Common risk factors in bank stocks

This paper provides evidence on the risk factors that are priced in bank equities. Alternative empirical models with precedent in the nonfinancial asset pricing literature are tested, including the single-factor CAPM, three-factor Fama–French model, and ICAPM. Our empirical results indicate that an unconditional two-factor ICAPM model that includes the stock market excess return and shocks to the slope of the yield curve is useful in explaining the cross-section of bank stock returns. However, we find no evidence that firm specific factors such as size and book-to-market ratios are priced in bank stock returns. These results have a number of important implications for the estimation of the banks’ cost of capital as well as regulatory initiatives to utilize market discipline to evaluate bank risk under Basel II.     

Conditional beta pricing models: A nonparametric approach

We propose a two-stage procedure to estimate conditional beta pricing models that allows for flexibility in the dynamics of asset betas and market prices of risk (MPR). First, conditional betas are estimated nonparametrically for each asset and period using the time-series of previous data. Then, time-varying MPR are estimated from the cross-section of returns and betas. We prove the consistency and asymptotic normality of the estimators. We also perform Monte Carlo simulations for the conditional version of the three-factor model of Fama and French (1993) and show that nonparametrically estimated betas outperform rolling betas under different specifications of beta dynamics. Using return data on the 25 size and book-to-market sorted portfolios, we find that the nonparametric procedure produces a better fit of the three-factor model to the data, less biased estimates of MPR and lower pricing errors than the Fama–MacBeth procedure with betas estimated under several alternative parametric specifications.     

Using the credit spread as an option-risk factor: Size and value effects in CAPM

This paper takes an option-theoretic approach to explain why pricing anomalies are observed when traditional CAPM is used. By extending CAPM to incorporate the option-risk factor of stocks, we show that stockholders’ limited liability can explain Fama and French’s size and value effects. We use bonds’ excess credit spread as a proxy for stocks’ default risk to control for the changing non-diversifiable option-risk characteristic of stocks. Because sensitivity to the excess credit spread becomes smaller as size increases and as value decreases, excess credit spread explains the CAPM anomalies in a fashion similar to the Fama–French factors. While the excess credit spread is significant in explaining Fama and French’s size and value effects, adding the Fama–French factors does not improve the performance of our model. Our revised model resembles conditional CAPM, but it offers a more intuitive explanation for the size and value effects.     

Stock price reaction following large one-day price changes: UK evidence

We examine the short-term price reaction of 424 UK stocks to large one-day price changes. Using the GJR-GARCH(1,1), we find no statistical difference amongst the cumulative abnormal returns (CARs) of the Single Index, the Fama–French and the Carhart–Fama–French models. Shocks ?5% are followed by a significant one-day CAR of 1% for all the models. Whilst shocks ?−5% are followed by a significant one-day CAR of −0.43% for the Single Index, the CARs are around −0.34% for the other two models. Positive shocks of all sizes and negative shocks ?−5% are followed by return continuations, whilst the market is efficient following larger negative shocks. The price reaction to shocks is unaffected when we estimate the CARs using the conditional covariances of the pricing variables.     

Testing conditional asset pricing models: An emerging market perspective

The CAPM as the benchmark asset pricing model generally performs poorly in both developed and emerging markets. We investigate whether allowing the model parameters to vary improves the performance of the CAPM and the Fama–French model. Conditional asset pricing models scaled by conditioning variables such as Trading Volume and Dividend Yield generally result in small pricing errors. However, a graphical analysis reveals that the predictions of conditional models are generally upward biased. We demonstrate that the bias in prediction may be the consequence of ignoring frequent large variation in asset returns caused by volatile institutional, political and macroeconomic conditions. This is characterised by excess kurtosis. An unconditional Fama–French model augmented with a cubic market factor performs the best among some competing models when local risk factors are employed. Moreover, the conditional models with global risk factors scaled by global conditioning variables perform better than the unconditional models with global risk factors.     

Liquidity,default, taxes,and yields on municipal bonds

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9–13% of municipal yields for AAA bonds, 9–15% for AA/A bonds and 8–19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle.     

Accounting measures and international pricing models: Justifying accounting homogeneity

We study the importance of homogeneous accounting data when testing international versions of asset pricing models. Specifically, we focus on a pricing model commonly used by practitioners – the Fama–French three-factor model – which uses accounting information and has traditionally performed poorly at the cross-country level. We show that international versions of the model perform significantly better if the accounting information is homogeneous across firms. We apply the model to a set of firms that follow common accounting standards – the IAS/IFRS – and also to firms that have issued ADRs in the US – and therefore must report following both US GAAP and their own domestic standards. In both cases our results show that the accounting dimension is relevant: the use of homogeneous accounting measures allows for much higher goodness-of-fit of international versions of the three-factor model, at levels similar to those of domestic versions and superior to those of non-homogeneous versions. This suggests that further accounting homogeneity could lead to more accurate pricing and valuation of international assets and to an improvement of the efficiency of international fund allocation.     

What explains the investment growth anomaly?

We examine if an existing asset pricing model in an unconditional or conditional setting can explain the investment growth anomaly, as represented by higher returns on stocks of the firms with lower growth in capital expenditures. Our results indicate that the conditional Fama–French 3-factor model that allows factor loadings to be time-varying and further linked to firm-level characteristics and the business cycle can explain the anomaly.     

A tale of two prices: Liquidity and asset prices in multiple markets

This paper investigates the liquidity effect in asset pricing by studying the liquidity–premium relationship of an American depositary receipt (ADR) and its underlying share. Using the [Amihud, Yakov, 2002. Illiquidity and stock returns: cross-section and time series effects. Journal of Financial Markets 5, 31–56] measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.     

Pricing innovations in consumption growth: A re-evaluation of the recursive utility model

We re-evaluate the cross-sectional asset pricing implications of the recursive utility function of  and , using innovations in future consumption growth in our tests. Our empirical specification helps explain the size, value and momentum effects. Specifically, we find that (?) the beta associated with news about consumption growth has a systematic pattern: beta decreases along the size dimension and increases along the book-to-market and momentum dimensions, (??) innovation in consumption growth is significantly priced in asset returns using both the Fama and MacBeth (1973) and the stochastic discount factor approaches, and (???) the model performs better than both the CAPM and Fama–French model.     

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.     

Semiparametric estimation of a characteristic-based factor model of common stock returns

We introduce an alternative version of the Fama–French three-factor model of stock returns together with a new estimation methodology. We assume that the factor betas in the model are smooth nonlinear functions of observed security characteristics. We develop an estimation procedure that combines nonparametric kernel methods for constructing mimicking portfolios with parametric nonlinear regression to estimate factor returns and factor betas simultaneously. The methodology is applied to US common stocks and the empirical findings compared to those of Fama and French.     

中国股票市场流动性风险溢价研究

本文在对Fama三因素模型和LACAPM模型进行改进的基础上,实证研究了中国股票市场的流动性风险溢价、规模效应以及价值效应。实证结果发现,改进的FAMA三因素模型能够比CAPM更好地解释价值效应,但却不能解释规模效应和流动性风险溢价现象;而改进的LACAPM在解释市场异象上的有效性则明显优于其他定价模型。     

Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

The components of the illiquidity premium: An empirical analysis of US stocks 1927–2010

This paper implements a conditional version of the liquidity adjusted CAPM (LCAPM). The conditional LCAPM allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The estimated average annual total illiquidity premium for US stocks 1927–2010 is 1.74–2.08%, which is substantially lower than in most previous studies. The contributions from illiquidity level and illiquidity risk are 1.25–1.28% and 0.46–0.83%, respectively. Of the three illiquidity risk components, risk related to the hedging of wealth shocks is the most important, while commonality risk is the least important. The illiquidity premia are clearly time-varying, with peaks in downturns and crises, but with no general tendency to decrease over time. The level premium and the risk premium are significantly positively correlated, at around 0.35; indicating that in periods of turbulence both illiquidity cost and illiquidity risk premia tend to be high.     

Market-making costs in Treasury bills: A benchmark for the cost of liquidity

We focus on market-making costs by examining the daily bid–ask spreads for off-the-run, one-month Treasury bills around two liquidity-changing events. Event one, Salomon Brothers’ supply shock, results in a roughly 2.5-basis-point increase in the spread because of an increase in ask prices; and event two, the Long-Term Capital Management demand shock, results in a doubling of the spread because of a decrease in bid prices. Our results provide a benchmark for researchers examining bid–ask spreads of securities that include a liquidity premium, a risk premium, and an asymmetric information premium.     

State uncertainty in stock markets: How big is the impact on the cost of equity?

We propose a novel Bayesian framework to incorporate uncertainty about the state of the market. Among others, one advantage of the framework is the ability to model a large collection of time-varying parameters simultaneously. When we apply the framework to estimate the cost of equity we find economically significant effects of state uncertainty. A state-independent pricing model overestimates the cost of equity by about 4% per annum for a utility firm and by as much as 3% for industries. We also observe that the expected return, volatility, risk loading, and pricing error all display state-dependent dynamics that coincide with the business cycle. More interestingly, the forecasted market and Fama–French factor risk premiums can predict the future real GDP growth rate even though the model does not use any macroeconomic variables, which suggests that the proposed Bayesian framework captures the state-dependent dynamics well.     

Stock repurchases: How firms choose between a self tender offer and an open-market program

In practice, open-market stock repurchase programs outnumber self tender offers by approximately 10–1. This evidence is puzzling given that tender offers are more efficient in disbursing free cash and in signaling undervaluation – the two main motivations suggested in the literature for repurchasing shares. We provide a theoretical model to explore this puzzle. In the model, tender offers disburse free cash quickly but induce information asymmetry and hence require a price premium. Open-market programs disburse free cash slowly, and hence do not require a price premium, but because they are slow, result in partial free cash waste. The model predicts that the likelihood that a tender offer will be chosen over an open-market program increases with the agency costs of free cash and decreases with uncertainty (risk), information asymmetry, ownership concentration, and liquidity. These predictions are generally consistent with the empirical evidence.     

The expected value premium

Fama and French [2002. The equity premium. Journal of Finance 57, 637–659] estimate the equity premium using dividend growth rates to measure expected rates of capital gain. We apply their method to study the value premium. From 1945 to 2005, the expected value premium is on average 6.1% per annum, consisting of an expected dividend growth component of 4.4% and an expected dividend price ratio component of 1.7%. Unlike the equity premium, the value premium has been largely stable over the last half century.