The Variation of Economic Risk Premiums

It is well-documented that the rates of return to holding common stocks and bonds are to some extent predictable over time. There is controversy over the source of the predictability. Some authors attribute predictability to market inefficiencies, while others maintain that predictability is the result of changes in the required return. The relative importance of these 2 explanations for monthly portfolio return is calibrated, and the predictable components of monthly common stock and bond portfolio returns are analyzed. Most of the predictability is associated with sensitivity to economic variables in a rational asset pricing model with multiple betas. The stock market risk premium is the most important for capturing predictable variation of the stock portfolios, while premiums associated with interest rate risks capture predictability of the bond returns. Time variation in the expected risk premium - not betas - is the primary source of predictability at the portfolio level.