Volatilities and Momentum Returns in Real Estate Investment Trusts

We examine the relation of time-varying idiosyncratic risk and momentum returns in REITs using a GARCH-in-mean model and incorporate liquidity risk in the asset pricing model. This is important because illiquidity may be more severe for REITs due to the nature of their underlying assets. We find that momentum returns display asymmetric volatility, i.e., momentum returns are higher when volatility is higher. Additionally, we find evidence that REITs with lowest past returns (losers) have higher idiosyncratic risks than those with highest past returns (winners) and that investors require a lower risk premium for holding losers’ idiosyncratic risks. Therefore, although losers have higher levels of idiosyncratic risks, their low risk premia cause low returns, which contribute to momentum. Lastly, we find a positive relation between REITs’ momentum return and turnover.     

Can Asset Pricing Models Price Idiosyncratic Risk in U.K. Stock Returns?

I examine how well different linear factor models and consumption‐based asset pricing models price idiosyncratic risk in U.K. stock returns. Correctly pricing idiosyncratic risk is a significant challenge for many of the models I consider. For some consumption‐based models, there is a clear tradeoff in the performance of the models between correctly pricing systematic risk and idiosyncratic risk. Linear factor models do a better job in most cases in pricing systematic risk than consumption‐based models but the reverse is true for idiosyncratic risk.     

Can tail risk explain size,book‐to‐market,momentum, and idiosyncratic volatility anomalies?

We examine the impact of tail risk on the return dynamics of size, book‐to‐market ratio, momentum and idiosyncratic volatility sorted portfolios. Our time‐series analyses document significant portfolio return exposures to aggregate tail risk. In particular, portfolios that contain small, value, high idiosyncratic volatility and low momentum stocks exhibit negative and statistically significant tail risk betas. Our cross‐sectional analyses at the individual stock level suggest that tail risk helps in explaining the four pricing anomalies, particularly size and idiosyncratic volatility anomalies.     

Industry‐Specific Human Capital,Idiosyncratic Risk,and the Cross‐Section of Expected Stock Returns

Human capital is one of the largest assets in the economy and in theory may play an important role for asset pricing. Human capital is heterogeneous across investors. One source of heterogeneity is industry affiliation. I show that the cross‐section of expected stock returns is primarily affected by industry‐level rather than aggregate labor income risk. Furthermore, when human capital is excluded from the asset pricing model, the resulting idiosyncratic risk may appear to be priced. I find that the premium for idiosyncratic risk documented by several empirical studies depends on the covariance between stock and human capital returns.     

Idiosyncratic Consumption Risk and the Cross Section of Asset Returns

This paper investigates the importance of idiosyncratic consumption risk for the cross‐sectional variation in asset returns. We find that besides the rate of aggregate consumption growth, the cross‐sectional variance of consumption growth is also a priced factor. This suggests that consumers are not fully insured against idiosyncratic consumption risk, and that asset returns reflect their attempts to reduce their exposure to this risk. The resulting two‐factor consumption‐based asset pricing model significantly outperforms the CAPM, and its performance compares favorably with that of the Fama–French three‐factor model.     

Limits‐to‐arbitrage,investment frictions,and the investment effect: New evidence

This study comprehensively reexamines the debate over behavioral and rational explanations for the investment effect in an updated sample. We closely follow the previous literature and provide several differences. Our tests include five prominent measures of corporate investment and corporate profitability in q‐theory and recent investment‐based asset pricing models. Both classical and Bayesian inferences show that limits‐to‐arbitrage tend to be supported by more evidence than investment frictions for all investment measures. When idiosyncratic volatility and cash flow volatility are used in measuring investment frictions, the inference is more favorable for the rational explanation.     

Market Illiquidity and Conditional Equity Premium

We examine the time‐series relation between aggregate bid‐ask spreads and conditional equity premium. We document that average marketwide relative effective bid‐ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out‐of‐sample tests. These findings are important because they provide strong support for the literature's conjecture that marketwide liquidity is an important asset pricing risk factor.     

Anomalies and financial distress

This paper explores commonalities across asset pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. In contrast, the value-based strategy derives most of its profitability from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception. It is robust among high and low credit risk firms in all credit conditions.     

Idiosyncratic volatility and equity returns: UK evidence

The proposition that idiosyncratic volatility may matter in asset pricing is currently a topic of research and controversy. Using data from the UK market we examine the predictive ability of various measures of idiosyncratic risk and provide evidence which suggests that: (a) it is the idiosyncratic volatility of small capitalization stocks that matters for asset pricing and (b) that small stocks idiosyncratic volatility predicts the small capitalization premium component of market returns and is unrelated to either the market or the value premium. The predictive power of the aggregate idiosyncratic volatility of small stocks remains intact even after we control for the possible proxying effects of business cycle fluctuations and liquidity and is robust across time and different econometric specifications.     

Value and Momentum Everywhere

We find consistent value and momentum return premia across eight diverse markets and asset classes, and a strong common factor structure among their returns. Value and momentum returns correlate more strongly across asset classes than passive exposures to the asset classes, but value and momentum are negatively correlated with each other, both within and across asset classes. Our results indicate the presence of common global risks that we characterize with a three‐factor model. Global funding liquidity risk is a partial source of these patterns, which are identifiable only when examining value and momentum jointly across markets. Our findings present a challenge to existing behavioral, institutional, and rational asset pricing theories that largely focus on U.S. equities.     

Disclosure Risk and Price Drift

Disclosures play an apparently critical role in the empirical regularity of the short‐run momentum and long‐run reversal in stock returns. Motivated by this evidence, this paper integrates an analysis of disclosures within an asset pricing model to arrive at a framework in which disclosures and asset returns are jointly determined. Disclosures resolve uncertainty, but the increased information flow also raises the risks during the disclosure period. When disclosures and asset returns are modeled jointly, apparently good news is associated with the upward revision of future disclosure risks. The model generates predictions that have the outward appearance of short‐run momentum and long‐run reversal.     

The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

We analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.     

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.     

Equilibrium asset pricing: with non-Gaussian factors and exponential utilities

We analyse the equilibrium asset pricing implications for an economy with single period return exposures to explicit non-Gaussian systematic factors, that may be both skewed and long-tailed, and Gaussian idiosyncratic components. Investors maximize expected exponential utility and equilibrium factor prices are shown to reflect exponentially tilted prices for non-Gaussian factor risk exposures. It is shown that these prices may be directly estimated from the univariate probability law of the factor exposure, given an estimate of average risk aversion in the economy. In addition, a residual form of the capital asset pricing model continues to hold and prices the idiosyncratic or Gaussian risks. The theory is illustrated on data for the US economy using independent components analysis to identify the factors and the variance gamma model to describe the probability law of the non-Gaussian factors. It is shown that the residual CAPM accounts for no more than 1% of the pricing of risky assets, while the exponentially tilted systematic factor risk exposures account for the bulk of risky asset pricing.     

Aggregate implications of micro asset market segmentation

An extensive empirical literature finds that micro asset markets are segmented from one another. We develop a consumption-based asset pricing model to quantify the aggregate implications of a financial system comprised of many such segmented micro asset markets. We specify exogenously the level of segmentation that determines how much idiosyncratic risk traders bear in their micro market and calibrate the segmentation to match facts about systematic and idiosyncratic return volatility. In our benchmark model traders bear 30% of their idiosyncratic risk, the unconditional aggregate equity premium is 2.4% annual, and the welfare costs of segmentation are substantial, 1.8% of lifetime consumption.     

The Cross-Section of Volatility and Expected Returns

We examine the pricing of aggregate volatility risk in the cross‐section of stock returns. Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns. Stocks with high idiosyncratic volatility relative to the Fama and French (1993, Journal of Financial Economics 25, 2349) model have abysmally low average returns. This phenomenon cannot be explained by exposure to aggregate volatility risk. Size, book‐to‐market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility.     

Time series momentum and macroeconomic risk

The time series momentum strategy, previously known as trend following, has been shown to deliver consistent profitability over a long time horizon in futures markets. Funds pursuing this strategy are now a component of many institutional portfolios, due to the expectation of positive returns in equity bear markets. However, the return drivers of the strategy and its performance in other economic conditions are less well understood. We find evidence that the returns to the strategy are connected to the business cycle. Returns are positive in both recessions and expansions, but profitability is higher in expansions. Decomposing asset prices into factor related and idiosyncratic components, we associate a significant portion of returns with exposure to time varying economic factors, consistent with rational asset pricing theories having a role in explaining the profitability of the strategy.     

Implications of Keeping‐Up‐with‐the‐Joneses Behavior for the Equilibrium Cross Section of Stock Returns: International Evidence

This paper tests the cross‐sectional implications of “keeping‐up‐with‐the‐Joneses” (KUJ) preferences in an international setting. When agents have KUJ preferences, in the presence of undiversifiable nonfinancial wealth, both world and domestic risk (the idiosyncratic component of domestic wealth) are priced, and the equilibrium price of risk of the domestic factor is negative. We use labor income as a proxy for domestic wealth and find empirical support for these predictions. In terms of explaining the cross‐section of stock returns and the size of the pricing errors, the model performs better than alternative international asset pricing models.     

The effect of time-varying covariances on asset risk premia

In this article we examine an intertemporal capital asset pricing model (CAPM) that allows for time-varying conditional covariances that are assumed to follow a multivariate integrated generalized autoregressive conditional heteroscedastic (IGARCH) process. The resulting pricing equation includes idiosyncratic risk premia in addition to the usual market beta. Empirical analysis based on ten size and ten industry portfolios reveals significant idiosyncratic premia for most portfolios. Overall, we reject the static CAPM in favor of the intertemporal CAPM.     

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.