Profitability,investment and average returns

Valuation theory says that expected stock returns are related to three variables: the book-to-market equity ratio (B_t/M_t), expected profitability, and expected investment. Given B_t/M_t and expected profitability, higher expected rates of investment imply lower expected returns. But controlling for the other two variables, more profitable firms have higher expected returns, as do firms with higher B_t/M_t. These predictions are confirmed in our tests.     

Testing for monotonicity in expected asset returns

Many postulated relations in finance imply that expected asset returns strictly increase in an underlying characteristic. To examine the validity of such a claim, one needs to take the entire range of the characteristic into account, as is done in the recent proposal of Patton and Timmermann (2010). But their test is only a test for the direction of monotonicity, since it requires the relation to be monotonic from the outset: either weakly decreasing under the null or strictly increasing under the alternative. When the relation is non-monotonic or weakly increasing, the test can break down and falsely ‘establish’ a strictly increasing relation with high probability. We offer some alternative tests that do not share this problem. The behavior of the various tests is illustrated via Monte Carlo studies. We also present empirical applications to real data.     

Real‐Time Risk Pricing Over the Business Cycle: Some Evidence for the UK

Abstract:   The fully‐revised data typically utilized in empirical research do not reflect the true information available to financial market participants at the time of their decision‐making. This paper uses a new real‐time macroeconomic dataset to appraise the relative importance of different vintages of data on economic variables as determinants of UK stock returns using the framework of Arbitrage Pricing Theory. We find that two factors influence expected stock returns, namely unanticipated inflation and economic uncertainty, but only when measured in real‐time. Moreover, their pricing influence is only present during phases of the business cycle when their associated risks are at their most prevalent.     

Idiosyncratic risk and expected returns in frontier markets: Evidence from GCC

We investigate the pricing of idiosyncratic volatility of seven frontier markets in six GCC countries. We find a significant (marginal) negative relationship between expected returns and lagged idiosyncratic volatility for individual stocks in Saudi Arabia (Qatar) but none in Kuwait and Abu Dhabi. However, when we estimate conditional idiosyncratic volatility either by EGARCH or AR Models, the relationship turns positive. Introducing unexpected idiosyncratic volatility as an explanatory variable to control for any unexpected returns uncovers the true relationship between expected idiosyncratic volatility and expected returns. The evidence turns out to be robust for return reversals and other control variables. Moreover, the pricing of idiosyncratic risk is less evident in higher country governance and seems to be unrelated to the degree of financial development.     

An Empirical Investigation of the Arbitrage Pricing Theory

Empirical tests are reported for Ross' [48] arbitrage theory of asset pricing. Using data for individual equities during the 1962–72 period, at least three and probably four priced factors are found in the generating process of returns. The theory is supported in that estimated expected returns depend on estimated factor loadings, and variables such as the own standard deviation, though highly correlated (simply) with estimated expected returns, do not add any further explanatory power to that of the factor loadings.     

Are the Latent Variables in Time-Varying Expected Returns Compensation for Consumption Risk?

Multibeta asset pricing models are examined using proxies for economic state variables in a framework which exploits time-varying expected returns to estimate conditional betas. Examples include multiple consumption-beta models and models where asset returns proxy for the state variables. When the state variables are not specified, the tests indicate two or three time-varying expected risk premiums in the sample of quarterly asset returns. Conditional betas relative to consumption generate less striking evidence against the model than betas relative to asset returns, but both the consumption and the market variables fail to proxy for the state variables.     

Macroeconomic Seasonality and the January Effect

Many financial markets researchers have sought an explanation for the role of January in stock returns. Any explanation of this phenomenon that is consistent with rational pricing must specify a source of seasonality in expected returns. The pervasive seasonality in the macroeconomy is an appealing possibility. A multifactor model that links macroeconomic risk to expected return is found to show substantial seasonality in expected returns. This model accounts for the seasonality in average returns, while the capital asset pricing model cannot.     

Financial Flexibility,Bank Capital Flows,and Asset Prices

In our parsimonious general‐equilibrium model of banking and asset pricing, intermediaries have the expertise to monitor and reallocate capital. We study financial development, intraeconomy capital flows, the size of the banking sector, the value of intermediation, expected market returns, and the risk of bank crashes. Asset pricing implications include: a market's dividend yield is related to its financial flexibility, and capital flows should be important in explaining expected returns and the risk of bank crashes. Our predictions are broadly consistent with the aggregate behavior of U.S. capital markets since 1950.     

Some Tests of the Risk-Return Relationship Using Alternative Asset Pricing Models and Observed Expected Returns

This study examines the performance of three asset pricing models: the CAPM, the APT and the UAPT using observed expected returns from a three-phase dividend discount model with Value Line analyst estimates of future company-level earnings, dividends and growth rates. Our study is the first we know of to test the three major asset pricing models using observed expected returns. Our results are similar to prior research using ex post (realized) returns in that we find that the UAPT using macroeconomic factors is the best performing model, followed by the APT and the CAPM. However, our results also suggest that the importance of macroeconomic factors is much greater to expected returns than to realized returns, and the corresponding R2 values for models using expected returns are much higher than for models using realized returns. Combining our results for the UAPT with those of Marston and Harris (1993) for the CAPM suggests that these models are more successful in tests using observed expected returns than in tests using realized returns as proxies for expected returns. Unit root tests suggest that monthly observed expected returns follow the classic random walk without drift model while monthly realized returns do not.     

COMMON STOCK RETURNS,EXPECTED INFLATION,AND THE RATIONAL EXPECTATIONS HYPOTHESIS

This paper provides empirical evidence that expected inflation has a cross-sectional impact on common stock returns. The study differs from others in that (a) the relation between stock returns and expected inflation is investigated in a two-factor asset pricing model, where the factors are the return on an equally weighted stock portfolio and the expected rate of inflation; (b) the estimation of the expected rate of inflation is based on the rational expectations hypothesis of Muth; and (c) a non-linear seemingly unrelated regression technique is employed to determine consistent and asymptotically efficient estimates. The joint hypothesis of the two-factor asset pricing model and rational expectations is not rejected in this study. It is found that the return on common stocks is significantly affected by expected inflation. Also stocks whose returns are positively correlated with expected inflation have lower expected returns.     

Does PIN affect equity prices around the world?

This study examines the empirical controversy over the pricing effect of the Easley, Hvidkjaer, and O?Hara (2002) probability of information-based trading, PIN, on a sample of 30,095 firms from 47 countries worldwide. Contrary to the empirical evidence of Easley, Hvidkjaer, and O?Hara, but consistent with that of Duarte and Young (2009), we do not find that PIN exhibits a positive effect on a cross section of expected stock returns in international markets. Alternative information-based trading measures also display no effect on expected stock returns, corroborating our finding that information risk proxied by PIN, in general, has no pricing effect in world markets.     

Fundamental Economic Variables,Expected Returns,and Bond Fund Performance

In this article, we develop relative pricing (APT) models that are successful in explaining expected returns in the bond market. We utilize indexes as well as unanticipated changes in economic variables as factors driving security returns. An innovation in this article is the measurement of the economic factors as changes in forecasts. The return indexes are the most important variables in explaining the time series of returns. However, the addition of the economic variables leads to a large improvement in the explanation of the cross-section of expected returns. We utilize our relative pricing models to examine the performance of bond funds.     

Real estate returns,money and fiscal deficits: Is the real estate market efficient?

This research examines the causal relationship between several financial variables and a portfolio of real estate returns using monthly data from January 1965 to December 1986. The empirical analysis is based on multivariate Granger-causality tests in conjunction with Akaike's final prediction error criterion. The results indicate that measures approximating monetary policy and market returns play an important role in causing changes in real estate returns. In particular, our findings suggest that base money and market returns have had significant lagged effects on current real estate returns.     

INTERTEMPORAL ASSET PRICING WITHOUT CONSUMPTION DATA: EMPIRICAL TESTS

In this paper I conduct tests of an intertemporal asset pricing model using variables that forecast stock returns as the risk factors. I document that the forecasting variables are priced so that expected excess returns are related to their conditional covariances with the forecasting variables. The variability in the covariance risk fails to explain the cross-sectional and time-series variation in expected stock returns. Evidence rejects restrictions on the prices of covariance risk imposed by the model with constant volatilities. I also find that an extended model that allows time-varying conditional volatilities is misspecified.     

On the real estate market efficiency

This reseach reexamines the efficiency hypothesis of the real estate market using monthly data and the vector autoregressive (VAR) modelling technique. The tests focus on the causal linkage between real estate returns and a number of relevant financial and economic variables. An eight-by-eight VAR model is estimated using the FPE and the specific gravity criteria, in conjunction with an extensive series of specification tests. The empirical results distilled from system estimations suggest that the real estate market is efficient with respect to available information on the industrial production, the risk premia, the term structure of interest rates, and the monetary base. Movements in these variables are quickly and fully utilized by market agents, perhaps owing to the intensity with which their relationship with stock returns has been discussed in the literature and the popular media. However, the results also suggest the presence of a significant lagged relationship between real estate returns and fiscal policy moves, even when the paths through other potential determinants of these returns are taken into account. Of course, our finding that the fiscal policy measure is useful in predicting stock returns does not necessarily imply that the real estate market is inefficient. At a minimum, inefficiency is revealed only if a careful analysis of the budgetary process can help design a profitable (exploitable) trading strategy.     

Testing Volatility Restrictions on Intertemporal Marginal Rates of Substitution Implied by Euler Equations and Asset Returns

The Euler equations derived from intertemporal asset pricing models, together with the unconditional moments of asset returns, imply a lower bound on the volatility of the intertemporal marginal rate of substitution. This paper develops and implements statistical tests of these lower bound restrictions. While the availability of short time series of consumption data often undermines the ability of these tests to discriminate among different utility functions, we find that the restrictions implied by a number of widely studied financial data sets continue to pose quite a challenge to the current generation of intertemporal asset pricing theories.     

Consumption Fluctuations and Expected Returns

This paper introduces a novel consumption-based variable, cyclical consumption, and examines its predictive properties for stock returns. Future expected stock returns are high (low) when aggregate consumption falls (rises) relative to its trend and marginal utility from current consumption is high (low). We show that the empirical evidence ties consumption decisions of agents to time variation in returns in a manner consistent with asset pricing models based on external habit formation. The predictive power of cyclical consumption is not confined to bad times and subsumes the predictability of many popular forecasting variables.     

Conditioning information and cross-sectional anomalies

Recent empirical work suggests that predictability of future returns is related to a time-varying component that expected returns exhibit. In this paper, I use conditional asset pricing models to investigate whether return anomalies exhibit common dynamic patterns in returns. The prediction of a model might hinge on the specific interaction between its underlying state variables and considered portfolios. Using well known anomalies and alternative state variables I study such interaction. I document that different state variables identify similar time-varying behavior for the anomalies in extreme economic conditions, but such anomalies show no commonalities in their overall patterns.     

The relationship between earnings' yield,market value and return for NYSE common stocks: Further evidence

The empirical relationship between earnings' yield, firm size and returns on the common stock of NYSE firms is examined in this paper. The results confirm that the common stock of high E/P firms earn, on average, higher risk-adjusted returns than the common stock of low E/P firms and that this effect is clearly significant even if experimental control is exercised over differences in firm size. On the other hand, while the common stock of small NYSE firms appear to have earned substantially higher returns than the common stock of large NYSE firms, the size effect virtually disappears when returns are controlled for differences in risk and E/P ratios. The evidence presented here indicates that the E/P effect, however, is not entirely independent of firm size and that the effect of both variables on expected returns is considerably more complicated than previously documented in the literature.     

Return generating process and the determinants of term premiums

This paper examines asset pricing theories for treasury bonds using longer maturities than previous studies and employing a simple multi-factor model. We allow bond factor loadings to vary over time according to term structure variables. The model examines not only the time variation in the expected returns of bonds but also their unexpected returns. This allows us to explicitly test some asset pricing restrictions which are difficult to study under existing frameworks. We confirm that the pure expectation theory of the term structure of interest rates is rejected by the data. Our empirical study of a two-factor model finds substantial evidence of time-varying term-premiums and factor loadings. The fact that factor loadings vary with long-term interest rates and yield spreads suggest that bond return volatilities are sensitive to interest rate levels.