A liquidity-augmented capital asset pricing model

Using a new measure of liquidity, this paper documents a significant liquidity premium robust to the CAPM and the Fama–French three-factor model and shows that liquidity is an important source of priced risk. A two-factor (market and liquidity) model well explains the cross-section of stock returns, describing the liquidity premium, subsuming documented anomalies associated with size, long-term contrarian investment, and fundamental (cashflow, earnings, and dividend) to price ratios. In particular, the two-factor model accounts for the book-to-market effect, which the Fama–French three-factor model fails to explain.     

The cross section of cashflow volatility and expected stock returns

I show that historical cashflow volatility is negatively related to future returns cross-sectionally. The negative association is large; economically meaningful; long-lasting up to five years; robust to known return-informative effects of size, value, price and earnings momentums and illiquidity; and extends to both systematic and idiosyncratic cashflow volatilities. Using the standard deviations of cashflow to sales and of cashflow to book equity as proxies for cashflow volatility, the least volatile decile portfolio outperforms the most volatile decile portfolio by 13% a year relative to the Fama–French four factors. The cashflow volatility effect is closely related to the idiosyncratic return volatility effect documented in Ang et al. [Ang, A., Hodrick, R.J., Xing, Y. and Zhang, X. “The cross-section of volatility and expected returns.” Journal of Finance, 51 (2006), 259–299.]. However, in portfolios simultaneously sorted on both cashflow and return volatilities, and in cross sectional regressions of returns at the firm level, these two effects neither drive out nor dominate each other. While the pricing of idiosyncratic cashflow volatility represents an anomaly against the traditional asset pricing theories, the pricing of historical cashflow uncertainty sheds light on potential fundamental risks embodied in the Fama–French HML and SMB factors.     

TRANSITORY MARKET STATES AND THE JOINT OCCURRENCE OF MOMENTUM AND MEAN REVERSION

In this article we derive and investigate the implications of the Fama–French and Poterba–Summers model—in which the market price of equity contains permanent and temporary components—to explain cross‐sectional differences in equity risk premia and returns. Shocks to the transitory component are regarded a Merton risk factor. We obtain estimates from a simple Kalman decomposition of the market price. The transitory component estimate is used in a conditional capital asset pricing model to test implications of the model related to predictability, cross‐sectional performance, and the existence of momentum and mean reversion.     

THE IMPORTANCE OF LIQUIDITY AS A FACTOR IN ASSET PRICING

We employ the Fama‐French time‐series regression approach to examine liquidity as a risk factor affecting stock returns. Prior studies establish liquidity as an important consideration in investment decisions. Here, liquidity is found to be an important factor affecting portfolio returns, even after the effects of market, size, book‐to‐market equity, and momentum are considered. Nonzero intercepts remain, however, indicating continued missing risk factors.     

Value versus growth: Australian evidence

The value‐growth effect is one of the most pervasive patterns in stock prices. In this study, the ability of four proxies for value‐growth, book‐to‐market, sales‐to‐price, earnings‐to‐price and cash‐flow‐to‐price to explain equity returns is analysed. The findings show that in aggregate, book‐to‐market best explains cross‐sectional variation in Australian equity returns, which in isolation suggests that it is the superior proxy for value‐growth. The analysis is taken further and the value‐growth effect is examined separately in positive and negative earnings firms. After segregating firms, it is found that in the negative earnings sample, book‐to‐market is the best value‐growth proxy and in the positive earnings sample, cash‐flow‐to‐price has the highest level of significance and is thus the superior value‐growth proxy. The economic significance of this result is telling, as the firms that report positive earnings are much larger than those that report negative earnings.     

Stock Liquidity Risk and the Cross‐sectional Earnings‐Returns Relationship

We argue that a higher sensitivity to aggregate market‐wide liquidity shocks (i.e., a higher liquidity risk) implies a tendency for a stock's price to converge to fundamentals. We test this intuition within the framework of the earnings‐returns relationship. We find a positive liquidity risk effect on the relationship between return and expected change in earnings. This effect on the earnings‐returns relationship is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book‐to‐market; and (c) are profit making.     

The Book-to-Price Effect in Stock Returns: Accounting for Leverage

This paper lays out a decomposition of book‐to‐price (B/P) that derives from the accounting for book value and that articulates precisely how B/P “absorbs” leverage. The B/P ratio can be decomposed into an enterprise book‐to‐price (that pertains to operations and potentially reflects operating risk) and a leverage component (that reflects financing risk). The empirical analysis shows that the enterprise book‐to‐price ratio is positively related to subsequent stock returns but, conditional upon the enterprise book‐to‐price, the leverage component of B/P is negatively associated with future stock returns. Further, both enterprise book‐to‐price and leverage explain returns over those associated with Fama and French nominated factors—including the book‐to‐price factor—albeit negatively so for leverage. The seemingly perverse finding with respect to the leverage component of B/P survives under controls for size, estimated beta, return volatility, momentum, and default risk.     

LIQUIDITY AND ASSET PRICING UNDER THE THREE‐MOMENT CAPM PARADIGM

We examine whether the use of the three‐moment capital asset pricing model can account for liquidity risk. We also make a comparative analysis of a four‐factor model based on Fama–French and Pástor–Stambaugh factors versus a model based solely on stock characteristics. Our findings suggest that neither of the models captures the liquidity premium nor do stock characteristics serve as proxies for liquidity. We also find that sensitivities of stock return to fluctuations in market liquidity do not subsume the effect of characteristic liquidity. Furthermore, our empirical findings are robust to differences in market microstructure or trading protocols between NYSE/AMEX and NASDAQ.     

Equilibrium "Anomalies"

Many empirical “anomalies” are actually consistent with the single beta capital asset pricing model if the empiricist utilizes an equity‐only proxy for the true market portfolio. Equity betas estimated against this particular inefficient proxy will be understated, with the error increasing with the firm's leverage. Thus, firm‐specific variables that correlate with leverage (such as book‐to‐market and size) will appear to explain returns after controlling for proxy beta simply because they capture the missing beta risk. Loadings on portfolios formed on relative leverage and relative distress completely subsume the powers of the Fama and French (1993) returns to small minus big market capitalization (SMB) portfolios and returns to high minus low book‐to‐market (HML) portfolios factors in explaining cross‐sectional returns.     

Conditional Asset Pricing and Stock Market Anomalies in Europe

This study provides European evidence on the ability of static and dynamic specifications of the Fama‐French (1993) three‐factor model to price 25 size‐B/M portfolios. In contrast to US evidence, we detect a small‐growth premium and find that the size effect is still present in Europe. Furthermore, we document strong time variation in factor risk loadings. Incorporating these risk fluctuations in conditional specifications of the three‐factor model clearly improves its ability to explain time variation in expected returns. However, the model still fails to completely capture cross‐sectional variation in returns as it is unable to explain the momentum effect.     

‘Hot’ Debt Markets and Capital Structure

This paper examines the motives of debt issuance during hot‐debt market periods and its impact on capital structure over the period 1970–2006. We find that perceived capital market conditions as favourable, an indication of market timing, and adverse selection costs of equity (i.e., information asymmetry) are important frictions that lead certain firms to issue more debt in hot‐ than cold‐debt market periods. Using alternative hot‐debt market issuance measures and controlling for other effects, such as structural shifts in the debt market, industry, book‐to‐market, price‐to‐earnings, size, tax rates, debt market conditions and adjustment costs based on debt credit ratings, we find that firms with high adverse selection costs issue substantially more (less) debt when market conditions are perceived as hot (cold). Moreover, the results indicate that there is a persistent hot‐debt market effect on the capital structure of debt issuers; hot‐debt market issuing firms do not actively rebalance their leverage to stay within an optimal capital structure range.     

INTANGIBLE ASSETS,BOOK‐TO‐MARKET,AND COMMON STOCK RETURNS

I examine two anomalies where the Fama and French three‐factor model fails to adequately explain monthly industry and index returns. Both anomalies are consistent with a bad model problem where the book‐to‐market factor introduces a negative bias in the intercepts. I propose the intangibles model as an alternative where the three‐factor model is known to have difficulty. This alternative model, which replaces the book‐to‐market factor with zero investment portfolio returns based on prior investments in intangible assets, is well specified in random samples, has comparable power, and fully explains both anomalies.     

New Evidence on Sources of Leverage Effects in Individual Stocks

I test Black's leverage effect hypothesis on a panel of U.S. stocks from 1997 to 2012. I find that negative stock return innovations increase the future volatility of equity returns by about 36% more than positive ones. There is a strong and positive relation between variation in the size of these leverage effects and variation in the firm's use of debt. I uncover this relation by applying the Fama/French/Carhart 4‐factor asset pricing model in the exponential generalized autoregressive conditional heteroskedasticity mean equation and by using panel data to control for firm‐ and time‐invariant unobservables via first differences and two‐way fixed effects.     

Asset Pricing and the Illiquidity Premium

In this paper, we examine the asset‐pricing role of liquidity (as proxied by share turnover) in the context of the Fama and French (1993) three‐factor model. Our analysis employs monthly Australian data, covering the sample period from 1990 to 1998. The key finding of our research is that the main test is unable to reject the test of over‐identifying restrictions, thus supporting the overall favorability of the liquidity‐augmented Fama–French model. In addition, we find that the asset‐pricing performance of the liquidity factor is generally very robust to a wide range of sensitivity checks.     

The relationship between size,book-to-market equity ratio,earnings–price ratio,and return for the Hong Kong stock market

In this paper, we investigate the relation between stock returns and β, size (ME), leverage, book-to-market equity ratio, and earnings–price ratio (E/P) in Hong Kong stock market using the Fama and French (FF) [J. Finance 47 (1992) 427] approach. FF find that two variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with β, size, leverage, book-to-market equity, and E/P ratios. In this paper, similar to previous studies in Hong Kong and US stock markets, we find that β is unable to explain the average monthly returns on stocks continuously listed in Hong Kong Stock Exchange for the period July 1984–June 1997. But three of the variables, size, book-to-market equity, and E/P ratios, seem able to capture the cross-sectional variation in average monthly returns over the period. The other two variables, book leverage and market, are also able to capture the cross-sectional variation in average monthly returns. But their effects seem to be dominated by size, book-to-market equity, and E/P ratios, and considered to be redundant in explaining average returns when size, book-to-market equity, and E/P ratios are also considered. The results are consistent across subperiods, across months, and across size groups. These suggest that the results are not driven by extreme observations or abnormal return behavior in some of the months or by size groups.     

Oil Risk Exposure: The Case of the U.S. Oil and Gas Sector

We estimate oil price risk exposures of the U.S. oil and gas sector using the Fama‐French‐Carhart's four‐factor asset pricing model augmented with oil price and interest rate factors. Results show that the market, book‐to‐market, and size factors, as well as momentum characteristics of stocks and changes in oil prices are significant determinants of returns for the sector. Oil price risk exposures of U.S. oil and gas companies in the oil and gas sector are generally positive and significant. Our study also finds that oil price risk exposures vary considerably over time, and across firms and industry subsectors.     

Do Low‐Priced Stocks Drive Long‐Term Contrarian Performance on the London Stock Exchange?

We investigate whether low‐priced stocks drive long‐term contrarian performance on the U.K. market. We find that contrarian performance at low, middle, and high price levels is positive. On the Fama‐French risk adjusted basis, we find both low‐priced and middle‐priced losers have significantly positive returns. When we adjust returns by market and liquidity risk, only middle‐priced losers maintain their positive returns. Our results reveal that low‐priced stocks are not fully responsible for contrarian performance. Our empirical evidence is generally consistent with the overreaction hypothesis and behavioral models of value investing.     

Default Risk in Equity Returns

This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book‐to‐market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama–French (FF) factors SMB and HML contain some default‐related information, but this is not the main reason that the FF model can explain the cross section of equity returns.     

A Comparison of the Efficacy of Liquidity,Momentum, Size and Book‐to‐Market Value Factors in Equity Pricing on a Heterogeneous Sample: Evidence from Asia

This paper compares the size and book‐to‐market value factors of Fama and French (1993) alongside Momentum of Jagadeesh and Titman ( 1993 ) with two Liu ( 2006 ) liquidity factors formed from 1 year rebalancing and 1 month rebalancing respectively. A heterogeneous and comprehensive sample of the top blue chip stocks of all national Asian equity markets with further differentiation undertaken between sub samples formed for Japan only and Asia excluding Japan for period January 2000 to August 2014. Our empirical results suggest that multifactor time invariant pricing models based on augmented capital asset pricing model (CAPM) framework are ineffective in explaining the cross section of stock returns in the presence of significant inter and intra‐market segmentation. However an alternative model specification based on a time varying parameter specification and using same sets of factors yields significant enhancements in explaining cross section of stock returns across universe. We find that momentum factor largely lacks significance while a time varying two factor model, based on CAPM plus liquidity factor, is optimal. The liquidity factor being that of Liu (2006) and annually rebalanced. Our findings are important for investment managers seeking appropriate factors and modelling techniques to hedge against risks as well as firm's financial managers seeking to reduce costs of equity capital.     

Characterizing the Risk of IPO Long‐Run Returns: The Impact of Momentum,Liquidity, Skewness,and Investment

We study 6,686 initial public offerings (IPOs) spanning the period 1981‐2005 and find that the new issues puzzle disappears in a Fama‐French three‐factor framework. IPOs do not underperform in the aftermarket on a risk‐adjusted basis and do not underperform a matched sample of nonissuers. IPO underperformance is concentrated in the 1980s and early 1990s, and IPOs either perform the same as the market or outperform on a risk‐adjusted basis from 1998 to 2005. We find that outperformance in the later period is driven by large firms. Factors for momentum, investment, liquidity, and skewness help to explain aftermarket returns, although size and book‐to‐market tend to proxy for skewness. IPO investors receive smaller expected returns due to negative momentum and investment exposure and in exchange for higher liquidity.