Macroeconomic risks and characteristic-based factor models

We show that book-to-market, size, and momentum capture cross-sectional variation in exposures to a broad set of macroeconomic factors identified in the prior literature as potentially important for pricing equities. The factors considered include innovations in economic growth expectations, inflation, the aggregate survival probability, the term structure of interest rates, and the exchange rate. Factor mimicking portfolios constructed on the basis of book-to-market, size, and momentum therefore, serve as proxy composite macroeconomic risk factors. Conditional and unconditional cross-sectional asset pricing tests indicate that most of the macroeconomic factors considered are priced. The performance of an asset pricing model based on the macroeconomic factors is comparable to the performance of the Fama and French (1993) model. However, the momentum factor is found to contain incremental information for asset pricing.     

Future labor income growth and the cross-section of equity returns

This paper examines the equilibrium relation between future labor income growth and expected asset returns; it proposes revisions in the expectation of future labor income growth as a macroeconomic state variable and suggests a three-factor model, including a factor related to this variable, along with the consumption growth factor and the market factor. The proposed future labor income growth factor is positively associated with the Fama-French factors and subsumes their explanatory power in explaining the cross-section of stock returns. These results provide a possible economic explanation for the roles of the Fama-French factors: they are compensation for higher exposure to the risk related to changes in the value of human capital. This paper also compares the performance of the proposed three-factor model with other competing models and finds that the proposed model specification better captures cross-sectional variation in average returns than any of the competing asset pricing models considered.     

Profitability of momentum strategies in international markets: The role of business cycle variables and behavioural biases

The paper investigates whether business cycle variables and behavioural biases can explain the profitability of momentum trading in three major European markets. Unlike previous studies, the paper nests both risk-based and behavioural-based variables in a two-stage model specification in an attempt to explain momentum profits. The findings show that, although momentum profitability in European markets is unexplained by conditional asset pricing models, it is attributable to asset mispricing that systematically varies with global business conditions. In addition, behavioural variables do not appear to matter much. Thus risk factors, which are undetected thus far and are largely attributable to the business cycle, could explain the momentum payoffs in European stock markets.     

Higher co-moments and asset pricing on London Stock Exchange

This study examines the asset pricing implications of preferences over the higher moments of returns’ distributions. We show that in a market populated by risk-averse, prudent and temperate investors, firms whose returns exhibit negative coskewness or positive cokurtosis should yield higher premia relative to counterpart firms with positive coskewness and negative cokurtosis respectively. These theoretical predictions are empirically tested using a comprehensive dataset of shares listed on the London Stock Exchange during the period 1986-2008. Our empirical results confirm that coskewness and cokurtosis premia are genuinely priced in the UK market, over and above what covariance risk, size, value and momentum factors can explain. We also show that a theoretically motivated, higher co-moment asset pricing model has significant explanatory ability over the cross-section of coskewness and cokurtosis portfolio returns.     

Style investing,comovement and return predictability

Barberis and Shleifer (2003) argue that style investing generates momentum and reversals in style and individual asset returns, as well as comovement between individual assets and their styles. Consistent with these predictions, in some specifications, past style returns help explain future stock returns after controlling for size, book-to-market and past stock returns. We also use comovement to identify style investing and assess its impact on momentum. High comovement momentum portfolios have significantly higher future returns than low comovement momentum portfolios. Overall, our results suggest that style investing plays a role in the predictability of asset returns.     

The critical role of conditioning information in determining if value is really riskier than growth

Conditional asset pricing models have been used to determine whether the value premium and other CAPM anomalies are due to risk. We show that the conclusions on whether these anomalies are due to risk are very sensitive to the choice of the information variables used to define good and bad states of the world. We use a conditional CAPM framework allowing for alternative sets of plausible conditioning information and find that value appears to be riskier than growth in only about ten to twenty percent of specifications. We find even less evidence that size, issuance, momentum, and asset growth portfolio returns are due to risk. Overall, our results suggest that common CAPM anomalies are not due to risk.     

Maxing out: Stocks as lotteries and the cross-section of expected returns

Motivated by existing evidence of a preference among investors for assets with lottery-like payoffs and that many investors are poorly diversified, we investigate the significance of extreme positive returns in the cross-sectional pricing of stocks. Portfolio-level analyses and firm-level cross-sectional regressions indicate a negative and significant relation between the maximum daily return over the past one month (MAX) and expected stock returns. Average raw and risk-adjusted return differences between stocks in the lowest and highest MAX deciles exceed 1% per month. These results are robust to controls for size, book-to-market, momentum, short-term reversals, liquidity, and skewness. Of particular interest, including MAX reverses the puzzling negative relation between returns and idiosyncratic volatility recently shown in 2 and 3.     

Housing,consumption and asset pricing

This paper considers a consumption-based asset pricing model where housing is explicitly modeled both as an asset and as a consumption good. Nonseparable preferences describe households’ concern with composition risk, that is, fluctuations in the relative share of housing in their consumption basket. Since the housing share moves slowly, a concern with composition risk induces low frequency movements in stock prices that are not driven by news about cash flow. Moreover, the model predicts that the housing share can be used to forecast excess returns on stocks. We document that this indeed true in the data. The presence of composition risk also implies that the riskless rate is low which further helps the model improve on the standard CCAPM.     

The role of shorting,firm size,and time on market anomalies

We examine the role of shorting, firm size, and time on the profitability of size, value, and momentum strategies. We find that long positions make up almost all of size, 60% of value, and half of momentum profits. Shorting becomes less important for momentum and more important for value as firm size decreases. The value premium decreases with firm size and is weak among the largest stocks. Momentum profits, however, exhibit no reliable relation with size. These effects are robust over 86 years of US equity data and almost 40 years of data across four international equity markets and five asset classes. Variation over time and across markets of these effects is consistent with random chance. We find little evidence that size, value, and momentum returns are significantly affected by changes in trading costs or institutional and hedge fund ownership over time.     

Consumption growth predictability and asset prices

We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.     

Macroeconomic risk and the cross-section of stock returns

We develop a conditional version of the consumption capital asset pricing model (CCAPM) using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of competing predictive variables. In addition, our conditional CCAPM performs approximately as well as Fama and French’s (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times, supporting the risk-based story.     

Risk,uncertainty, and asset prices

We identify the relative importance of changes in the conditional variance of fundamentals (which we call “uncertainty”) and changes in risk aversion in the determination of the term structure, equity prices, and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in price–dividend ratios and the equity risk premium is primarily driven by risk aversion, uncertainty plays a large role in the term structure and is the driver of countercyclical volatility of asset returns.     

Can stochastic discount factor models explain the cross-section of equity returns?

We propose a multivariate test of the capital asset pricing model (C-CAPM) of the cross-sectional variation in equity returns in which we compare cross-sectional variation in equity returns to the cross-sectional variation in their conditional covariance with stochastic discount factors. We use a multivariate generalized heteroskedasticity in mean model to estimate 25 portfolios that are formed on size and the book-to-market ratio. Each portfolio is allowed to have its own no-arbitrage condition. We find that although the conditional covariances of returns with consumption exhibit negative variation across size, they do not vary across the book-to-market ratio. Thus, C-CAPM can capture the size effect, but not the value effect. The fit is, however, improved by allowing the coefficients on the consumption covariances to be different. The value effect appears to be associated with the book-to-market ratio as well as size. On its own the book-to-market ratio does not generate additional information about average returns to C-CAPM. A possible explanation for these findings is that both small and low book-to-market ratio firms are expected to have higher rates of growth.     

Asset Pricing Models and Financial Market Anomalies

This article develops a framework that applies to single securitiesto test whether asset pricing models can explain the size, value,and momentum anomalies. Stock level beta is allowed to varywith firm-level size and book-to-market as well as with macroeconomicvariables. With constant beta, none of the models examined captureany of the market anomalies. When beta is allowed to vary, thesize and value effects are often explained, but the explanatorypower of past return remains robust. The past return effectis captured by model mispricing that varies with macroeconomicvariables.     

Do industries matter in explaining stock returns and asset-pricing anomalies?

Industry returns cannot be explained fully by well-known asset pricing models. This study reveals that common factors extracted from industry returns carry significant risk premiums that go beyond the explanatory power of size, book-to-market (BM) ratios, and momentum. In particular, this study shows that (1) the small-firm effect is significant only for firms whose market capitalization is below their industry average; (2) the BM effect is an intra-industry phenomenon; (3) a one-year momentum effect is significant only for firms whose BM ratio is smaller than the industry average and limited to non-January months; and (4) there is seasonality in all effects that cannot be explained by risk-based asset-pricing models. Neither rational nor behavioral theories alone can explain industry returns, and it is perhaps too hasty to attribute asset pricing anomalies to a single driving force.     

Reward-risk momentum strategies using classical tempered stable distribution

We implement momentum strategies using reward-risk measures as ranking criteria based on classical tempered stable distribution. Performances and risk characteristics for the alternative portfolios are obtained in various asset classes and markets. The reward-risk momentum strategies with lower volatility levels outperform the traditional momentum strategy regardless of asset class and market. Additionally, the alternative portfolios are not only less riskier in risk measures such as VaR, CVaR and maximum drawdown but also characterized by thinner downside tails. Similar patterns in performance and risk profile are also found at the level of each ranking basket in the reward-risk portfolios. Higher factor-neutral returns achieved by the reward-risk momentum strategies are statistically significant and large portions of the performances are not explained by the Carhart four-factor model.     

An Empirical Investigation of the Campbell-Cochrane Habit Utility Model

Abstract:  This paper tests whether the Campbell and Cochrane (1999) habit utility model generates a valid stochastic discount factor for the 25 Fama-French size/book-to-market and size/momentum sorted portfolios. Campbell and Cochrane (1999) derive a consumption based habit utility asset pricing model and calibrate it to aggregate US stock market data. However, they do not test whether their model is consistent with a larger cross section of asset returns. We test their model using the methodology of Hansen and Jagannathan (1991) and Burnside (1994) . In contrast to previous studies, we find that for reasonable parameter values, the model's stochastic discount factor is inside the Hansen-Jagannathan bounds and therefore satisfies the necessary conditions for a valid stochastic discount factor. We trace the difference between our results and previous studies to the method used to estimate the model's parameters and the parameter values themselves.     

Asymmetric dynamics of stock price continuation

This paper finds that the dynamics of stock price continuation are asymmetrical, in terms of both business cycles and past performances. During times of recession, stock returns are explained differently for past losers and winners; the level of credit quality dominates the return dynamics for extreme losers, while levels of information-based trading activity and information ambiguity contribute to winners’ medium-term returns. Such asymmetry is proposed as the source of insignificant profits achieved using conventional momentum strategies. On the other hand, in times of expansion, conventional asset pricing factors are found to affect stock returns with a dependence on the level of credit quality; this suggests that more profitable momentum strategies remain to be discovered.     

Liquidity and asset pricing: Evidence from the Hong Kong stock market

This study investigates the role of liquidity in pricing stock returns in the Hong Kong stock market. Our results show that liquidity is an important factor for pricing returns in Hong Kong after taking well-documented asset pricing factors into consideration. The results are robust to adding portfolio residuals and higher moment factor in the factor models. The results are also robust to seasonality, and conditional-market tests. We also compare alternative factor models and find that the liquidity four-factor model (market excess return, size, book-to-market ratio, and liquidity) is the best model to explain stock returns in the Hong Kong stock market, while the momentum factor is not found to be priced.