campbell and Yogo (2006) provide a more rigorous way to account for uncertainty about .
22
(31). It turns out that the adjusted slopes associated with IDY12 and all other vari-
ables in Panel B are smaller than the original OLS estimates in the second column. None
of the predictors in Panel B are signicant, while IDY12 is still signicant at the 5% level.
4.1.2 Multivariate regressions
In order to check if the in-sample (IS) predictability is robust to the inclusion of pre-
dictor variables that have been used in earlier work, I also run multivariate regressions,
including the 16 implied predictive variables in addition to four other commonly used
predictive variables: the term spread (tms), the one-month t-bill rates (tbill), the de-
fault spread (defspread) and the credit spread (crespread). Table 3 reports the results.
We can see that conditional on these four variables, the IDYs, DUR12, CON12 remain
signicant at the 5% level. The magnitudes of their coecients are larger in the multi-
variate regressions than in the univariate regressions. Moreover, the ICGs turn out to
be signicant as well, which does not exist in the univariate regressions.
This nding suggests that the univariate regression suers from an omitted variable
bias that lowers the marginal impact of the implied predictive instruments, consistent
with what Ang and Bekaert (2007) nd. Engstrom (2003), Menzly, Santos and Veronesi
(2004) and Lettau and Ludvigson (2005) also argue that the univariate return predictive
regressions by using only dividend yield may understate the dividend yields ability to
forecast returns. I nd that the same concern applies to the implied predictive variables
as well.
4.2 Long-horizon predictability
In this section, I investigate the predictive power of the implied variables at varying hori-
zons, following Fama and French (1988, 1989), Hodrick (1992) and Boudoukh, Richard-
son and Whitelaw (2008), among others. Regressing the long-horizon stock returns on
variables that are usually quite persistent, such as dividend yields, term structure slopes,
and credit spread, etc, gives a strong evidence of return predictability. The calculation
of the predictors are by construction specic to their horizons, so it is necessary to con-
duct long-horizon regressions.
23
I calculate the estimated standard errors according to Hodrick (1992). Hodrick
(1992) develops an alternative estimator of the spectral density evaluated at frequency
zero of w
t+k
=
t+1,t+h
x
t
, which is given by
S
0
=
h1

j=h+1
E(w
t+k
w

t+kj
) (35)
where the vector x

t
= (1, D
t
/P
t
). The alternative estimator of S
0
is
S
b
T
=
1
T
T

t=h
wh
t
wh

t
, (36)
where wh
t
=
t+1
_

h1
i=0
x
ti
_
and
t+1
is the residuals of a regression of rx
t+1
on a con-
stant, rx
t+1
=
1
+
t+1
. Hodrick (1992) shows that the alternative estimator is positive
denite which is an add-on advantage compared to its counterpart as in Hansen and Ho-
drick (1980) and has better small sample properties of test statistics. Ang and Bekaert
(2007) show that the performance of Hodrick (1992) standard errors is far superior to
the Newey-West (1987) standard errors in terms of their power. The latter deteriorates
for long horizon regressions. Therefore, Ang and Bekaert (2007) exclusively focus on
Hodrick t-statistics when they evaluate the long-horizon predictability evidence. Hence,
I also report the t-statistics corrected by standard errors of the parameters = (
h
,
h
)

following Hodrick (1992).

4.2.1 Correcting for nite sample biases
In order to account for the concern that the poor small sample properties of the esti-
mation methods and the low power of tests undermine the long-horizon predictability
of excess returns, I also adjust the estimated coecients and provide their empirical
correspondents by using bootstrapping method. It is well known that the nite-sample
distribution of the long-horizon regression coecient and its associated t-statistic can
be quite dierent from the asymptotic distribution due to the persistent regressors and
overlapping returns (Hodrick (1992), Nelson and Kim (1993), Ang and Bekaert (2007)).
As pointed out by Cooper and Priestley (2009), this problem is particularly severe when
24
the predictor variables are scaled by price. Since the price appears in both predictive
regressions and the autoregressive model of the predictor regression, the innovations on
both regressions are highly correlated by construction. It is the case for all implied
variables constructed in the previous section.
In order to obtain an empirical distribution that better characterizes the the coe-
cient estimates of nite-sample, I follow the approach to bootstrapping in Kilian (1999),
Goyal and Santa-Clara (2003), Goyal and Welch (2008), and Maio (2012). Perform-
ing bootstrap experiment is a common way to examine the impact of the small sample
biases. As a nonparametric randomization technique, the bootstrap draws from the ob-
served distribution of the data and models the distribution of a test statistic of interest
accordingly. Under the null of no predictability (
h
= 0) and the assumption that the
persistent predictor x
t
follows an AR(1) process, the data generating process (DGP) for
bootstrapping is specied as follows:
rx
t+1,t+h
=
h
+
t+1,t+h
(37)
x
t+1
= +x
t
+
t+1
(38)
This system not only preserves the autocorrelation structure of the predictive variables,
but also preserves the cross-correlation structure of the two residuals, since the residuals
from both estimation of the excess returns and the predictor itself are allowed to be
correlated.
The restricted VAR in equation (37) and (38) is estimated by OLS using the full
sample of observations, which gives
h
, and . The residuals from the estimation are
stored for re-sampling. Pseudo-samples are constructed by drawing with replacement
from the pairs of residuals. These sample values are substituted recursively to the
following system
rx
s
t+1,t+h
=
h
+
s
t+1,t+h
(39)
x
s
t+1
= + x
s
t
+
s
t+1
(40)
25
where the up-front value
14
for the predictor, x
0
is randomly picked from one of the
observations of x
t
. Based on this simulated bivariate time series
_
rx
s
t+1,t+h
, x
s
t+1
_
10,000
s=1
,
the h-horizon predictive regression
rx
s
t+1,t+h
= a
s,h
+b
s,h
x
s
t
+
t+1,t+h
(41)
gives an empirical distribution of the regression slope estimates,
_

b
s,h
_
10,000
s=1
. This series
of estimated coecients are then used to calculate the p-value associated with the slope
estimate according to
p
empirical
=
_

_
1
10,000

10,000
s=1
1
{

b
s,h

b
h

b
s,h

b
h
}
if

b
h
0
1
10,000

10,000
s=1
1
{

b
s,h

b
h

b
s,h

b
h
}
if

b
h
< 0
, (42)
where p
empirical
actually calculates the proportion of the simulated coecients that lies
outside the interval given by (

b
h
,

b
h
) (or (

b
h
,

b
h
) if

b
h
< 0).
15
Table 4 reports long-horizon regression results in the case of the S&P 500 index
excess return. The slope estimates associated with IDYs are all positive, which is
consistent with the ndings in single-period regressions. For both IDY6 and IDY12,
the slope coecients are statistically signicant at the 5% level for horizons up to 60
months, according to the empirical p-values. The Newey-West-corrected t-statistics are
on average larger than the Hodrick (1992)s t-statistics. Except for the 24-month hori-
zon, both IDY6 and IDY12 are statistically signicant at the 5% level in terms of their
Newey-West-corrected t-statistics. This ndings are mostly the same based on Hodrick
(1992)s t-statistics. However, ICGs are only signicant based on the bootstrapped
p-values and over horizons 36- and 48-month. For the group of cash ow characteris-
tics, both DUR and CON are signicant over most horizons in terms of their empirical
p-value or t-values. Again, the exceptional case is the 24-month horizon. In terms of
Hodrick (1992)s t-statistics, only CON6 is signicant at the level of 5%.
Table 5 reports the long-horizon regression results using the popular competing vari-
14
The initial value of the simulated time series just prior to the start value of simulated predictor.
15
I bootstrap the regression coecients instead of the t-statistics as suggested by Efron and Tibshirani
(1993). An application for the latter solution is represented by Goyal and Santa-Clara (2003). For more
details on the bootstrap algorithm, see Appendix, page 7 of Maio (2012).
26
ables as predictors. Among them, ldy, ep, bm and lty, are all statistically signicant
according to their empirical p-values or Newey-West t-values. However, if we only as-
sess the predictive ability in terms of their Hodrick (1992)s t-values, all of them are not
signicant when the horizon h > 12-month. This nding indicates that the long-term
predictive ability of log-dividend yields, earnings per share, aggregate book-to-market
ratio and long-term treasury bond yields that are documented in the current literature
are actually quite limited. To the contrary, the implied variables such as IDY, DUR and
CON have robust predictive ability for the long-horizon risk premium calculated based
on S&P 500.
Table 6 reports the results for the long-horizon regressions in the case of CRSP
value-weighted excess return. Table 7 reports the same regression results except that
the predictors are changed into the popular competing predictive variables for compar-
ison. We can see that the predictive ability of implied variables (i.e., IDY, DUR and
CON) have lower forecasting power than the case in S&P 500. For horizons longer than
12-month, the forecasting power deteriorates, which implies that the long-horizon pre-
dictive ability for implied variables is conned to the context of S&P 500.
4.2.2 Implied long-horizon estimates
The interpretation to the long-horizon regression results requires special treatment es-
pecially when using overlapping observations. Boudoukh, Richardson and Whitelaw
(BRW, 2008) show that if the predictor is highly persistent, under the null hypothesis of
no predictability, the coecient estimates and

R
2
are highly correlated across horizons.
Under the same hypothesis and assuming the estimators are asymptotically distributed
as multivariate normal with a mean of zero, BRW calculate the implied estimate at the
h-th horizon, given the one-period estimate

1
,
E(

h
|

1
) =
_
1 +
(1
h1
)
1
_

1
(43)
where is the autocorrelation coecient of the predictive variable. Similarly, the esti-
mates of R
2
h
at long horizons are also mechanically related with the R
2
estimate from
27
the one-period regression. BRW show that the R
2
s over long horizons are a function of
the single-period R
2
:
E(R
2
h
|R
2
1
) =
_
1 +
(1
h1
)
1
_
2
h
R
2
1
. (44)
where the subscripts h stand for horizons, R
2
1
is the Single-period R-squared.
An alternative approach to the long-horizon predictive regressions is based on Ho-
drick (1992), who shows that the implied long-horizon eects of the predictor on excess
returns can be obtained by estimating a rst-order vector autoregression (VAR). The
advantage of Hodrick (1992)s framework is that it can circumvent the small-sample
biases associated with the long-horizon regressions as I show in the previous subsection.
I follow Hodrick (1992), Lettau and Ludvigson (2001) and Maio (2012) by estimating
a VAR(1) given as
z
t+1
= a +Az
t
+u
t+1
(45)
where the state vector z
t
= [rx
t
, X
t
]

and X
t
is the vector of predictors. The VAR com-
pletely characterizes the autocovariances of the time series. The implicit long-horizon
statistics can be generated by iterating one-step ahead linear predictions from VAR(1),
without actually measuring data over a long horizon. The implied long-horizon statis-
tics are highly nonlinear in the underlying parameters of the VAR. The slope coecient
implied from the bivariate VAR is given by
(h) =
e1

[C(1) + +C(h)]e2
e2

C(0)e2
(46)
where e1 = (1, 0)

and e2 = (0, 1)

are the indicator vectors. The unconditional variance

of the z
t
process is C(0) =

j=0
A
j
V A
j

, where V = E(u
t+1
u

t+1
). In the calculation,
I approximate the innite sum in C(0) with h = 400. The variance of the sum of h
28
consecutive z
t
s is given by
V
h
= hC(0) +
h1

j=1
(h j)[C(j) +C(j)

],
where C(j) = A
j
C(0). Therefore, the implied ratio of the explained variance of the
predictor to its total variance is given by
R
2
(h) = (h)
2
_
e2

C(0)e2
e1

V
h
e1
_
(47)
Table 8 reports the implied long-horizon estimation results, including the implied
coecients and the R
2
calculated according to BRW (2008) and Hodrick (1992). Focus-
ing rst on IDY12, the implied estimates for the coecient from both methods increase
monotonically with the horizon. However due to the relatively low persistence for IDY12
(around 0.93), the implied R
2
exhibits a pattern of hump-shaped over the horizons and
peaks at h = 12. Compared to the actual estimates in Table 4 which increase mono-
tonically with the horizon, the pattern of the implied R
2
indicates that the observed
long-horizon predictability particularly at longer horizons are not driven by the persis-
tence of IDY12. For example, the actual R
2
at long horizon (h = 60) is approximately
30% which is much higher than the implied R
2
of 6.38% (using BRW method) or 4.25%
(using Hodricks VAR method) under the null of no predictability. Similarly, there are
dierences in the pattern of the actual and implied R
2
for the case of DUR12, and
CON12. For the cases of highly persistent predictors, ldy and ep, the implied R
2
s
are monotonically increasing and only ldys actual R
2
are higher than the implied at
long horizons (based on R
2
-BRW). For ep, the actual estimated R
2
s over long-horizons
(when h >12) are always lower than the corresponding implied R
2
s, indicating that the
predictive power of ep at long horizons are probably induced by the bias discussed in
BRW (2008).
4.3 Out of sample predictability
Incorporating the insights from Lettau and Ludvigson (2001), Goyal and Welch (2008),
Campbell and Thompson (2008), Cooper and Priestley (2009), Rapach, Strauss and
Zhou (2010) and Maio (2012) among others, I investigate the OOS predictive ability
29
associated with the implied predictive instruments for both excess returns and volatility.
Although IS tests is more powerful in detecting the existence of return predictability,
reasonable OOS performance is a necessary complement for IS performance, in that OOS
tests better mimic the behavior of a real-world investor, and work as protection against
model overtting (Lettau and Ludvigson (2010)). For example, Goyal and Welch (2008)
suggest to evaluate the performance of a given predictive model using OOS statistics.
The OOS tests are not used as a tool for detecting the evidence of return predictability,
for which the IS tests are better. Rather, OOS tests are used as an important regression
diagnostic conditional on the IS signicant model.
The OOS forecast is a recursive scheme to evaluate the predictive performance for
interested regressions. Dierent from IS forecast, OOS forecast uses only the data
available up to the time at which the forecast is made. The basic setup of OOS fore-
casting in this paper is as follows: a sample of observations {rx
t
, x

2,t
}
T
t=1
consists of a
scalar risk premium rx
t
to be predicted, as well as a (k
1
+ k
2
= k) vector of predictors
x
2,t
= (x

1,t
, x

22,t
)

, which include the constant vector. The whole sample is split into
IS portion (with R observations) and OOS portion (with L observations). Forecasts of
the risk premium (rx
t+h
, t = R, , T h) are generated using the two linear models
rx
t+h
= x

1,t

1
+ u
1,t+h
(model 1) and rx
t+h
= x

2,t

2
+ u
2,t+h
(model 2). Under the
null hypothesis of forecast encompassing, model 2 nests model 1 for all t and model 2
contains k
2
extra parameters.
The forecasts based on model 1 and 2 are generated recursively, by using the esti-
mated parameters only through time t. When data for the next period are added, both

1
and

2
are reestimated. Thus, models 1 and 2 yield two sequences of L h + 1
forecast errors, denoted as u
1,t+h
and u
2,t+h
respectively. Following the notation in
Clark and MacCracken (2005), I denote MSE
i
= (L h + 1)
1

Th
t=R
u
i,t+h
(i = 1, 2)
and specify the model 1 (the historical mean model) as benchmark, and the model 2
as the alternative model. The OOS performance is most often measured by the OOS
30
coecient of determination which is calculated as
OOS R-square: R
2
OS
= 1
MSE
2
MSE
1
(48)
The above equation describes the procedure of calculating OOS R
2
. A positive OOS R
2
means that the predictive regression has a lower prediction error than its correspond-
ing historical mean model. It represents the improvement in MSE for the predictive
regression v.s. the historical average. The OOS diagnostics should be interpreted as
follows: for a predictor with high predictive power, it should have both signicant IS
and reasonably good OOS performance over the entire sample period. Its OOS R
2
in
general has an upward drift.
4.3.1 Encompassing tests
In addition to calculating the OOS R
2
, I conduct several OOS tests as in Cooper and
Priestley (2009) and Goyal and Welch (2008). The rst is the encompassing test dis-
cussed in Clark and McCracken (2001) and Harvey, Leybourne and Newbold (1998).
I dene c
t+h
= u
1,t+h
( u
1,t+h
u
2,t+h
) and the sample average of this covariance term
c = (L h + 1)
1

Th
t=R
c
t+h
. The test statistics of the F-type encompassing test is
formed as the covariance between u
1,t+h
and u
1,t+h
u
2,t+h
scaled by the estimated
variance of one of the forecast errors:
ENC-F = (L h + 1)
c
MSE
2
, (49)
where T is the number of observations, h is the degree of overlap (h = 1 for the case
of one-period prediction). The null hypothesis is that the restricted model encompasses
the unrestricted model, which states that the unrestricted model cannot improve the
forecast based on the restricted model. The limiting distributions of this F-type test are
nonstandard when the forecasts are nested under the null.
The second test is the MSE-F test developed by Clark and McCracken (2001) and
McCracken (2007). The associated null hypothesis is that the constant expected return
31
model has a mean-squared forecasting error that is less than, or equal to that of the
time-varying expected return model. The test statistic is given as
MSE - F = (L h + 1)
_

d
MSE
2
_
(50)
where

d = MSE
1
MSE
2
is the dierence between the mean-square error from the his-
torical mean model and from the alternative predictive model. I chose to use the MSE-F
in this article following Goyal and Welch (2008), as Clark and McCracken (2001) nd
that MSE-F statistic has higher power than MSE-T. Because the sample used in this pa-
per is relatively small, and because the independent variables are often highly correlated,
I obtain empirical p-values from the bootstrap procedure as in Clark and McCracken
(2005), using the same data generating process in the previous section. For each boot-
strap, the re-samplings are conducted 1,000 time, following Kilian (1999).
Table 10 presents the OOS test results. The forecasting horizons vary from 1-, 3-
to 12-month. For the case of IDY, over all horizons, the ENC-F encompassing tests
reject the null hypothesis that the forecasts from the constant expected return model
encompass the forecasts from alternative models using IDY measured over horizons 3-,
6- and 12-month.
4.3.2 Constrained out-of-sample regressions
In this section, I show that the forecasting strategies suggested by Campbell and Thomp-
son (2008) deliver statistically and economically signicant out-of-sample gains. Camp-
bell and Thompson (2008) develop an economically motivated model restrictions and
show that sensible restrictions on forecasting models lead to signicant improvement of
out-of-sample predictability. I impose the prior restriction that the forecast risk pre-
mium can never be negative. This restriction rules out the possibility that an investor
shorts equity investment in the portfolios.
Table 10 reports the OOS R
2
, the MSE-F and ENC-F statistics when further im-
posing the prior restrictions to the risk premium predictions. For the case of IDY and
32
ICG, the constraints almost have no eect at all (the only exceptional case is IDY3, but
the magnitude is small). For the cases of DUR and CON, the constraints lead to minor
improvement in the OOS forecast performance. The OOS R
2
hardly changes from neg-
ative to positive. Hence, I come to the conclusion that the non-negative constraint to
the risk premium suggested by Campbell and Thompson (2008) does not improve the
implied explanatory variables OOS performance profoundly in this paper.
4.3.3 Utility gains
MSE is not necessarily the most relevant metric for forecast accuracy (Rapach and Zhou
(2012)). Forecast protability is a more relevant metric for assessing forecasts. In this
section, I evaluate the economic value of equity return forecasts for a risk averse in-
vestor using utility-based metrics. I compute the certainty equivalent return (CER)
for a mean-variance agent who optimally allocates across equities and risk-free assets,
using the improved forecasts. To incorporate the degree of risk aversion into the asset
allocation decision making is very important.
Following Campbell and Thompson (2008) and Ferreira and Santa-Clara (2011), the
mean-variance investors expected utility is given as
U(R
p
) = E(R
p
)
1
2
(R
p
) (51)
where R
p
is the simple return on the investors portfolio and is the investors coecient
of relative risk aversion. At the end of each month, the investor optimally allocates w
t
of the portfolio to equities during month t + 1 by following the Markowitz rule. The
weight is given as
w
p,t
=
1

_
r
t+1

2
t+1
_
, (52)
where r
t+1
is the forecast of the equity risk premium and
2
t+1
is the forecast of its
variance. The rest 1 w
t
is allocated to risk-free asset. Then at the end of period t +1,
the portfolio return is given as
R
p,t+1
= w
t
r
t+1
+ (1 w
t
)R
f,t+1
(53)
33
where R
f,t+1
denotes the risk-free rate of return. By following Campbell and Thompson
(2008), a 5-year rolling window of past monthly returns are used for the investor to es-
timate the variance of the equity risk premium. The weights w
t
are further constrained
to be between 0 and 1.5, namely, the investor is precluded from short selling and the
leverage is bounded from above at 50%.
The certainty equivalent return (CER) for the portfolio is given by
CER
p
=
p

1
2

2
p
(54)
where
p
and
2
p
are the sample mean and variance for the investors portfolio over the
forecast evaluation period. If the investor instead relies on the historical average forecast
of the equity premium, the share allocated in the equities during t + 1 is
w
0,t
=
1

_
r
t+1

2
t+1
_
. (55)
Over the forecasting period, the realized average utility is given by
CER
0
=
0

1
2

2
0
(56)
The dierence CER
p
CER
0
represents the utility gain accrued to the agent by using
the predictive regression forecast of the equity premium.
Column headed UG in Table 10 reports the utility gains when the agents coe-
cient of relative risk averse is set to ve. We can see that the utility gains are broadly
consistent with the OOS R
2
reported in the same table. All IDYs have positive utility
gains. Despite of a negative while on a boarder line OOS R
2
, the OOS forecast using
IDY3 has utility gains as high as 0.003 per month, which is the highest level for one-
period OOS forecast. To the contrary, all ICGs have non-positive utility gains. The cash
ow characteristics that are measured over relatively long horizons have higher gains in
general. In summary, the adoption of implied predictors generates sizable utility gains
from an asset allocation perspective.
34
4.3.4 Does the implied predictors perform better than the historical ones?
It is interesting to know whether the implied dividend yield can have higher predictive
ability than the historical one, which requires the comparison between two non-nested
models (with dierent predictive variables) using the same loss function. This compar-
ison of forecast accuracy is pivotal for investors.
16
I follow Diebold and Mariano (1995) and West (1996) and the relevant applications
in Lettau and Ludvigson (2001), Goyal and Welch (2008), and Maio (2012) to compute
the encompassing test statistics in the context of nonnested models. For example, for
the case of comparing ldy and IDY, the competing models can be specied as
Model 1 : rx
t,h
= a +b ldy
t1
+u
1,t+h
(57)
Model 2 : rx
t,h
= c +d IDY
t1
+u
2,t+h
(58)
The encompassing test is formed as
ENC-T =

L h + 1
c
_

S
c,c
(59)
where the sample standard errors are dened by

S
c,c
=
1
Lh+1

Th
t=R
( c
t+h
c
t+h
)
2
. The
calculation of ENC-T statistic can be simplied by nding the t-statistic corresponding
to the constant for a regression of c on a constant, as they are asymptotically equivalent.
The tests results are presented in Table 11. Three implied predictive variables,
IDY12, DUR12 and CON12, are compared to the six competing variables. Focusing on
the pair of ldy and IDY12 rst, the null hypothesis that ldy encompasses the IDY12
model cannot be rejected when the forecast horizon is 1-month. However, when the
forecast horizons are lengthen to 3- and 12-month, the null hypothesis is rejected at the
level of 1% or 5%, which suggests that IDY12 contains information that can improve the
forecast merely based on ldy. Such pattern applies to equity DUR and CON as well. The
16
As a natural competitor for ldy, the IDY12 contains the market-anticipated dividend information
12-month in the future, analogous to the nominator of ldy, which is the 12-month moving sum of the
dividends from S&P 500 market portfolios into the future.
35
case of earnings per share is somehow exceptional. Only over the 3-month horizon can
IDY12 and CON12 reject the null at the signicance level of 5%. When compared to the
Treasury bills rate, the implied predictive variables can only have additional predictive
content over the 12-month horizon. Moreover, they dominate the default spread over
all horizons.
4.4 Risk adjustment to ICG and IDY
Section 2 shows that under a particular T-forward measure, the expected excess capital
gains yield should be equal to the excess returns calculated using the forward price as
the measure of market anticipated future market index (see equation (11)). However,
to the extent that returns on index futures contract are predictable, one would make
systematic forecast errors if one used unadjusted forward-spot ratio (f
(Tt)
t
/S
t
) as the
proxy for gross capital gains (S
T
/S
t
). This type of systematic error is similar to the
case of using forward rates as the estimator of future spot rate.
17
This error can be demonstrated by the following. Denote the forward price by f
(Tt)
t
as usual. Standard no-arbitrage reasoning implies that,
E
t
_
m
T
(S
T
f
(Tt)
t
)
_
= 0, (60)
where m
T
is the stochastic pricing kernel. It simply means that the forward price is
chosen such that the present value of the forward contract is zero. Rearranging the
above equation gives
f
(Tt)
t
= E
t
(S
T
) +
cov
t
(f
(Tt)
t
, m
T
)
E
t
m
T
, (61)
which means that the forward price f
(Tt)
t
is the expectation for the future realized
value plus the risk premium. This does not indicate what the pricing kernel is.
18
The
17
For example, Piazzesi and Swanson (2008) show that failing to implement the adjustment to federal
funds rate policy forecasts can lead to substantial deviations from expectations of the subsequently
realized fed funds rate. The expectation hypothesis which claims that the expected future spot rates
under the forward martingale measure are equal to the forward rates, has been tested and rejected using
two measures of predictors (federal fund futures rates and Eurodollar futures rates), over a variety of
time periods and monetary policy regimes.
18
Under the risk-neutral measure, the pricing kernel is the bank account m
T
=
1
B
t,T
. Under the
T-forward measure, m
T
= P
t,T
, which is non-stochastic so that the risk premium component is zero.
36
pricing formula of the forward price as in equation (61) raises caveats when we use the
forward price of stock index as the proxy for the future spot price.
4.4.1 Risk-adjusted measures of capital gains return
In order to deal with this inconsistency between the estimates under the risk neutral
measure and their counterparts under the natural expectation, I risk-adjust the ratio of
the futures prices and the spot price at time t, following Piazzesi and Swanson (2008).
19
To do that, one can forecast the returns from investing in futures using kitchen sink
method, i.e., including a bunch of popular variables either nancial ratios or business
cycle variables, or both (see Goyal and Welch (2008)):
S
T
F
h
t
S
t
=
h
+
h
X
t
+
h
T
, (62)
where X
t
is a vector of variables known to nancial markets in month t, and h = T t.
Since GDP growth rate is not available at monthly frequency, and it is not a useful
variable for forecasting monthly excess returns, I use the year-on-year change in the
logarithm of U.S. nonfarm payroll employment as the main predictor. The dependent
variable is in fact the basis (dierence between the realized future spot price and the
delivery price of the forward contract) scaled by the spot price at time t.
Taking expectations of both sizes of equation (62) and solve for the expected capital
gains gives the following regression model:
E
t
_
S
T
S
t
_
=
F
h
t
S
t
+
_

h
+
h
X
t
_
. .
Adjustment
. (63)
Risk-adjusted forecasts of the capital gains adds a time-varying adjustment term to the
returns calculated based on futures price. The risk-adjusted future spot ratios are ob-
tained from expanding window OLS estimates of regression in equation (62) using only
data up through time t. The tted value of the basis at time t is computed using esti-
19
Again, here I neglect marking-to-market considerations, so that there is no dierence between futures
and forward prices. This assumption abstracts from the fact that futures contracts are marking to
market every day, based on a margin account. The dierence between a precise denition of forwards
and futures in the context of this paper is very small and does not matter for my results.
37
mated
h
and

h
. Then the risk-adjusted future spot ratios are obtained using equation
(63).
To access the predictability of the returns on futures, I rst run univariate regressions
on the variables in X
t
separately. Table 12 presents results for ve forecast horizons,
h = 1, 3, 6, 9, 12 months. The regression is run at monthly frequency, sampling the fu-
tures data on the last day of each month t. The standard error is Newey-West corrected.
To account for the small-sample distributional properties of the t-statistics, Table 12 also
reports the bootstrapped p-value for each t-statistic using 10,000 bootstrap draws fol-
lowing the procedure in section 4.2. The importance of the predictors diers in horizons.
For the one-month horizon, the importance of dividend yield (ldy), earnings price ra-
tio (ep) are more pronounced than other variables. For the intermediate horizons (6-9
months), sentiments and default spread have the highest predictive power. For the rel-
atively longer horizons (9-12 months), the term spread (tms), the employment growth
rate (nfp), and the default spread are the most important predictors.
Then I use the kitchen sink method and the expanding window OOS regressions
to get the forecasts for risk premium. In the expanding window regressions, only data
up through time t 1 is used and then I use the predictors at time t, X
t
, as the condi-
tioning variables for the forecast. These forecasts are used to make risk adjustments to
the original predictor F
h
t
/S
t
. The rst two years of observations are saved for upfront
estimation, so that the forecast errors are computed over 1984M4 - 2008M12 period.
Figure 4 plots the realized capital returns on S&P 500 over the 3-month and 12-month
horizons separately. The risk-adjusted future-spot ratios are more time-varying than
the unadjusted ratios.
The unadjusted and risk-adjusted future-spot ratios are then used to forecast the
realized capital gains over horizons from 1- to 12-month. Table 14 reports the forecast
errors (ME), root-mean-squared errors (RMSE). In Column 2, the negative ME based
on unadjusted future-spot ratios implies that it always underpredicts the realized S&P
500 capital returns. However, it is not the case for the risk-adjusted forward ratio.
The risk-adjusted future-spot ratios generate smaller ME (in absolute terms) and lower
38
RMSE, for all horizons from 1-month to 12-month. This is especially true for longer
forecasting horizons. Figure 14 plots the ME and RMSE for both the unadjusted and
risk-adjusted future-spot ratios. The RMSE for risk-adjusted ratios always lies below
the unadjusted ratios. For the average forecast errors, the unadjusted ratios lead to a
higher RMSE especially over the longer horizons (h = 10-12 months). This means that
the risk premium matters for the forward-based measures of equity returns. Ignoring
the risk premium components and naively using the futures price as the measure of
market-anticipated future spot price tends to underpredict the future capital returns.
And the forecast based on unadjusted future-spot ratios can lead to quite misleading
results.
4.4.2 Risk-adjusted measures of dividend yield
I implement the same approach to risk-adjusting the implied capital gains to the div-
idend yield, which constitutes a relatively small portion of the total returns but much
more pronounced in the return predictive exercises.
The dierence between the realized dividend yield and the implied dividend yield
(including risk-free rates) are regressed on a vector of predictors, X
t
,
D
T
S
t
IDY X
t
= a
h
+b
h
X
t
+u
h
T
, (64)
where D
T
represents the accumulated value of monthly dividends over the period [t, T]
as of time T. All cash ows are accumulated by using the corresponding risk-free rate.
Table 13 reports the univariate regression results. For the one month horizon, no pre-
dictors are statistically signicant at the level of 5%. The dierence are then estimated
recursively using the data only up through time t 1, similar to how the estimation
of expected basis is estimated. That is, in order to get the estimated dierence be-
tween the realized and implied dividend yield at time t, I rst estimate the parameters
( a
h
,

b
h
) using the observations before time t 1. Then the forecast at time t is made
by using the information at time t. In the end, a time series of the forecast of
D
T
S
t
is
39
obtained as the sum of the implied dividend yield and the estimated dierence term,
IDY X
h
t
+ a
h
+

b
h
X
t
. Figure 5 plots the realized dividend yield, the risk-adjusted and
unadjusted implied dividend yield, over horizons 3- and 12-month respectively. The
risk-adjusted dividend yield coincides more with the realized dividend yield, especially
after year 2000, when the unadjusted implied dividend yields tend to underpredict the
realized dividend yield.
Panel B of Table 14 reports the ME and RMSE by using the adjusted and unad-
justed IDYs to forecast the realized dividend yields by using OOS regression. The
corresponding plot lies in Subgure (b) of Figure 6. The risk-adjusted IDYs do not
have lower RMSE than the unadjusted IDYs for all horizons. The adjusted IDYs have
lower average dividend yield only when the forecast horizons are longer than 6 months,
and the improvement is very small in magnitude. In terms of the forecast error, the
risk adjustment to the IDY does not improve the forecast of the future dividend yield
in general. This is quite dierent from the case of ICG, in which the risk-adjusted ICG
outperforms the unadjusted ICG for all horizons to a substantial extent.
4.4.3 Forecast the total returns using risk adjusted ICG and IDY
Based on the risk-adjusted ICG and IDY obtained in the previous two subsections, I
investigate the predictability of S&P 500 total returns. The whole procedure of calculat-
ing the forecast errors, ME and RMSE, are the same as the cases of forecasting capital
returns, except that the OOS regressions are bivariate. The total returns are regressed
on the unadjusted ICG and IDY, as opposed to the risk adjusted ICG and IDY. The
forecast errors are reported in Panel C of Table 14. The corresponding plottings lie in
the third column of Figure 6. Similar to the case of forecasting capital gains, the risk-
adjusted ICG and IDY lead to lower forecast errors measured by both ME and RMSE.
Panel D presents the ME and RMSE by using the risk-adjusted IDY and ICG as
the only predictor. In Panel E, the unadjusted IDY and ICG are used for comparison.
The fourth and fth column of Figure 6 plot the corresponding forecast errors. We can
see that both the risk-adjusted IDY and ICG generate lower errors than the unadjusted
IDY and ICG. Column 4 shows that the risk-adjusted ICG generates lower errors than
40
the IDY over almost all horizons. For the unadjusted univariate predictors in Column
5, except for the horizons of 1-2 months, ICG generates lower errors than IDY.
In summary, using the futures price of market index as the market expected future
spot index directly might lead to a higher return forecast error than using the risk
adjusted ICG. However, the unadjusted IDY seems to have at least the same predictive
power as the adjusted IDY.
5 Conclusion
This paper extends the estimation method promoted in Binsbergen, Brandt and Koijen
(2012) to a general framework, so that not only the dividend yield part of the equity
premium, but also the capital gains part, can be estimated from the observations in the
index futures market. The new framework provides a novel way of measuring the aggre-
gate cash ows and market returns by using the index futures prices and unsmoothed
Fama-Bliss term structure. The notion of duration and convexity prevailing in the xed-
income analysis is extended to the aggregate equity market. Thus, the aggregate equity
duration and convexity are also constructed from the interpolated S&P 500 index fu-
tures prices and forward rates.
This paper conducts a comprehensive analysis of the forecasting ability of the four
groups of imputed predictive variables: IDY, ICG, DUR and CON. The predictive re-
gressions show that the aggregate equity total returns are highly predictable by IDY.
The predictive power of IDY dominates the power of ICG and also a battery of com-
peting predictors adopted in the conventional predictive exercises, both in-sample and
out-of-sample. When combined with the term spread (tms), the one-month t-bill rates
(tbill ), the default spread (defspread) and the credit spread (crespread), ICGs are neg-
atively related to the monthly risk premium and the slope coecients are statistically
signicant.
The cash ow characteristics for the aggregate market also have strong predictive
power for the total market return. Both equity duration and convexity negatively pre-
41
dict the risk premium, and the slope coecients are signicant over horizons from 1- to
60-month. As the equity duration measures the timing of the cash ows for the aggregate
market, the higher the duration implies more dividend payments or higher future spot
index are to be realized in the far instead of immediate future. The main implication is
that when more cash ows are postponed to the far future instead of immediate future,
the lower the risk premium there would be. As duration measures the rst order price
sensitivity with respect to the discount rates, this paper also gives support to the view
that the ultimate object of interest in the eld of asset pricing should be focusing on
prices and not only on returns (Campbell (2000), Menzly, Santos and Veronesi (2004)).
The out-of-sample analysis shows that the IDY, DUR and CON have reasonable out-
of-sample predictive ability for the equity premium relative to a simple historical mean
model over the horizons 3- and 12-month. And the out-of-sample forecasting power of
IDY, DUR and CON is economically signicant in terms of the utility gains they in-
duce. Furthermore, they encompass the historical dividend yields over the horizons 3-
and 12-month, which highlights the advantage of using the implied dividend yields as
the improved explanatory variable for equity premium forecast.
Finally, I investigate the practice of using unadjusted forward-spot ratio (f
(Tt)
t
/S
t
)
as the proxy for gross capital gains (S
T
/S
t
). I nd that to the extent that returns
on index futures contract are predictable, one would make systematic forecast errors
by using the unadjusted forward-spot ratio directly as the predictor. The expectation
hypothesis also fails in the context of equities.
42
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47
Appendix A Tables and gures
Table 1: Descriptive statistics
Item Mean SD
Skew-
ness
Kur-
tosis
Z
t
p-
value
KPSS
p-
value
Panel A
vwretd 0.01 0.04 -0.93 3.23 0.11 -16.21 0.01 0.53 0.03
mtr 0.01 0.04 -0.74 2.79 0.09 -17.22 0.01 0.73 0.01
IDY3 0.01 0.00 0.96 6.74 0.61 -11.81 0.01 3.68 0.01
IDY6 0.01 0.01 1.63 4.81 0.86 -6.78 0.01 4.04 0.01
IDY12 0.02 0.02 1.57 3.69 0.93 -4.39 0.01 4.20 0.01
ICG3 0.01 0.01 0.63 1.07 0.70 -7.75 0.01 0.87 0.01
ICG6 0.01 0.01 0.18 -0.45 0.89 -3.93 0.01 0.99 0.01
ICG12 0.03 0.02 0.10 -0.38 0.94 -2.70 0.28 0.95 0.01
DUR3 0.91 0.01 -0.27 1.98 0.14 -15.29 0.01 0.10 0.10
DUR6 1.82 0.02 0.07 0.08 0.22 -15.08 0.01 1.08 0.01
DUR12 3.62 0.03 -0.83 2.38 0.69 -10.21 0.01 3.43 0.01
CON3 0.42 0.01 -0.18 1.95 0.14 -15.28 0.01 0.05 0.10
CON6 1.67 0.03 0.19 0.08 0.20 -15.08 0.01 0.63 0.02
CON12 6.60 0.08 -0.61 1.59 0.62 -11.89 0.01 3.48 0.01
Panel B
ldy 0.03 0.01 0.77 0.12 0.98 -1.15 0.91 5.24 0.01
ep 0.06 0.02 0.97 0.92 0.97 -3.18 0.09 3.66 0.01
bm 0.38 0.21 1.50 2.46 0.97 -3.24 0.08 4.40 0.01
tms 0.02 0.01 -0.15 -1.12 0.96 -3.04 0.14 0.42 0.07
in 0.00 0.00 -1.25 7.50 0.49 -9.56 0.01 0.50 0.04
tbill 0.05 0.02 0.27 -0.08 0.97 -3.27 0.08 4.12 0.01
lty 0.07 0.02 0.83 0.03 0.97 -3.97 0.01 5.67 0.01
ntis 0.01 0.02 -0.53 0.12 0.97 -2.07 0.55 0.74 0.01
sent 0.27 0.65 1.11 0.67 0.97 -2.51 0.36 0.94 0.01
This table presents descriptive statistics for the forecasting variables and market returns considered in the
paper. Panel A reports the implied variables. Panel B reports some of the competing variables in the current
literature. The mean, standard deviations (SD), skewness, and kurtosis are reported for every variable, as well
as the rst-order sample autocorrelation coecients (). The 7th and 8th columns report the Z
t
test statistic
for the Phillips and Perron unit root test (The estimated regression takes the form of x
t
= +x
t1
+u
t
. The
null hypothesis is x
t
= x
t1
+ u
t
. The critical values corresponding to p-values of 0.01, 0.025, 0.05 and 0.10
are -3.46, -3.14, -2.88, -2.57, respectively) and the associated MacKinnon approximate p-value (see Phillips and
Perron (1998) and MacKinnon (1994)). The stationarity test is the Kwiatkowski-Phillips-Schmidt-Shin (KPSS)
test for the null hypothesis that x
t
is level or trend stationary. The KPSS test statistics and the corresponding
p-values are reported in the last two columns. All data are on monthly frequency, spanning the time period
1982M4 - 2008M12.
48
Table 2: One-period excess return predictability
Panel A t R
2

adj
t
adj
p
adj


IDY3 1.52 2.61 2.71 1.77 3.66 0.00 0.61 0.63
IDY6 0.81 2.35 2.14 0.70 2.44 0.02 0.86 -0.79
IDY12 0.36 2.14 1.53 0.29 2.03 0.04 0.93 -0.91
ICG3 -0.52 -1.04 0.17 -0.49 -1.16 0.25 0.71 0.12
ICG6 -0.17 -0.60 -0.17 -0.06 -0.25 0.81 0.90 1.07
ICG12 -0.05 -0.37 -0.27 -0.01 -0.07 0.94 0.96 1.05
DUR3 -0.12 -0.76 -0.18 -0.44 -2.36 0.02 0.14 -0.37
DUR6 -0.23 -1.74 0.48 -0.43 -2.98 0.00 0.22 -0.26
DUR12 -0.24 -2.46 1.96 -0.25 -2.84 0.00 0.69 -0.03
CON3 -0.11 -0.64 -0.22 -0.44 -2.14 0.03 0.14 -0.38
CON6 -0.10 -1.40 0.16 -0.20 -2.42 0.02 0.20 -0.12
CON12 -0.08 -2.27 1.53 -0.08 -2.67 0.01 0.62 -0.02
ldy 0.45 2.05 0.91 0.41 1.91 0.06 0.99 -3.23
ep 0.21 1.64 0.76 0.17 1.59 0.11 0.99 -5.71
bm 0.02 1.52 0.44 0.00 0.14 0.89 0.98 -1.19
tms 0.01 0.04 -0.28 -0.04 -0.24 0.81 0.96 -1.34
in -0.21 -0.26 -0.26 -0.55 -0.73 0.47 0.56 -0.75
tbill 0.06 0.58 -0.16 0.06 0.64 0.52 0.99 -0.09
lty 0.07 0.67 -0.13 0.07 0.69 0.49 1.00 -1.77
ntis 0.05 0.31 -0.24 0.04 0.38 0.70 0.97 -0.06
sent -0.01 -1.30 0.27 -0.01 -1.46 0.14 0.98 -0.02
Panel B t R
2

adj
t
adj
p
adj


IDY3 1.38 2.28 2.08 1.68 3.40 0.00 0.61 0.76
IDY6 0.75 2.03 1.66 0.66 2.23 0.03 0.86 -0.62
IDY12 0.33 1.84 1.18 0.27 1.84 0.07 0.93 -0.79
ICG3 -0.60 -1.17 0.29 -0.62 -1.44 0.15 0.71 -0.07
ICG6 -0.24 -0.82 -0.04 -0.15 -0.57 0.57 0.90 0.92
ICG12 -0.10 -0.64 -0.16 -0.06 -0.40 0.69 0.96 1.00
DUR3 -0.18 -1.12 -0.02 -0.55 -2.90 0.00 0.14 -0.43
DUR6 -0.24 -1.74 0.46 -0.44 -2.94 0.00 0.22 -0.26
DUR12 -0.21 -2.03 1.37 -0.23 -2.59 0.01 0.69 -0.07
CON3 -0.18 -1.02 -0.08 -0.56 -2.68 0.01 0.14 -0.44
CON6 -0.11 -1.43 0.18 -0.21 -2.42 0.02 0.20 -0.12
CON12 -0.07 -1.82 0.96 -0.08 -2.39 0.02 0.62 -0.03
ldy 0.44 1.86 0.78 0.39 1.75 0.08 0.99 -4.32
ep 0.19 1.37 0.48 0.14 1.28 0.20 0.99 -6.12
bm 0.02 1.34 0.32 0.00 0.02 0.98 0.98 -1.18
tms 0.06 0.31 -0.26 0.02 0.09 0.93 0.96 -1.09
in -0.48 -0.56 -0.17 -0.71 -0.92 0.36 0.56 -0.52
tbill 0.02 0.21 -0.27 0.02 0.24 0.81 0.99 -0.01
lty 0.04 0.38 -0.23 0.04 0.38 0.70 1.00 -1.42
ntis 0.04 0.27 -0.25 0.04 0.38 0.71 0.97 0.06
sent -0.01 -1.45 0.47 -0.01 -1.71 0.09 0.98 -0.02
This table presents estimation results associated with the 1-month predictive regressions on the SP 500 (Panel A)
and the CRSP value weighted returns (Panel B), which are adjusted for nite-sample bias according to Lewellen
(2004). denotes the un-adjusted estimator. t is the Newey-West t-values with one lag.

adj
is the bias-adjusted
estimator. t
adj
(p
adj
) is the bias-adjusted t-value (p-value).

denotes the associated autoregressive coecients and
the slope estimate of regression in Equation (31).
49
Table 3: Monthly multivariate predictive regressions for S&P 500 excess returns
x tms tbill defspread crespread

R
2
IDY3 19.89 -2.13 -0.36 -7.36 6.02 4.10
(2.37) (-0.75) (-0.2) (-0.88) (1.71)
IDY6 15.37 -3.54 -1.65 -11.1 6.20 4.31
(2.35) (-1.09) (-0.78) (-1.34) (1.77)
IDY12 7.79 -4.03 -1.99 -11.15 6.51 3.84
(2.37) (-1.22) (-0.92) (-1.32) (1.83)
ICG3 -20.79 -2.15 4.77 -8.13 6.09 4.24
(-2.35) (-0.75) (2.45) (-0.98) (1.73)
ICG6 -15.37 -2.99 6.04 -11.53 6.30 4.26
(-2.22) (-0.93) (2.46) (-1.37) (1.82)
ICG12 -7.32 -2.51 5.43 -11.51 6.65 3.63
(-2.12) (-0.81) (2.29) (-1.33) (1.90)
DUR3 -0.87 -0.1 1.53 -2.41 6.9 1.81
(-0.47) (-0.04) (0.99) (-0.27) (1.92)
DUR6 -2.46 -0.23 1.36 -4.03 6.83 2.34
(-1.49) (-0.09) (0.86) (-0.46) (1.90)
DUR12 -3.41 -2.5 -0.29 -8.13 6.41 3.72
(-2.26) (-0.83) (-0.16) (-0.96) (1.82)
CON3 -0.77 -0.11 1.53 -2.35 6.93 1.79
(-0.39) (-0.04) (0.99) (-0.26) (1.93)
CON6 -1.09 -0.13 1.45 -3.46 6.91 2.12
(-1.23) (-0.05) (0.93) (-0.39) (1.91)
CON12 -1.05 -2.02 -0.07 -6.82 6.61 3.20
(-2.00) (-0.68) (-0.04) (-0.79) (1.86)
This table presents the multivariate predictive regression results. The excess returns on S&P 500 are regressed on
the one-month lagged implied predictive instruments (denoted by x) and four other control variables, tms, tbill,
defspread and crespread. For each regression, the coecient estimates are reported in line 1. The asympotic
Newey-West t-statistics are reported in parenthesis. The last column reports the adjusted R-square in percentage.
50
Table 4: Long-horizon regressions for the excess stock returns using implied
predictive instruments (S&P 500)
h = 3 6 12 24 36 48 60
IDY6 2.40 4.43 6.27 8.35 14.45 18.97 21.14
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (3.61) (3.48) (2.38) (1.63) (2.41) (3.13) (2.88)
t Hodrick (2.43) (2.71) (2.21) (1.61) (2.13) (2.13) (2.01)
R
2
0.06 0.10 0.10 0.09 0.18 0.25 0.28
IDY12 1.11 2.11 3.02 4.28 7.38 9.79 10.90
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (3.15) (3.08) (2.19) (1.62) (2.40) (3.17) (2.98)
t Hodrick (2.22) (2.45) (2.00) (1.56) (2.07) (2.08) (1.95)
R
2
0.05 0.09 0.09 0.09 0.19 0.27 0.30
ICG6 0.11 0.24 0.28 -1.97 -4.62 -5.12 -4.19
p [0.80] [0.72] [0.75] [0.22] [0.02] [0.01] [0.06]
t (0.16) (0.19) (0.12) (-0.43) (-0.81) (-0.82) (-0.49)
t Hodrick (0.14) (0.18) (0.11) (-0.50) (-0.89) (-0.83) (-0.63)
R
2
-0.00 -0.00 -0.00 0.00 0.02 0.02 0.01
ICG12 0.14 0.22 0.40 -0.83 -2.53 -3.00 -2.50
p [0.61] [0.57] [0.48] [0.28] [0.02] [0.00] [0.06]
t (0.38) (0.30) (0.29) (-0.31) (-0.78) (-0.84) (-0.52)
t Hodrick (0.34) (0.29) (0.29) (-0.36) (-0.83) (-0.83) (-0.65)
R
2
-0.00 -0.00 -0.00 0.00 0.02 0.02 0.01
DUR6 -0.98 -1.67 -1.67 -2.06 -3.18 -3.27 -4.11
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.01] [0.00]
t (-3.57) (-4.00) (-3.00) (-1.91) (-2.43) (-2.58) (-3.11)
t Hodrick (-3.36) (-3.56) (-2.79) (-1.93) (-2.43) (-2.03) (-2.16)
R
2
0.04 0.06 0.03 0.02 0.03 0.03 0.04
DUR12 -0.69 -1.27 -1.88 -2.59 -4.28 -5.39 -6.10
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (-3.68) (-3.64) (-2.85) (-1.82) (-2.57) (-3.27) (-3.13)
t Hodrick (-2.54) (-2.86) (-2.43) (-1.80) (-2.29) (-2.23) (-2.17)
R
2
0.06 0.09 0.10 0.09 0.18 0.23 0.26
CON6 -0.50 -0.83 -0.74 -0.92 -1.39 -1.34 -1.76
p [0.00] [0.00] [0.02] [0.06] [0.00] [0.02] [0.01]
t (-3.15) (-3.63) (-2.76) (-1.83) (-2.22) (-2.25) (-2.90)
t Hodrick (-3.12) (-3.34) (-2.75) (-1.97) (-2.48) (-1.95) (-2.15)
R
2
0.03 0.04 0.01 0.01 0.02 0.01 0.02
CON12 -0.24 -0.44 -0.66 -0.92 -1.49 -1.87 -2.14
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (-3.47) (-3.51) (-2.99) (-1.97) (-2.73) (-3.53) (-3.64)
t Hodrick (-2.55) (-2.86) (-2.49) (-1.85) (-2.29) (-2.22) (-2.18)
R
2
0.05 0.09 0.09 0.09 0.16 0.20 0.23
This table presents the results of long-horizon regressions for the excess returns on the S&P 500 market
index, using predictors IDY, ICG, DUR, CON over horizons 6 months and 12 months respectively. The
forecast horizons vary from 3-month to 5-year. For each predictor, the rst line reports the coecient
estimates, and the second line reports the p-values (in square brackets) which are calculated from a
bootstrap experiment. The third line reports the asymptotic Newey-West t-statistics (with h 1 lags).
The fourth line reports t-value calculated according to Hodrick (1992). The nal line reports the R-
squares.
51
Table 5: Long-horizon regressions for the excess stock returns using compet-
ing predictors (S&P 500)
h = 3 6 12 24 36 48 60
ldy 1.40 2.92 5.08 8.19 12.44 16.12 18.64
p [0.14] [0.02] [0.02] [0.00] [0.00] [0.01] [0.00]
t (2.66) (2.96) (2.60) (2.14) (3.00) (4.11) (4.35)
t Hodrick (2.05) (2.33) (2.17) (1.75) (1.83) (1.82) (1.85)
R
2
0.04 0.08 0.12 0.16 0.25 0.34 0.40
ep 1.05 1.93 2.89 3.57 5.23 6.60 7.24
p [0.02] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (3.49) (3.58) (3.08) (2.29) (2.92) (3.15) (3.22)
t Hodrick (2.70) (2.77) (2.36) (1.56) (1.62) (1.61) (1.62)
R
2
0.07 0.12 0.13 0.10 0.15 0.19 0.20
bm 0.08 0.16 0.25 0.33 0.48 0.64 0.76
p [0.20] [0.04] [0.02] [0.04] [0.02] [0.01] [0.00]
t (2.66) (2.93) (2.34) (1.58) (2.01) (2.72) (3.05)
t Hodrick (1.98) (2.31) (2.12) (1.41) (1.40) (1.42) (1.48)
R
2
0.04 0.08 0.10 0.09 0.12 0.18 0.23
tms -0.23 -0.14 1.54 7.13 9.73 11.01 10.58
p [0.62] [0.82] [0.06] [0.00] [0.00] [0.00] [0.00]
t (-0.46) (-0.16) (0.95) (2.14) (2.73) (3.54) (2.24)
t Hodrick (-0.42) (-0.14) (0.82) (2.19) (2.16) (2.20) (2.18)
R
2
-0.00 -0.00 0.01 0.15 0.19 0.19 0.15
in 1.60 -1.24 -5.27 -5.32 -1.32 5.32 10.87
p [0.24] [0.54] [0.10] [0.15] [0.78] [0.41] [0.17]
t (0.67) (-0.45) (-1.22) (-1.25) (-0.30) (0.88) (1.65)
t Hodrick (0.81) (-0.50) (-1.75) (-1.35) (-0.27) (0.90) (1.69)
R
2
0.00 -0.00 0.01 0.00 -0.00 -0.00 0.00
tbill 0.63 1.17 1.55 1.24 1.93 3.21 3.97
p [0.08] [0.03] [0.02] [0.20] [0.16] [0.07] [0.04]
t (2.11) (1.97) (1.60) (1.30) (1.49) (1.78) (1.78)
t Hodrick (1.99) (2.01) (1.51) (0.71) (0.82) (1.04) (1.11)
R
2
0.03 0.06 0.05 0.01 0.02 0.05 0.07
lty 0.61 1.22 2.14 3.47 4.99 6.82 7.56
p [0.04] [0.02] [0.00] [0.00] [0.00] [0.00] [0.00]
t (2.08) (2.10) (2.03) (2.39) (3.49) (3.87) (4.01)
t Hodrick (1.87) (2.06) (1.97) (1.65) (1.62) (1.66) (1.65)
R
2
0.03 0.06 0.09 0.12 0.17 0.24 0.25
ntis 0.50 1.01 1.72 2.41 2.35 3.24 3.48
p [0.07] [0.00] [0.00] [0.00] [0.01] [0.01] [0.01]
t (1.29) (1.23) (1.22) (1.41) (1.24) (0.97) (0.83)
t Hodrick (1.30) (1.35) (1.24) (1.05) (0.80) (0.98) (0.90)
R
2
0.02 0.03 0.05 0.05 0.03 0.03 0.03
sent -0.01 -0.02 -0.04 -0.06 -0.01 -0.01 -0.00
p [0.33] [0.09] [0.00] [0.03] [0.78] [0.83] [1.00]
t (-0.79) (-1.01) (-1.10) (-0.76) (-0.10) (-0.07) (-0.00)
t Hodrick (-0.66) (-0.92) (-1.13) (-0.84) (-0.10) (-0.07) (-0.00)
R
2
0.00 0.01 0.03 0.02 -0.00 -0.00 -0.00
This table presents the results of long-horizon regressions for the excess returns on the S&P 500 market
index, using competitive predictors. The forecast horizons vary from 3-month to 5-year. For each
predictor, the rst line reports the coecient estimates, and the second line reports the empirical p-
values (in square brackets) which are calculated from a bootstrap experiment. The third line reports
the asymptotic Newey-West t-statistics (with h 1 lags). The fourth line reports t-value calculated
according to Hodrick (1992). The nal line reports the R-squares.
52
Table 6: Long-horizon regressions for the excess stock returns using implied
predictive instruments (CRSPVW)
h = 3 6 12 24 36 48 60
IDY6 2.27 4.19 5.82 6.71 12.01 15.21 16.36
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (3.07) (3.01) (2.11) (1.39) (2.22) (2.89) (2.66)
t Hodrick (2.23) (2.45) (1.98) (1.25) (1.72) (1.68) (1.52)
R
2
0.05 0.09 0.08 0.06 0.15 0.21 0.22
IDY12 1.05 2.00 2.79 3.42 6.03 7.79 8.37
p [0.00] [0.00] [0.00] [0.01] [0.00] [0.00] [0.00]
t (2.70) (2.64) (1.91) (1.37) (2.17) (2.90) (2.74)
t Hodrick (2.05) (2.22) (1.79) (1.21) (1.64) (1.62) (1.46)
R
2
0.04 0.08 0.08 0.06 0.15 0.22 0.23
ICG6 -0.16 -0.24 -0.69 -3.52 -6.34 -6.38 -5.34
p [0.74] [0.70] [0.56] [0.02] [0.00] [0.00] [0.01]
t (-0.22) (-0.18) (-0.29) (-0.79) (-1.19) (-1.16) (-0.76)
t Hodrick (-0.21) (-0.17) (-0.26) (-0.85) (-1.17) (-1.00) (-0.77)
R
2
-0.00 -0.00 -0.00 0.02 0.05 0.04 0.03
ICG12 -0.02 -0.07 -0.15 -1.73 -3.49 -3.70 -3.12
p [0.94] [0.83] [0.76] [0.02] [0.00] [0.00] [0.01]
t (-0.05) (-0.09) (-0.11) (-0.67) (-1.16) (-1.19) (-0.79)
t Hodrick (-0.05) (-0.09) (-0.10) (-0.72) (-1.10) (-0.99) (-0.78)
R
2
-0.00 -0.00 -0.00 0.02 0.05 0.05 0.03
DUR6 -1.00 -1.68 -1.59 -1.75 -2.84 -2.57 -3.29
p [0.00] [0.00] [0.01] [0.02] [0.00] [0.00] [0.00]
t (-3.46) (-3.82) (-2.78) (-1.64) (-2.28) (-2.24) (-2.95)
t Hodrick (-3.35) (-3.49) (-2.56) (-1.58) (-2.11) (-1.58) (-1.68)
R
2
0.04 0.05 0.02 0.01 0.03 0.02 0.03
DUR12 -0.65 -1.18 -1.74 -2.16 -3.65 -4.37 -4.80
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (-3.04) (-3.02) (-2.47) (-1.57) (-2.37) (-2.94) (-2.87)
t Hodrick (-2.30) (-2.55) (-2.17) (-1.43) (-1.88) (-1.77) (-1.66)
R
2
0.04 0.08 0.08 0.07 0.15 0.19 0.21
CON6 -0.51 -0.84 -0.70 -0.79 -1.26 -1.05 -1.43
p [0.00] [0.00] [0.04] [0.08] [0.00] [0.06] [0.01]
t (-3.12) (-3.53) (-2.56) (-1.59) (-2.11) (-1.93) (-2.79)
t Hodrick (-3.15) (-3.32) (-2.54) (-1.63) (-2.18) (-1.51) (-1.69)
R
2
0.03 0.04 0.01 0.01 0.02 0.01 0.02
CON12 -0.22 -0.40 -0.60 -0.77 -1.26 -1.51 -1.68
p [0.00] [0.00] [0.00] [0.00] [0.00] [0.00] [0.00]
t (-2.83) (-2.85) (-2.52) (-1.68) (-2.48) (-3.13) (-3.34)
t Hodrick (-2.27) (-2.52) (-2.20) (-1.46) (-1.88) (-1.76) (-1.67)
R
2
0.04 0.07 0.07 0.07 0.14 0.17 0.19
This table presents the results of long-horizon regressions for the excess returns on the CRSP value
weighted market index, using predictors IDY, ICG, DUR, CON over horizons 6 months and 12 months
respectively. The forecast horizon varies from 3-month to 5-year. For each predictor, the rst line
reports the coecient estimates, and the second line reports the empirical p-values (in square brackets)
which are calculated from a bootstrap experiment. The third line reports the asymptotic Newey-West
t-statistics (with h 1 lags). The fourth line reports t-value calculated according to Hodrick (1992).
The nal line reports the R-squares.
53
Table 7: Long-horizon regressions for the excess stock returns using compet-
ing predictors (CRSPVW)
h = 3 6 12 24 36 48 60
ldy 1.33 2.77 4.61 6.68 10.07 12.66 14.07
p [0.22] [0.07] [0.04] [0.03] [0.00] [0.00] [0.00]
t (2.30) (2.55) (2.27) (1.81) (2.56) (3.47) (3.65)
t Hodrick (1.89) (2.12) (1.92) (1.39) (1.45) (1.41) (1.37)
R
2
0.03 0.07 0.09 0.11 0.19 0.26 0.30
ep 1.00 1.83 2.60 2.65 3.98 4.98 5.22
p [0.04] [0.00] [0.02] [0.02] [0.01] [0.01] [0.01]
t (3.09) (3.12) (2.61) (1.72) (2.25) (2.45) (2.68)
t Hodrick (2.52) (2.54) (2.09) (1.14) (1.22) (1.21) (1.15)
R
2
0.06 0.10 0.10 0.06 0.10 0.14 0.14
bm 0.07 0.15 0.24 0.28 0.38 0.50 0.57
p [0.18] [0.07] [0.07] [0.12] [0.02] [0.02] [0.01]
t (2.37) (2.66) (2.19) (1.41) (1.82) (2.46) (2.72)
t Hodrick (1.89) (2.19) (1.97) (1.13) (1.11) (1.10) (1.08)
R
2
0.03 0.07 0.09 0.07 0.09 0.14 0.17
tms -0.08 0.14 2.00 7.44 9.55 10.18 9.19
p [0.86] [0.78] [0.02] [0.00] [0.00] [0.00] [0.00]
t (-0.16) (0.15) (1.25) (2.41) (2.98) (3.84) (2.36)
t Hodrick (-0.14) (0.13) (1.02) (2.18) (2.02) (1.94) (1.81)
R
2
-0.00 -0.00 0.02 0.18 0.22 0.21 0.15
in 0.77 -2.46 -6.11 -6.84 -2.36 4.20 8.96
p [0.54] [0.22] [0.04] [0.05] [0.64] [0.40] [0.15]
t (0.32) (-0.88) (-1.34) (-1.48) (-0.52) (0.71) (1.45)
t Hodrick (0.39) (-1.00) (-2.01) (-1.72) (-0.48) (0.70) (1.39)
R
2
-0.00 0.00 0.01 0.01 -0.00 -0.00 0.00
tbill 0.51 0.95 1.13 0.35 0.81 1.86 2.39
p [0.15] [0.07] [0.14] [0.61] [0.40] [0.20] [0.18]
t (1.61) (1.48) (1.08) (0.34) (0.59) (1.07) (1.34)
t Hodrick (1.58) (1.59) (1.07) (0.20) (0.34) (0.60) (0.65)
R
2
0.02 0.04 0.02 -0.00 0.00 0.02 0.03
lty 0.53 1.08 1.81 2.60 3.73 5.13 5.41
p [0.14] [0.06] [0.02] [0.01] [0.00] [0.00] [0.00]
t (1.69) (1.71) (1.64) (1.81) (2.63) (3.14) (3.44)
t Hodrick (1.57) (1.74) (1.62) (1.21) (1.19) (1.24) (1.15)
R
2
0.02 0.04 0.06 0.07 0.11 0.17 0.17
ntis 0.51 1.06 1.82 2.43 2.16 3.13 3.43
p [0.06] [0.00] [0.00] [0.00] [0.01] [0.00] [0.00]
t (1.25) (1.26) (1.33) (1.61) (1.33) (1.15) (1.06)
t Hodrick (1.28) (1.36) (1.27) (1.04) (0.72) (0.94) (0.88)
R
2
0.01 0.03 0.05 0.05 0.03 0.04 0.04
sent -0.01 -0.02 -0.05 -0.07 -0.02 -0.02 -0.01
p [0.25] [0.09] [0.02] [0.00] [0.41] [0.56] [0.70]
t (-0.92) (-1.08) (-1.18) (-0.97) (-0.27) (-0.24) (-0.15)
t Hodrick (-0.78) (-1.00) (-1.17) (-0.97) (-0.23) (-0.18) (-0.11)
R
2
0.00 0.01 0.03 0.04 -0.00 -0.00 -0.00
This table presents the results of long-horizon regressions for the excess returns on the CRSP value
weighted market index, using competitive predictors. The forecast horizon varies from 3-month to 5-
year. For each predictor, the rst line reports the coecient estimates, and the second line reports the
empirical p-values (in square brackets) which are calculated from a bootstrap experiment. The third
line reports the asymptotic Newey-West t-statistics (with h 1 lags). The fourth line reports t-value
calculated according to Hodrick (1992). The nal line reports the R-squares.
54
Table 8: Implied long-horizon estimated coecients and R
2
from 1-month estimates
and the VAR (S&P 500)
h = 3 6 12 24 36 48 60
IDY6 BRW 2.15 3.50 4.89 5.65 5.77 5.79 5.79
VAR 2.13 3.48 4.86 5.62 5.74 5.76 5.76
R
2
BRW 5.63 7.47 7.27 4.86 3.38 2.55 2.04
R
2
VAR 4.91 6.29 5.91 3.82 2.62 1.96 1.57
IDY12 BRW 1.02 1.83 3.02 4.30 4.83 5.06 5.15
VAR 1.00 1.81 2.98 4.23 4.75 4.96 5.05
R
2
BRW 4.97 8.09 11.00 11.10 9.36 7.69 6.38
R
2
VAR 3.70 5.89 7.81 7.65 6.34 5.15 4.25
ICG6 BRW -0.29 -0.49 -0.73 -0.90 -0.94 -0.95 -0.95
VAR -0.48 -0.84 -1.28 -1.63 -1.72 -1.75 -1.75
R
2
BRW 0.14 0.20 0.22 0.17 0.12 0.09 0.07
R
2
VAR 0.43 0.58 0.65 0.53 0.39 0.30 0.25
ICG12 BRW -0.05 -0.10 -0.16 -0.24 -0.28 -0.30 -0.31
VAR -0.17 -0.32 -0.57 -0.89 -1.08 -1.18 -1.24
R
2
BRW 0.01 0.03 0.04 0.04 0.04 0.03 0.03
R
2
VAR 0.23 0.32 0.47 0.58 0.57 0.52 0.46
DUR6 BRW -0.28 -0.28 -0.28 -0.28 -0.28 -0.28 -0.28
VAR -0.30 -0.31 -0.31 -0.31 -0.31 -0.31 -0.31
R
2
BRW 0.37 0.19 0.09 0.05 0.03 0.02 0.02
R
2
VAR 0.46 0.23 0.11 0.06 0.04 0.03 0.02
DUR12 BRW -0.52 -0.69 -0.77 -0.78 -0.78 -0.78 -0.78
VAR -0.52 -0.69 -0.76 -0.77 -0.77 -0.77 -0.77
R
2
BRW 3.60 3.20 1.98 1.01 0.68 0.51 0.41
R
2
VAR 3.32 2.87 1.73 0.88 0.59 0.44 0.35
CON6 BRW -0.12 -0.12 -0.12 -0.12 -0.12 -0.12 -0.12
VAR -0.13 -0.13 -0.13 -0.13 -0.13 -0.13 -0.13
R
2
BRW 0.20 0.10 0.05 0.03 0.02 0.01 0.01
R
2
VAR 0.28 0.14 0.07 0.04 0.02 0.02 0.01
CON12 BRW -0.16 -0.19 -0.20 -0.20 -0.20 -0.20 -0.20
VAR -0.16 -0.19 -0.20 -0.20 -0.20 -0.20 -0.20
R
2
BRW 2.46 1.87 1.04 0.52 0.35 0.26 0.21
R
2
VAR 2.28 1.70 0.93 0.47 0.31 0.23 0.19
ldy BRW 1.28 2.49 4.71 8.43 11.36 13.69 15.52
VAR 1.32 2.58 4.88 8.77 11.86 14.32 16.28
R
2
BRW 3.63 6.84 12.21 19.56 23.73 25.81 26.56
R
2
VAR 0.99 1.85 3.38 5.69 7.21 8.15 8.68
ep BRW 0.94 1.80 3.29 5.57 7.15 8.24 9.00
VAR 0.89 1.73 3.25 5.77 7.70 9.19 10.34
R
2
BRW 6.68 12.21 20.50 29.38 32.27 32.18 30.70
R
2
VAR 2.57 4.85 8.74 14.26 17.56 19.35 20.14
tms BRW -0.17 -0.32 -0.56 -0.90 -1.10 -1.22 -1.29
VAR -0.12 -0.22 -0.38 -0.61 -0.74 -0.83 -0.88
R
2
BRW 0.08 0.14 0.22 0.28 0.28 0.26 0.23
R
2
VAR 0.11 0.09 0.11 0.12 0.12 0.11 0.10
This table presents simulated long-horizon slope coecients and R
2
estimates (in percentage) over horizons of h =
3, 12, 24, 36, 48, 60 months. The dependent variable is the S&P 500 equity premium. For each predictive variable,
the rst two rows ( BRW, VAR) report the implied coecients according to BRW (2006) and Hodrick
(1992) respectively. The third and fourth rows report the corresponding implied R
2
(R
2
BRW and R
2
VAR) in
percentage. The original sample spans the period from 1982M4 to 2008M12.
55
Table 9: Implied long-horizon estimated coecients and R
2
from 1-month estimates
and the VAR (CRSPVW)
h = 3 6 12 24 36 48 60
IDY6 BRW 1.97 3.21 4.47 5.17 5.28 5.30 5.30
VAR 1.98 3.25 4.54 5.26 5.37 5.39 5.39
R
2
BRW 4.53 6.01 5.85 3.91 2.72 2.05 1.64
R
2
VAR 4.01 4.95 4.61 2.99 2.05 1.54 1.23
IDY12 BRW 0.93 1.69 2.78 3.95 4.44 4.65 4.74
VAR 0.93 1.69 2.79 3.96 4.45 4.65 4.73
R
2
BRW 4.03 6.57 8.93 9.01 7.60 6.24 5.18
R
2
VAR 3.07 4.60 6.03 5.93 4.93 4.02 3.32
ICG6 BRW -0.49 -0.83 -1.23 -1.52 -1.59 -1.61 -1.61
VAR -0.70 -1.23 -1.88 -2.39 -2.52 -2.56 -2.57
R
2
BRW 0.37 0.54 0.59 0.45 0.33 0.25 0.20
R
2
VAR 1.02 1.17 1.25 0.99 0.74 0.57 0.46
ICG12 BRW -0.19 -0.34 -0.58 -0.87 -1.01 -1.08 -1.11
VAR -0.31 -0.60 -1.06 -1.66 -2.01 -2.20 -2.31
R
2
BRW 0.18 0.31 0.44 0.49 0.44 0.37 0.32
R
2
VAR 0.83 1.03 1.44 1.76 1.71 1.56 1.38
DUR6 BRW -0.28 -0.29 -0.29 -0.29 -0.29 -0.29 -0.29
VAR -0.32 -0.32 -0.32 -0.32 -0.32 -0.32 -0.32
R
2
BRW 0.37 0.19 0.09 0.05 0.03 0.02 0.02
R
2
VAR 0.68 0.33 0.16 0.08 0.05 0.04 0.03
DUR12 BRW -0.45 -0.61 -0.67 -0.68 -0.68 -0.68 -0.68
VAR -0.46 -0.62 -0.68 -0.69 -0.69 -0.69 -0.69
R
2
BRW 2.67 2.37 1.46 0.75 0.50 0.38 0.30
R
2
VAR 2.54 2.10 1.25 0.63 0.42 0.32 0.25
CON6 BRW -0.12 -0.12 -0.12 -0.12 -0.12 -0.12 -0.12
VAR -0.14 -0.14 -0.14 -0.14 -0.14 -0.14 -0.14
R
2
BRW 0.21 0.11 0.05 0.03 0.02 0.01 0.01
R
2
VAR 0.54 0.26 0.13 0.06 0.04 0.03 0.03
CON12 BRW -0.13 -0.16 -0.17 -0.17 -0.17 -0.17 -0.17
VAR -0.13 -0.17 -0.18 -0.18 -0.18 -0.18 -0.18
R
2
BRW 1.71 1.30 0.72 0.36 0.24 0.18 0.15
R
2
VAR 1.72 1.21 0.66 0.33 0.22 0.16 0.13
ldy BRW 1.22 2.37 4.48 8.03 10.83 13.04 14.79
VAR 1.25 2.46 4.66 8.37 11.31 13.65 15.51
R
2
BRW 3.16 5.97 10.65 17.07 20.70 22.51 23.16
R
2
VAR 1.02 1.57 2.74 4.58 5.81 6.58 7.01
ep BRW 0.88 1.69 3.09 5.24 6.72 7.75 8.46
VAR 0.84 1.65 3.12 5.54 7.41 8.84 9.95
R
2
BRW 5.67 10.37 17.41 24.95 27.40 27.32 26.07
R
2
VAR 2.26 3.95 7.02 11.48 14.19 15.68 16.36
tms BRW -0.03 -0.06 -0.11 -0.18 -0.22 -0.25 -0.26
VAR 0.03 0.07 0.13 0.22 0.28 0.31 0.33
R
2
BRW 0.00 0.01 0.01 0.01 0.01 0.01 0.01
R
2
VAR 0.36 0.18 0.09 0.06 0.04 0.03 0.03
This table presents simulated long-horizon slope coecients and R
2
estimates (in percentage) over horizons of h
= 3, 12, 24, 36, 48, 60 months. The dependent variable is the CRSP value-weighted equity premium. For each
predictive variable, the rst two rows ( BRW, VAR) report the implied coecients according to BRW (2006)
and Hodrick (1992) respectively. The third and fourth rows report the corresponding implied R
2
(R
2
BRW and
R
2
VAR) in percentage. The original sample spans the period from 1982M4 to 2008M12.
56
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57
Table 11: Encompassing t-tests for non-nested models
ENC - T, h = 1
ldy ep tms tbill defspread crespread
IDY12 0.009 -0.005 0.007 0.004 0.014 0.001
(1.711) (-1.029) (1.307) (0.861) (2.813) (0.190)
DUR12 0.002 -0.003 0.005 0.002 0.011 0.001
(0.500) (-0.602) (1.099) (0.349) (2.270) (0.139)
CON12 0.003 -0.003 0.005 0.002 0.012 0.001
(0.561) (-0.674) (1.052) (0.313) (2.367) (0.121)
ENC - T, h = 3
ldy ep tms tbill defspread crespread
IDY12 0.022 -0.012 0.016 0.006 0.024 0.010
(4.277) (-2.300) (3.083) (1.252) (4.685) (1.993)
DUR12 0.011 -0.010 0.012 0.003 0.019 0.009
(2.165) (-1.937) (2.331) (0.649) (3.836) (1.733)
CON12 0.010 -0.010 0.011 0.002 0.019 0.008
(1.943) (-1.985) (2.238) (0.483) (3.790) (1.625)
ENC - T, h = 12
ldy ep tms tbill defspread crespread
IDY12 0.022 0.010 0.028 0.020 0.037 0.027
(4.260) (1.931) (5.313) (3.854) (7.061) (5.094)
DUR12 0.019 0.009 0.028 0.015 0.039 0.025
(3.666) (1.674) (5.369) (2.931) (7.357) (4.821)
CON12 0.015 0.006 0.026 0.013 0.037 0.024
(2.811) (1.175) (4.984) (2.406) (6.947) (4.458)
This table reports the ENC-T test statistics in relation to the out-of-sample predictability of excess market returns
over horizons from h = 1-, 3- to 12-month. The associated asymptotic t-values are reported in parenthesis below
the ENC-T values. The forecast excess returns are on the S&P 500 index. The competing predictors are log-
dividend yields (ldy), earnings per share (ep), term spread (tms), one-month treasury bill rate (tbill), the default
spread (defspread) and the credit spread (crespread). In the OOS predictive regressions, the rst 120 months of
observations are saved for the up-front OLS regressions. For further details on the calculation of ENC-T statistics,
see Section 4.3.4.
58
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60
Table 14: Forecasts errors
Panel A Capital returns Panel B Dividend Yield
Unadjusted Risk-adjusted Unadjusted Risk-adjusted
h ME RMSE ME RMSE h ME RMSE ME RMSE
1 -0.0064 0.0446 -0.0043 0.0432 1 -0.0008 0.0011 -0.0008 0.0011
2 -0.0122 0.0651 -0.0049 0.0610 2 -0.0015 0.0018 -0.0015 0.0018
3 -0.0102 0.0766 -0.0050 0.0741 3 -0.0019 0.0022 -0.0020 0.0023
4 -0.0117 0.0859 -0.0037 0.0802 4 -0.0022 0.0027 -0.0023 0.0028
5 -0.0114 0.0903 -0.0023 0.0782 5 -0.0025 0.0031 -0.0025 0.0032
6 -0.0133 0.0978 -0.0016 0.0843 6 -0.0028 0.0034 -0.0028 0.0035
7 -0.0128 0.1032 -0.0009 0.0921 7 -0.0031 0.0039 -0.0030 0.0039
8 -0.0143 0.1117 -0.0001 0.0990 8 -0.0034 0.0043 -0.0033 0.0044
9 -0.0143 0.1187 0.0040 0.1038 9 -0.0038 0.0047 -0.0036 0.0048
10 -0.0153 0.1256 0.0046 0.1084 10 -0.0041 0.0052 -0.0039 0.0053
11 -0.0143 0.1339 0.0077 0.1130 11 -0.0045 0.0057 -0.0043 0.0058
12 -0.0141 0.1414 0.0095 0.1170 12 -0.0048 0.0061 -0.0046 0.0064
Panel C Total returns Panel D Total returns (Univariate adjusted)
Unadjusted Risk-adjusted IDY ICG
h ME RMSE ME RMSE h ME RMSE ME RMSE
1 -0.0046 0.0448 -0.0029 0.0442 1 -0.0036 0.0452 -0.0051 0.0433
2 -0.0067 0.0643 -0.0015 0.0612 2 -0.0063 0.0646 -0.0066 0.0610
3 -0.0171 0.0776 -0.0084 0.0745 3 -0.0165 0.0777 -0.0075 0.0743
4 -0.0248 0.0881 -0.0082 0.0805 4 -0.0211 0.0876 -0.0070 0.0803
5 -0.0315 0.0933 -0.0074 0.0785 5 -0.0271 0.0939 -0.0067 0.0784
6 -0.0350 0.1010 -0.0068 0.0846 6 -0.0313 0.1023 -0.0069 0.0846
7 -0.0398 0.1068 -0.0075 0.0931 7 -0.0361 0.1106 -0.0074 0.0926
8 -0.0458 0.1160 -0.0049 0.0999 8 -0.0394 0.1201 -0.0075 0.0995
9 -0.0464 0.1224 0.0097 0.1044 9 -0.0342 0.1262 -0.0043 0.1042
10 -0.0497 0.1293 0.0124 0.1087 10 -0.0364 0.1338 -0.0048 0.1090
11 -0.0463 0.1366 0.0200 0.1129 11 -0.0336 0.1404 -0.0027 0.1136
12 -0.0480 0.1440 0.0254 0.1165 12 -0.0324 0.1467 -0.0020 0.1176
Panel E Total returns (Univariate unadjusted)
IDY ICG
h ME RMSE ME RMSE
1 -0.0032 0.0442 -0.0073 0.0447
2 -0.0054 0.0634 -0.0139 0.0654
3 -0.0162 0.0777 -0.0129 0.0771
4 -0.0222 0.0878 -0.0152 0.0866
5 -0.0298 0.0947 -0.0158 0.0910
6 -0.0328 0.1029 -0.0186 0.0988
7 -0.0372 0.1103 -0.0191 0.1043
8 -0.0421 0.1203 -0.0215 0.1129
9 -0.0425 0.1279 -0.0225 0.1199
10 -0.0462 0.1358 -0.0244 0.1269
11 -0.0461 0.1429 -0.0245 0.1352
12 -0.0485 0.1507 -0.0253 0.1427
This table reports the mean forecast errors (ME), root-mean-squared errors (RMSE) for the h-month-
ahead forecast, all over the period 1984M4-2008M12. The risk-adjusted futures-based forecast adjusts
the ratio F
(h)
t
/S
t
for risk premium using a vector of popular predictors (X
t
). The implied dividend
yields (including risk-free rate) are adjusted in a similar manner. Coecients of the risk-adjusted and
unadjusted regressions are recomputed at each date t using data only up through month t 1, so all
forecasts are out-of-sample. In Panel A, the dependent variable is the capital returns on S&P 500. In
Panel B, the dependent variable is the realized accumulated dividend yields. In Panel C-E, the dependent
variable is the total returns.
61
Figure 1: Timing convention for S&P 500 index futures contracts
This graph describes the structure of futures contract at time t. In this par-
ticular sample, the S&P 500 index futures contracts are available from the
Front to the 6th. The farthest contract has a maturity of n at time t. At
it comes to the next trading day t + t, this maturity reduces to n t.
Zeros
SP500 Front 2nd 3rd 4th 5th 6th
S
t
= F
(0)
t
F
(1)
t
F
(2)
t
F
(3)
t
F
(4)
t
F
(5)
t
F
(6)
t
u u u u u u u
u u u u u u u
t t +n t +n 1 t +n 2
P
t+n2,t+n1
..
e
e
t + t
-
New Maturity = n t
-
P
t,t+1
-
F
(1)
P
t+n2,t+n1
F
(2)
-
P
t,t+2
P
t+1,t+2
=
P
t,t+2
P
t,t+1
..
62
Figure 2: Time series of IDY, ICG, DUR, CON
Panel A shows the IDY on the left column and ICG on the right column, calculated
based on interpolated futures prices of the S&P 500 index and un-smoothed Fama-Bliss
daily term structure. Panel B illustrates the time series for the calculated equity
duration (on the left column) and convexity (right column), measured by days. The
horizon for all series is 12 months. The sample period is from 1982M4 to 2008M12.
(a)
Time
ID
Y
1
2
1985 1990 1995 2000 2005
0
.0
0
0
.0
2
0
.0
4
0
.0
6
0
.0
8
0
.1
0
IDY12
Realized dividend yield
Time
IC
G
1
2
1985 1990 1995 2000 2005
0
.0
0
0
.0
2
0
.0
4
0
.0
6
0
.0
8
(b)
Time
D
U
R
1
2
1985 1990 1995 2000 2005
3
.5
0
3
.5
5
3
.6
0
3
.6
5
3
.7
0
Time
C
O
N
1
2
1985 1990 1995 2000 2005
6
.3
6
.4
6
.5
6
.6
6
.7
6
.8
63
Figure 3: The term structure of IDY, ICG, DUR and CON
This 3d plotting illustrates the term structure of IDY, ICG (Panel 3a), DUR
and CON (Panel 3b) over horizons varying from 1 to 12 months. All time se-
ries are computed as the average of the observations for last ve trading days
within each month. The data period (the Date dimension) is from 1982M4 to 2008m12.
(a)
D
a
te
6000
8000
10000
12000
14000
H
o
riz
o
n
(in
m
o
n
th
s
)
2
4
6
8
10
12
Im
p
lie
d
D
iv
id
ie
n
d
Y
ie
ld
s
0.00
0.02
0.04
0.06
0.08
0.10
D
a
te
6000
8000
10000
12000
14000
H
o
riz
o
n
(in
m
o
n
th
s
)
2
4
6
8
10
12
Im
p
lie
d
C
a
p
ita
l G
a
in
s
0.02
0.00
0.02
0.04
0.06
0.08
(b)
D
a
te
6000
8000
10000
12000
14000
H
o
rizo
n
(in
m
o
n
th
s)
2
4
6
8
10
12
Im
p
lie
d
E
q
u
ity
D
u
ra
tio
n
1
2
3
D
a
te
6000
8000
10000
12000
14000
H
o
rizo
n
(in
m
o
n
th
s)
2
4
6
8
10
12
Im
p
lie
d
E
q
u
ity
C
o
n
v
e
x
ity
2
4
6
64
Figure 4: Realized S&P 500 capital gains and the future-spot ratio
The following graphs plot the net realized S&P 500 capital gains, the net unad-
justed future-spot ratio (F
h
t
/S
t
1), and the net risk-adjusted future-spot ratio over
3-month and 12-month horizons separately. The time period is 1982M4-2008M12.
Time
R
e
a
l
i
z
e
d

C
a
p
i
t
a
l

R
e
t
u
r
n
s

(
3

m
o
n
t
h

h
o
r
i
z
o
n
)
1985 1990 1995 2000 2005

0
.
4

0
.
2
0
.
0
0
.
2
0
.
4
0
.
6
Realized
Riskadjusted
Unadjusted
Time
R
e
a
l
i
z
e
d

C
a
p
i
t
a
l

R
e
t
u
r
n
s

(
1
2

m
o
n
t
h

h
o
r
i
z
o
n
)
1985 1990 1995 2000 2005

0
.
4

0
.
2
0
.
0
0
.
2
0
.
4
0
.
6
Realized
Riskadjusted
Unadjusted
Figure 5: Realized, risk-adjusted and unadjusted S&P 500 dividend yields
The following graphs plot the realized S&P 500 dividend yields, the unadjusted implied
dividend yield (including risk-free rates), and the risk-adjusted implied dividend yield
over 3-month and 12-month horizons separately. The time period is 1982M4-2008M12.
Time

D
i
v
i
d
e
n
d

Y
i
e
l
d

(
3

m
o
n
t
h

h
o
r
i
z
o
n
)
1985 1990 1995 2000 2005

0
.
0
3

0
.
0
1
0
.
0
0
0
.
0
1
0
.
0
2
0
.
0
3
0
.
0
4
Realized
Riskadjusted
Unadjusted
Time

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v
i
d
e
n
d

Y
i
e
l
d

(
1
2

m
o
n
t
h

h
o
r
i
z
o
n
)
1985 1990 1995 2000 2005
0
.
0
0
0
.
0
2
0
.
0
4
0
.
0
6
0
.
0
8
0
.
1
0
0
.
1
2
Realized
Riskadjusted
Unadjusted
65
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66