Model uncertainty and systematic risk in US banking

This paper uses Bayesian Model Averaging to examine the driving factors of equity returns of US Bank Holding Companies. BMA has as an advantage over OLS that it accounts for the considerable uncertainty about the correct set (model) of bank risk factors. We find that out of a broad set of 12 risk factors only the market, real estate, and high-minus-low Fama–French factors are reliably related to US bank stock returns over the period 1986–2010. Other factors are either only relevant over specific subperiods or for subsets of bank holding companies. We discuss the implications of our findings for empirical banking research.     

Tangibility and investment irreversibility in asset pricing

Zhang (2005) and Cooper (2006) provide a theoretical risk‐based explanation for the value premium by suggesting a nexus between firms’ book‐to‐market ratio and investment irreversibility. They argue that unproductive physical capacity is costly in contracting conditions but provides growth opportunities during economic expansions, resulting in covariant risk between firms’ investment in tangible assets and market‐wide returns. This article uses the Australian accounting environment to empirically test this theory – a test that is not possible using US data. Consistent with the theoretical argument, tangibility is priced in equity returns, and augmenting the Fama and French three‐factor model with a tangibility factor increases model explanatory power.     

Constructing and Testing Alternative Versions of the Fama–French and Carhart Models in the UK

This paper constructs and tests alternative versions of the Fama–French and Carhart models for the UK market with the purpose of providing guidance for researchers interested in asset pricing and event studies. We conduct a comprehensive analysis of such models, forming risk factors using approaches advanced in the recent literature including value‐weighted factor components and various decompositions of the risk factors. We also test whether such factor models can at least explain the returns of large firms. We find that versions of the four‐factor model using decomposed and value‐weighted factor components are able to explain the cross‐section of returns in large firms or in portfolios without extreme momentum exposures. However, we do not find that risk factors are consistently and reliably priced.     

Anomalies and stock returns: Australian evidence

Prior research has identified the existence of several cross‐sectional patterns in equity returns, commonly referred to as effects. This paper tests for the existence of a number of well‐known effects using data from the Australian equities market. Specifically, we investigate the size effect, book‐to‐market effect, earnings‐to‐price effect, cashflow‐to‐price effect, leverage effect and the liquidity effect. An additional aim of this paper is to investigate the capability of the Fama–French model in explaining any observed effects. We document a size, book‐to‐market, earnings‐to‐price and cashflow‐to‐price effect but fail to find evidence of a leverage or liquidity effect. Although our findings indicate that the Fama–French model can partially explain some of the observed effects, we conclude that its performance is less than satisfactory in Australia.     

Analysing the market–book value relation in large Australian and US firms: implications for fundamental analysis and the market–book ratio

This study compares the market–book relation of Australian and US firms using firm‐level dynamic analysis of using annual data for a long‐run period in error correction modelling. This paper contributes to a recent call for alternative ways of estimating Ohlson‐type linear valuation models (Ohlson and Kim, 2015). Log transformations of the data are used in this study to improve the statistical properties of the models. This study contributes to the findings on linear valuation model estimation for long‐run firms. Based on the returns model estimation, we find evidence of a higher level of co‐integration between market and book values for Australian firms.     

UK Evidence on the Characteristics versus Covariance Debate

We evaluate the Fama–French three‐factor model in the UK using the approach of Daniel and Titman (1997) to determine whether characteristics or covariance risk better explains the size and value premiums. Across all three factors, we find that return premiums bear little relationship to the corresponding loadings. We show that small and value stocks earn higher returns irrespective of their return covariance. Our study contributes to the existing literature by reporting original findings on the Fama–French three‐factor model in the UK and by reporting results that complement existing evidence from similar studies in the USA and Japan.     

A Dynamic Model of Firm Valuation

We propose a dynamic version of the dividend discount model, solve it in closed form, and assess its empirical validity. The valuation method is tractable and can be easily implemented. We find that our model produces equity value forecasts that are very close to market prices, and explains a large proportion of the observed variation in share prices. Moreover, we show that a simple portfolio strategy based on the difference between market and estimated values earns considerably positive returns. These returns cannot be simply explained either by the Fama‐French three‐factor model (even after adding a momentum factor) or the Fama‐French five‐factor model.     

Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms

Do the low long‐run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book‐to‐market borrowers as systematically riskier than larger borrowers with low book‐to‐market ratios, consistent with the asset pricing approach in Fama and French (1993) . Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk‐based explanations for the observed equity returns following IPOs and SEOs.     

Foreign exchange volatility and stock returns

This paper explores whether foreign exchange volatility is a priced factor in the US stock market. Our investigation is motivated by a number of empirical as well as theoretical considerations. Empirically, Menkhoff et al. (2012) find that foreign exchange volatility is a pervasive factor across a variety of test assets. Theoretically, Shapiro (1974), Dumas (1978), and Levi (1990) imply that foreign exchange volatility can influence firms’ cash flow volatility therefore the discount rate. In terms of empirical implementation, we employ the cross-sectional regression methodology of Fama and MacBeth (1973) as well as the time-series regression approach of Fama and French (1996). For robustness, we also use the mimicking portfolio approach of Fama and French (1993). We find that foreign exchange volatility has no power to explain either the time-series or the cross-section of stock returns, which calls for more research on foreign exchange risk. Bartov et al. (1996) and Adrian and Rosenberg (2008) suggest an alternative and maybe promising direction.     

Do industries contain predictive information for the Fama–French factors?

We examine whether the returns of US industry portfolios predict the returns and volatility of Fama and French's small-minus-big (SMB) and high-minus-low (HML) factors. The analysis reveals that all 30 industry returns strongly forecast one-month-ahead SMB factor returns. Moreover, a significant number of industry returns predict the volatility of the SMB and HML factors by up to two or three months. These findings suggest that US industry returns contain profitable information on Fama–French SMB and HML factors, and since most investors cannot extract the profitable information contained in industry returns in a timely manner, this information gradually diffuses in equity markets.     

The Performance of Hedge Fund Strategies and the Asymmetry of Return Distributions

We present hedge fund performance estimates that adjust for stale prices, Fama‐French risk factors and skewness. We contrast these new performance estimates with traditional performance measures. Using three‐factor models to adjust for staleness in prices and to incorporate Fama‐French factors along with the Harvey‐Siddique (2000) two‐factor model that incorporates skewness, we find that for the period 1990–2003, all hedge fund categories achieve above average performance when measured against an aggregate market index. More significantly, however, when we estimate performance at the individual hedge fund level, we discover that only 40 to 47% of the funds are shown to achieve an above average performance over that time period depending on the model used. These results have important implications for investors, endowments and pensions when they choose hedge fund managers.     

Implied volatility and future portfolio returns

Prior studies find that the CBOE volatility index (VIX) predicts returns on stock market indices, suggesting implied volatilities measured by VIX are a risk factor affecting security returns or an indicator of market inefficiency. We extend prior work in three important ways. First, we investigate the relationship between future returns and current implied volatility levels and innovations. Second, we examine portfolios sorted on book-to-market equity, size, and beta. Third, we control for the four Fama and French [Fama, E., French, K., 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33, 3–56.] and Carhart [Carhart, M., 1997. On persistence in mutual fund performance. Journal of Finance, 52, 57–82.] factors. We find that VIX-related variables have strong predictive ability.     

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.     

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.     

Information based trade,the PIN variable,and portfolio style differences: Evidence from Tokyo stock exchange firms

We investigate whether the variables related to information based trade proposed by Easley et al. [Easley, D., Kiefer, N.M., O'Hara, M., Paperman, J.B., 1996. Liquidity, information, and infrequently traded stocks. Journal of Finance 51, 1405–1436.] help explain the daily price discovery process in an electronically order-driven market of the Tokyo Stock Exchange using the microstructure tick data. We find strong evidence that the value firms show higher probability of bad news occurrences than the growth firms. We also find that the PIN is higher for smaller firms as is the case in the U.S. With the portfolio ranking tests and the Fama and MacBeth test we find that the alpha variable, which represents the information event occurrence rate, is systematically related to required returns, while the evidence related to the PIN is weaker. In the final Fama and MacBeth test, in which the PIN or alpha variable is used as an additional explanatory variable to the benchmark Fama and French three factor model, we find that the sign of the alpha variable supports our hypothesis that the arrival of new information reduces the risk of the stock, though not significantly. We also find that the higher PIN value increases the risk of the stock, at the same time it can marginally improve the explanatory power of the multifactor model. We conclude that the PIN variable cannot be a substitutable proxy variable for the book-to-market factor unlike in the U.S., and that it is strongly related to the size variable.     

An Analysis of Contrarian Investment Strategies in the UK

The performance of contrarian, or value strategies – those that invest in stocks that have low market value relative to a measure of their fundamentals – continues to attract attention from researchers and practitioners alike. While there is much extant evidence on the profitability of value strategies, however, most of this evidence pertains to the US. In this paper, we provide a detailed characterisation of value strategies using data on UK stocks for the period 1975 to 1998. We first undertake simple one-way and two-way classifications of stocks in which value is defined using both past performance and expected future performance. Using sales growth as a proxy for past performance and book-to-market, earnings yield and cash flow yield as measures of expected future performance, we find that that stocks that have both poor past performance and low expected future performance have significantly higher returns than those that have either good past performance or good expected future performance. Allowing for size effects in returns reduces the value premium but it nevertheless remains significant. We go on to explore whether the profitability of value strategies in the UK can be explained using the three factor model of Fama and French (1996). Broadly consistent with the results for the US, we find that using the one-way classification the excess returns to almost all value strategies can be explained by their loading on the market, book-to-market and size factors. However, in contrast with the US, using the two-way classification there are excess returns to value strategies based on book-to-market and sales growth, even after controlling for their loading on the market, book-to-market and size factors.     

Do the Fama–French Factors Proxy for Innovations in Predictive Variables?

The Fama–French factors HML and SMB are correlated with innovations in variables that describe investment opportunities. A model that includes shocks to the aggregate dividend yield and term spread, default spread, and one‐month Treasury‐bill yield explains the cross section of average returns better than the Fama–French model. When loadings on the innovations in the predictive variables are present in the model, loadings on HML and SMB lose their explanatory power for the cross section of returns. The results are consistent with an ICAPM explanation for the empirical success of the Fama–French portfolios.     

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.     

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.     

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.