The world price of sentiment risk

This paper examines whether sentiment can be considered a priced source of risk on international financial markets. We investigate whether residual sentiment is rewarded with a risk premium if added to a model with macroeconomic fundamentals and analyze the time-variation of the respective risk premia. The analysis is performed in the framework of a conditional multiple-beta pricing model and focusses on the excess returns of the G7 stock markets in the period from February 1999 to February 2012. The obtained results indicate that sentiment indeed earns a significant risk premium of around 2% p.a. on the considered markets.     

Local risk factors in emerging markets: Are they separately priced?

We provide new evidence on the pricing of local risk factors in emerging stock markets. We investigate whether there is a significant local currency premium together with a domestic market risk premium in equity returns within a partial integration asset pricing model. Given previous evidence on currency risk, we conduct empirical tests in a conditional setting with time-varying prices of risk. Our main results support the hypothesis of a significant exchange risk premium related to the local currency risk. Exchange rate and domestic market risks are priced separately for our sample of seven emerging markets. The empirical evidence also suggests that although statistically significant, local currency risk is on average smaller than domestic market risk but it increases substantially during crises periods, when it can be almost as large as market risk. Disentangling these two factors is thus important in tests of international asset pricing for emerging markets.     

Is There a Size Effect in the Pricing of Stocks in the Chinese Stock Markets?: The Case of Bull Versus Bear Markets

Size effect studies generally suggest that a return premium exists for small firms. While the size effect has mostly disappeared in recent years in mature markets (e.g., US and UK), it remains mostly strong in developing markets. The purpose of this paper is to examine the relationship between firm size and excess stock returns in the Chinese stock markets, and to examine this effect in both a bull and bear market. No studies have previously examined these relationships in the Chinese markets. The results of the study indicate that a size effect exists in the Chinese stock markets over the 6-year period from 1998 to 2003. We find small firms have significantly greater excess returns than large firms. Moreover, small firms are found to have a stronger reaction to the direction of the market than large firms. Small firms have significantly greater positive excess returns than large firms during the bull market. However, small firms have significantly greater negative returns (using total market value), or no significant difference in returns (using float market value) during the bear market period.     

An International Asset Pricing Model with Time-Varying Hedging Risk

This paper employs a two-factor international equilibrium asset pricing model to examine the pricing relationships among the world's five largest equity markets. In addition to the traditional market factor premium, a hedging factor premium is included as the second factor to explain the relationship between risks and returns in the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is needed to explain rates of return on international equities. Furthermore, the restriction that the coefficient on the hedge-portfolio covariance is one smaller than the coefficient on the market-portfolio covariance can not be rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to explain the returns on the five largest stock market indices.     

The Variation of Economic Risk Premiums in Real Estate Returns

We examine the predictable components of returns on stocks, bonds, and real estate investment trusts (REITs). We employ a multiple-beta asset pricing model and find that there are varying degrees of predictability among stocks, bonds, and REITs. Furthermore, we find that most of the predictability of returns is associated with the economic variables employed in the asset pricing model. The stock market risk premium is highly important in capturing the predictable variation in stock portfolios, and the bond market risk premiums (term and risk structure of interest rates) are important in capturing the predictable variation in bond portfolios. For REITs, however, both the stock and bond market risk premiums capture the predictable variation in returns. REITs have comparable return predictability to stock portfolios. We conclude that there is an important economic risk premium for REITs that are not captured by traditional multiple-beta asset pricing models.     

Volatility Risk Premium,Risk Aversion,and the Cross‐Section of Stock Returns

We test if innovations in investor risk aversion are a priced factor in the stock market. Using 25 portfolios sorted on book‐to‐market and size as test assets, our new factor together with the market factor explains 64% of the variation in average returns compared to 60% for the Fama‐French model. The new factor is generally significant with an estimated risk premium close to its time series mean also when industry portfolios and portfolios sorted on previous returns are augmented to the test assets.     

Do Beta Pricing Models Explain January Mean Reversion in Stock Returns?

Jegadeesh (1991) finds evidence of January mean reversion in stock returns. In this paper we attempt to distinguish between two competing economic explanations of January mean reversion in returns: (1) mispricing in irrational markets versus (2) predictable time variation in security risk premia. Excess portfolio returns are decomposed into “explained” and “unexplained” components using the Fama-French (1993) pricing model. The explained excess returns exhibit January mean reversion. The unexplained excess returns are not mean reverting. Mean reversion is therefore consistent with rational pricing in the framework of the Fama-French model. Mean reversion can be attributed to the component of return related to a relative distress factor (SMB). A comparison with the Chen, Roll, and Ross (1986) macroeconomic factors reveals that mean reversion is due to the components related to SMB and bond default premium.     

A macroeconomic hedge portfolio and the cross section of stock returns

We use a stock's returns on days when important macroeconomic news is released to form a hedge portfolio, which is long (short) in stocks which have a sensitive (insensitive) reaction to the surprise component of the macroeconomic news. This macroeconomic hedge portfolio (MHP) earns a risk premium of about 5% p.a. over time and a similar premium when used as a risk factor in an asset pricing model. This premium can be interpreted as a cost of an insurance against unexpected changes in an investor's marginal utility. We show that risk premiums associated with the MHP are estimated with a higher precision than traditional macroeconomic tracking portfolios. Furthermore, when the MHP is present in a common factor model, risk factors like high minus low lose much of their ability to explain the cross section of stock returns.     

Exchange rate and inflation risk premia in the EMU

This paper tests the effects of exchange rate and inflation risk factors on asset pricing in the European Union (EU) stock markets. This investigation was motivated by the results of Vassalou [J. Int. Money Finance, 2000, 19, 433–470] showing that both exchange rate and foreign inflation are generally priced in equity returns, and it studies the opportunity of evaluating the causality between these sources of risk after the elimination of the EU currency risks because of the adoption of the single currency. Our results show that both exchange rate and inflation risks are significantly priced in the pre- and post-euro periods. Moreover, the sizes of exchange rate and inflation risk premiums are economically significant in the pre- and post-euro periods. Futhermore, the UK and excluding-UK inflation risk premiums explain, in part, our evidence concerning a large EUR/GBP exchange rate risk premium and the existence of an economically significant domestic non-diversifiable risk after euro adoption. Hence overlooking inflation risk factors can produce an under/overestimation of the currency premiums and a miscalculation of the degree of integration of stock markets.     

Economic Risk Factors and Commercial Real Estate Returns

A great deal of research has focused on the links between stock and bond market returns and macroeconomic events such as fluctuations in interest rates, inflation rates, and industrial production. Although the comovements of real estate and other asset prices suggests that these same systematic risk factors are likely to be priced in real estate markets, no study has formally addressed this issue. This study identifies the growth rate in real per capita consumption, the real T-bill rate, the term structure of interest rates, and unexpected inflation as fundamental drivers or state variables that systematically affect real estate returns. The finding of a consistently significant risk premium on consumption has important ramifications for the vast literature that has examined the (risk-adjusted) performance of real estate, for it suggests that prior findings of significant abnormal returns (either positive or negative) that have ignored consumption are potentially biased by an omitted variables problem. The results also have important implications for dynamic asset allocation strategies that involve the predictability of real estate returns using economic data.     

Exchange Rate Exposure at the Firm and Industry Level

Previous work on the exposure of firms to exchange rate risk has primarily focused on U.S. firms and, surprisingly, found stock returns were not significantly affected by exchange‐rate fluctuations. The equity market premium for exposure to currency risk was also found to be insignificant. In this paper we examine the relation between Japanese stock returns and unanticipated exchange‐rate changes for 1,079 firms traded on the Tokyo stock exchange over the 1975–1995 period. Second, we investigate whether exchange‐rate risk is priced in the Japanese equity market using both unconditional and conditional multifactor asset pricing testing procedures. We find a significant relation between contemporaneous stock returns and unanticipated yen fluctuations. The exposure effect on multinationals and high‐exporting firms, however, is found to be greater in comparison to low‐exporting and domestic firms. Lagged‐exchange rate changes on firm value are found to be statistically insignificant implying that investors are able to assess the impact of exchange‐rate changes on firm value with no significant delay. The industry level analysis corroborates the cross‐sectional findings for Japanese firms in that they are sensitive to contemporaneous unexpected exchange‐rate fluctuations. The co‐movement between stock returns and changes in the foreign value of the yen is found to be positively associated with the degree of the firm's foreign economic involvement and inversely related to its size and debt to asset ratio. Asset pricing tests show that currency risk is priced. We find corroborating evidence in support of the view that currency exposure is time varying. Our results indicate that the foreign exchange‐rate risk premium is a significant component of Japanese stock returns. The combined evidence from the currency exposure and asset pricing analyses, suggests that currency risk is priced and, therefoe, has implications for corporate and portfolio managers.     

Interest Rate Risk of European Financial Corporations

We investigate the interest rate exposure of large European financial corporations' equity returns. For the period from January 1982 to March 1995 we estimate multifactor index models to examine the sensitivity of equity returns to market index returns and domestic as well as global interest rate movements. In addition, we specify an APT‐model to test whether an exposure to interest rate movements is rewarded in the cross‐section of expected returns. In the four European markets both domestic and global interest rate shifts constitute driving forces of stock returns beyond the influence of the domestic market indices. However, the exposure to interest rate movements does not seem to be rewarded in the same fashion among the markets.     

International Asset Excess Returns and Multivariate Conditional Volatilities

This paper constructs a multivariate model in relating multi-asset excess returns to their conditional variances. Applying weekly data to investigate the foreign-exchange risk premium, the evidence from a multivariate GARCH model shows that the foreign-exchange excess returns are significantly correlated with economic fundamentals such as the real interest-rate differential, long-short interest-rate spread differential, and equity-premium differential. The evidence also suggests that foreign-exchange excess returns are not independent of the conditional variances of these fundamental variables, supporting the time-varying risk-premium hypothesis.     

Is Financial Flexibility a Priced Factor in the Stock Market?

This paper develops a factor analysis–based measure for shifts in corporate financial flexibility (FFLEX) that can be observed from public accounting information. Companies that experience positive shifts in FFLEX are associated with higher future investment growth opportunities. We show that FFLEX is a robust determinant of future stock returns. Firms that have increased their financial flexibility are associated with lower stock returns in the subsequent period. A zero‐cost return portfolio produces a significant positive monthly premium of 0.69%, which is driven by covariance (risk). Risk inherent in the flexibility factor is not explained away by either prominent pricing characteristics or factors.     

Conditional Equity Premium and Aggregate Corporate Investment

We document a strong negative relation between aggregate corporate investment and conditional equity premium estimated from direct stock market risk measures. Consistent with the investment-based asset pricing model, the comovement with conditional equity premium fully accounts for aggregate investment's market return predictive power. Similarly, conditional equity premium is a significant determinant of classic Tobin's q measure, although q has much weaker explanatory power for aggregate investment possibly because of its measurement errors. Moreover, the positive relation between aggregate investment and investor sentiment documented in previous studies reflects the fact that both variables correlate closely with conditional equity premium.     

The relation between stock returns and short-term interest rates

This study examines the relation between the expected returns on common stocks and short-term interest rates. Using a two-factor model of stock returns, we show that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk, which are estimated as the sensitivity of common-stock excess returns to the excess return on the equally weighted market index and to the federal fund premium, respectively. We find that the interest-rate risk for small firms is a significant source of investors' portfolio risk, but is not properly reflected in the single-factor market risk. We also find that the interest-rate risk for large firms is “negative” in the sense that the market risk estimated from the single-factor model overstates the true risk of large firms. An application of the Fama-MacBeth methodology indicates that the interest-rate risk premium as well as the market's risk premium are significant, implying that both the market risk and the interest-rate risk are priced. We show that the interest-rate risk premium explains a significant portion of the difference in expected returns between the top quintile and the bottom quintile of the NYSE and AMEX firms. We also show that the turn-of-the-year seasonal is observed for the interest-rate risk premium; however, the risk premium for the rest of the year is still significant, although small in mangitude.     

Time-varying stock returns and labor income risks in the US and UK

I propose and estimate conditional asset pricing models where the risk premiums of the markets are related to the conditional covariance of the markets with labor income growth within and across countries and the volatility of the markets are related to the shocks and interactions of stock returns and labor income growth. I document that the risk premiums for the US and UK stock markets are more related to the conditional covariance of returns with the labor income growth within countries than across countries. I also find significant interactions of volatilities between stock returns and labor income within countries but not across countries. The results are consistent with the hypothesis that prices of domestic stocks are determined to a greater extent by stochastic discount factors of domestic investors than foreign investors and vice versa.     

Corporate Bond Returns and Volatility

Recent literature emphasizes the relation of stock volatility to corporate bond yields. We demonstrate that during 1996–2005 corporate bond excess return volatility is directly related to contemporaneous corporate bond excess returns. In fact, the decompositions of aggregate bond volatility have a higher contemporaneous correlation with bond yields in comparison to idiosyncratic stock risk. Additionally, bond volatility and idiosyncratic risk are significant predictors of corporate three‐month and six‐month ahead bond excess returns. We also find that corporate bond volatility contains both slow moving and time‐varying components.     

Have European Stocks become More Volatile? An Empirical Investigation of Idiosyncratic and Market Risk in the Euro Area

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the 12 euro area stock markets over the period 1974–2004. Similarly to Campbell et al. (2001) , we find a rise in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to the US, however, market risk is trended upwards in Europe and correlations are not trended downwards. Both the volatility and correlation measures are pro‐cyclical, and they rise during times of low market returns. Market and average idiosyncratic volatility jointly predict market wide returns, and the latter impact upon both market and idiosyncratic volatility. This has asset pricing and risk management implications.     

Foreign exchange risk and the cross-section of stock returns

We examine the relation between the cross-section of US stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange-sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's [2004. Forecast dispersion and the cross-section of expected returns. Journal of Finance, 59, 1957–1978] option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.