Paper Beyond Arbitrage: Deviations from the Risk-Return Tradeoff

Differences in expected returns reflect and guide investment decisions in the economy. One challenge for economic agents and academics is to understand whether differences in risk exposure drive differences in expected returns. We propose two tests to assess whether risk alone can explain differences in expected returns. We develop the tests’ equilibrium foundations, which hold within a large class of models. We study the tests’ properties asymptotically and in simulations. Empirically, we find that risk cannot explain most differences in expected returns of characteristic-sorted portfolios. Our findings are consistent with a prominent role for frictions and behavioral biases.

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