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One of the basic laws of finance is that risk and return and positively related. Hold on. I didn’t say that quite right. Risk and expected return are positively related.

You see, that’s the hard part. We’re not talking about return itself, but the perception of what it should be, or supposed to be. How, exactly, can we measure expected return?

Finance professors have wrestled with that question for a long time. All the good measurements, like standard deviation are trailing numbers. But we need to know the here and now.

Three researchers, Long Chen, Hui Guo and Lu Zhang, had an idea. They said that to find the expected return of a stock, don’t look at the stock—look at the company’s bonds. Specifically, look at the spread between the company’s bond yield and a Treasury yield of the same maturity. This little trick is not only forward-looking, but it doesn’t lean on unreliable proxies.

Using this method, they found a positive correlation between risk and expected return. The paper is at the Web site of the Federal Reserve Bank of St. Louis, which is a great resource for all sorts of financial data. Here’s a PDF of their paper (warning: It’s written in the incomprehensible secret language of finance professors).

Posted by edelfenbein at January 31, 2006 7:42 AM