Expected Returns, Yield Spreads, and Asset Pricing Tests

We use information contained in yield spreads to recover investors’ ex ante required rates of return on corporate securities, and then use these ex ante returns to study the pricing of risky assets. Differently from the standard approach, our asset pricing tests do not rely on the use of ex post average equity returns as proxies for expected equity returns. We Þnd that: (i) the market beta plays a signiÞcant role in the cross-section of expected equity returns, and its role persists even after size and book-to-market factors are accounted for; (ii) the risk premia associated with size and book-to-market are positive, signiÞcant, and countercyclical; and (iii) there is little evidence on positive momentum proÞts. We also Þnd that systematic risk, as captured by common equity factors, is the main driver of the cross-sectional variation in bond yield spreads. JEL ClassiÞcation: G12, E44