Risk Premium Predictability and the Efficient Markets Hypothesis
Summary
The note explains why indicators that forecast changes in risk premia need not contradict the Efficient Markets Hypothesis. The key distinction is between predictable differences in expected returns associated with risk exposure and predictable risk-adjusted abnormal returns. Credit spreads, for example, can affect debt-heavy firms differently from cash-rich firms because their sensitivities to credit conditions differ.
In the illustration, new information causes credit spreads to move unpredictably, while the relative impact of that movement on groups with different credit betas can be anticipated. A predictable exposure multiplied by an unpredictable market movement does not, by itself, make total returns predictable. The argument therefore permits time-varying risk premia while requiring that market surprises and residual abnormal returns remain unpredictable. It is a conceptual example, not an empirical test or a formal statement of every version of EMH; its conclusion depends on how risk and abnormal performance are defined.
Key ideas
- Predictable risk premia are distinct from predictable risk-adjusted abnormal returns.
- Different securities can respond differently to the same credit-spread movement because their risk exposures differ.
- If the market movement is unpredictable, a known sensitivity to that movement does not alone imply predictable returns.
- The EMH argument also requires residual abnormal returns to remain unpredictable.
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# Why is change in risk premium not a violation of the Efficient Markets Hypothesis? # Why is change in risk premium not a violation of the Efficient Markets Hypothesis? A passage in my textbook is confusing me. It states that various market indicators (e.g. yield spreads between high/low grade bonds, earnings yields) lead to predictability in the security's risk premium, not risk adjusted abnormal returns, which is therefore not a violation of the efficient markets hypothesis. The EMH is maintains that all securities prices affect available information. If such indicators signal something about a security's risk premium, doesn't this mean that this piece of information should have been reflected, but was not in the first place? How is this consistent with the EMH? ## Answer by demully (score 1, accepted) https://quant.stackexchange.com/a/47467 This one is gloriously semantic. The critical bit is adding the qualifying words "abnormal" and "risk-adjusted". Imagine for example's sake a market stylized by two groups of stocks: debt-heavy telecoms companies, and cash-rich tech companies. A change in credit spreads will obviously work to the relative benefit of one group, and to the relative cost of the other. Which is saying nothing more than different stocks have different credit betas. For the EMH to hold, you have to believe that all available information is reflected in the current valuation of credit spreads; and thus the future path of credit spreads is unpredictable. Future news and the surprise this represents will cause credit spreads to move. The effects this will have on different stocks is (relatively) predictable. But putting a predictable multiplier on a random input still gives you a random output. Plus the residuals of my companies' "alpha" excluding these effects, will still (in theory) be random noise. If return = beta * market + error, then the EMH holds if market and error are both random. When I go and buy dinner with my returns, neither I nor the supermarket care much whether these were generated by alpha, this beta, or that one. However, people who write textbooks seem to get hot under the collar about such things ;-)
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