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.     

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.     

Evaluating asset pricing models in the Korean stock market

This paper evaluates and compares asset pricing models in the Korean stock market. The asset pricing models considered are the CAPM, APT-motivated models, the Consumption-based CAPM, Intertemporal CAPM-motivated models, and the Jagannathan and Wang conditional CAPM model. By using various test portfolios as well as individual stocks, we conduct time-series tests and cross-sectional regression tests based on individual t-tests, the joint F-tests, the Hansen and Jagannathan (1997) distance, and R-squares. Overall, the Fama and French (1993) five-factor model performs most satisfactorily among the asset pricing models considered in explaining the intertemporal and cross-sectional behavior of stock returns in Korea. The Fama and French (1993) three-factor model, the Chen et al. (2010) three-factor model, and the Campbell (1996) model are the next. The results indicate that the two bond portfolios, term spread and default spread, play an important role in explaining stock returns in Korea.     

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.     

Do relative leverage and relative distress really explain size and book-to-market anomalies?

In a capital asset pricing model (CAPM) framework, Ferguson and Shockley [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] propose two factors constructed on relative leverage and relative distress, and show that the two factors subsume Fama and French's [1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33, 3–56] factors constructed on size and book-to-market (BM) in explaining the cross-sectional average returns of the 25 size-BM portfolios. Based on tests on individual securities, we find that all factors fail to fully explain the common asset-pricing anomalies. In the spirit of Merton's [1973. An intertemporal capital asset pricing model. Econometrica 41, 867–887] intertemporal CAPM, we propose an augmented five-factor model, which incorporates Ferguson and Shockley's [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] factors into the Fama–French three-factor model. The empirical results show that a simple conditional version of the augmented model is able to explain most well-known asset-pricing anomalies.     

Cross‐sectional Tests of Conditional Asset Pricing Models: Evidence from the German Stock Market

We study the performance of conditional asset pricing models and multifactor models in explaining the German cross‐section of stock returns. We focus on several variables, which (according to previous research) are associated with market expectations on future market excess returns or business cycle conditions. Our results suggest that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved when allowing for time‐varying parameters of the stochastic discount factor. A conditional CAPM using the term spread explains the returns on our size and book‐to‐market sorted portfolios about as well as the Fama‐French three‐factor model and performs best in terms of the Hansen‐Jagannathan distance. Structural break tests do not necessarily indicate parameter instability of conditional model specifications. Another major finding of the paper is that the Fama‐French model – despite its generally good cross‐sectional performance – is subject to model instability. Unconditional models, however, do a better job than conditional ones at capturing time‐series predictability of the test portfolio returns.     

Weighing asset pricing factors: a least squares model averaging approach

Empirical evidence has demonstrated that certain factors in asset pricing models are more important than others for explaining specific portfolio returns. We propose a technique that evaluates the factors included in popular linear asset pricing models. Our method has the advantage of simultaneously ranking the relative importance of those pricing factors through comparing their model weights. As an empirical verification, we apply our method to portfolios formed following Fama and French [A five-factor asset pricing model. J. Financ. Econ., 2015, 116, 1–22] and demonstrate that models accommodated to our factor rankings do improve their explanatory power in both in-sample and out-of-sample analyses.     

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.     

Asset pricing and energy consumption risk

This paper proposes energy consumption in the US as a new measure for the consumption capital asset pricing model. We find that (i) industrial energy growth produces reasonable values for the relative risk aversion coefficient and the implied risk-free rate; (ii) compared to alternative consumption measures, industrial energy performs well in explaining the cross-sectional variation in stock returns with the lowest implied risk aversion and pricing errors; (iii) the industrial energy consumption risk model performs equally well as the Fama–French three-factor model in the cross-sectional asset pricing tests; and (iv) total energy consumption risk is priced in the presence of the Fama–French factor risks.     

Systematic Risk and Empirical Research

We show here that risky asset returns generating processes stated in terms of factors which include both accounting and non-accounting based measures of risk (e.g. book to market ratios) imply, under fairly standard regularity conditions, that the Sharpe-Lintner-Black asset pricing model beta is a 'sufficient' statistic in the sense that it captures all important attributes of the returns generating process in a single number. We then derive the parametric relationship between betas based on inefficient index portfolios and betas based on the market or tangency portfolio. We demonstrate that the relationship between risky asset expected returns and betas computed on the basis of inefficient index portfolios is both consistent with the predictions of the Capital Asset Pricing Model and the multi-factor asset pricing models of Fama and French (1992, 1993, 1995 and 1996). The 'trick' is to realise that inefficient index portfolios are composed of the market portfolio and a collection of inefficient but self financing 'kernel' or 'arbitrage' portfolios. It then follows that there is a perfect linear cross sectional relationship between risky asset expected returns, betas based on inefficient index portfolios and the arbitrage portfolios. Hence, if we happen to stumble across variables that span the same subspace as the vectors representing the arbitrage portfolios, it is easy to create the illusion that risky asset expected returns depend on variables other than 'beta'.     

Long‐Run Stockholder Consumption Risk and Asset Returns

We provide new evidence on the success of long‐run risks in asset pricing by focusing on the risks borne by stockholders. Exploiting microlevel household consumption data, we show that long‐run stockholder consumption risk better captures cross‐sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross‐section of stocks.     

Asset liquidity and stock returns

We document the significant predictive power of firms' asset liquidity in the cross section of subsequent stock returns. The annual return spread between portfolios featuring the highest and lowest levels of asset liquidity is significantly positive. Our proposed measure of asset liquidity outperforms those measures developed by Gopalan et al. (2012) in predicting returns. The asset liquidity anomaly also provides significantly positive alphas when controlling for the asset pricing factors in the Fama and French (1993) three-factor model and the Carhart (1997) four-factor model. Asset liquidity exhibits strong return forecasting power even after controlling for acknowledged cross-sectional determinants of return. The positive relation between asset liquidity and future returns tends to be stronger for firms with greater asset productivity, higher quality cash flow and lower capital investment.     

Evaluating a non-linear asset pricing model on international data

The paper analyses the ability of a non-linear asset pricing model suggested by Dittmar [Dittmar, R.F., 2002. Non-linear pricing kernels, kurtosis preference, and the cross-section of equity returns. Journal of Finance 57, 369-403] to explain the returns on international value and growth portfolios. For comparison we use competing pricing models such as the ICAPM, the exchange rate risk augmented ICAPM and the international two-factor model proposed by Fama and French [Fama, E.F., French, K. R., 1998. Value versus growth: The international evidence. Journal of Finance 53, 1975-1999]. All models are evaluated both unconditionally and conditionally. The models are evaluated by applying the Hansen and Jagannathan distance measure, and we also employ several alternative measures to ensure a robust comparison of the models. We find support for the model of Dittmar [Dittmar, R.F., 2002. Non-linear pricing kernels, kurtosis preference, and the cross-section of equity returns. Journal of Finance 57, 369-403]. Evaluated conditionally, this model successfully passes all the different diagnostic tests performed in the analysis.     

Assessing Asset Pricing Anomalies

The optimal portfolio strategy is developed for an investorwho has detected an asset pricing anomaly but is not certainthat the anomaly is genuine rather than merely apparent. Theanalysis takes account of the fact that the parameters of boththe underlying asset pricing model and the anomalous returnsare estimated rather than known. The value that an investorwould place on the ability to invest to exploit the apparentanomaly is also derived and illustrative calculations are presentedfor the Fama and French SMB and HML portfolios, whose returnsare anomalous relative to the CAPM.     

An intertemporal capital asset pricing model with bank credit growth as a state variable

An ICAPM which includes bank credit growth as a state variable explains 94% of the cross-sectional variation in the average returns on the 25 Fama–French portfolios. We find compelling evidence that bank credit growth is priced in the cross-section of expected stock returns, even after controlling for well-documented asset pricing factors. These results are robust to the inclusion of industry portfolios in the set of test assets. They are also robust to the addition of firm characteristics and lagged instruments in the factor model. Bank credit growth is important because of its ability to predict business cycle variables as well as future labor income growth. These findings underscore the relevance of bank credit growth in stock pricing.     

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.     

Do zero-cost portfolios have the ability to predict economic growth? Evidence from Hong Kong, South Korea and Taiwan

In this paper we investigate the relationship between growth in future Gross Domestic Product (GDP) and Industrial Production (IDP) and the performance of SMB (small stocks minus big stocks) and HML (High book-to-market stocks minus low book-to-market stocks) portfolios for equities listed in Hong Kong, South Korea and Taiwan.We find evidence to suggest that: (a) the excess market return is positively related to future GDP or IDP growth in South Korea and Taiwan; (b) contrary to most European markets, Australia, Japan and the US, future economic growth is in general significantly negatively related to SMB in Hong Kong and South Korea; and, (c) a negative relationship between future economic growth and HML for Hong Kong. Our results cast doubt if SMB and HML portfolios are positive risk factors in the Fama and French (Fama, E. F., and French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3-56) three-factor asset pricing model for Hong Kong, South Korea and Taiwan.     

In America's thrall: the effects of the US market and US security characteristics on Australian stock returns

Can Australian equity returns be modelled by ‘home‐grown’ factors? We examine the indigenous capital asset pricing model, the indigenous Fama–French three‐factor model, and extensions to the latter, and find them all wanting. We find evidence of domestic market segmentation in Australia. For the smallest firms, all the models we study fail. For the largest Australian firms, we find that the US Fama–French three factors (downloaded from French's website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ ) provide a successful model of Australian returns. It is as if the largest firms in the Australian market are simply part of the larger US market.     

Evaluating asset pricing models using the second Hansen-Jagannathan distance

We develop a specification test and a sequence of model selection procedures for non-nested, overlapping, and nested models based on the second Hansen-Jagannathan distance, which requires a good asset pricing model to not only have small pricing errors but also be arbitrage free. Our methods have reasonably good finite sample performances and are more powerful than existing ones in detecting misspecified models with small pricing errors but are not arbitrage-free and in differentiating models that have similar pricing errors of a given set of test assets. Using the Fama and French size and book-to-market portfolios, we reach dramatically different conclusions on model performances based on our approach and existing methods.     

Australian evidence on the implementation of the size and value premia

This study investigates whether passive investment managers can exploit the size and value premia without incurring prohibitive transaction costs or being exposed to substantial tracking error risk. Returns on the value premium are shown to be pervasive across size groups, while the size premium is nonlinear and driven by microcaps. The value premium cannot be explained by the capital asset pricing model; however, returns on value portfolios do covary across monetary regimes. The substantial turnover required to achieve annual rebalancing and the relative illiquidity of Australian small‐cap firms means that investing in a portfolio of large‐cap value firms appears to be the best way for passive fund managers to exploit the Fama and French (1993) premia.