Accruals and the Conditional Equity Premium

Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.     

The Illiquidity of Corporate Bonds

This paper examines the illiquidity of corporate bonds and its asset‐pricing implications. Using transactions data from 2003 to 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bid–ask spreads. We establish a strong link between bond illiquidity and bond prices. In aggregate, changes in market‐level illiquidity explain a substantial part of the time variation in yield spreads of high‐rated (AAA through A) bonds, overshadowing the credit risk component. In the cross‐section, the bond‐level illiquidity measure explains individual bond yield spreads with large economic significance.     

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.     

Time‐Varying Risk–Return Trade‐off in the Stock Market

We uncover a strong comovement of the stock market risk–return trade‐off with the consumption–wealth ratio (CAY). The finding reflects time‐varying investment opportunities rather than countercyclical aggregate relative risk aversion. Specifically, the partial risk–return trade‐off is positive and constant when we control for CAY as a proxy for investment opportunities. Moreover, conditional market variance scaled by CAY is negatively priced in the cross‐section of stock returns. Our results are consistent with a limited stock market participation model, in which shareholders require an illiquidity premium that increases with CAY, in addition to the risk premium that is proportional to conditional market variance.     

NUMBER OF TRANSACTIONS AND VOLATILITY: AN EMPIRICAL STUDY USING HIGH‐FREQUENCY DATA FROM NASDAQ STOCKS

Our empirical evidence based on transactions data of a sample of Nasdaq stocks indicates that trades of large firms are related to the proxies of marketwide and firm‐specific information. For large firms, an increase in the number of trades seems to have a beneficial effect on liquidity as measured by bid‐ask spreads. On the other hand, trades of small and medium firms are associated with firm‐specific information and are not related to marketwide information. For small and medium firms, the frequency of trades is positively associated with bid‐ask spreads, apparently because of the adverse information content of trades. JEL classification: G10, G12, G13     

Commonality in Liquidity: Evidence from an Order-Driven Market Structure

Events such as the 1997 East Asian financial crisis indicate that individual firm liquidity is strongly influenced by marketwide factors. Previous market microstructure research, however, focuses almost exclusively on the firm‐specific attributes of liquidity. Our study follows the recent shift in emphasis toward commonality by examining systematic liquidity in an order‐driven market structure. Using data from the Stock Exchange of Hong Kong, we show that commonality in liquidity includes both market and industry components, and is pervasive across size‐sorted portfolios. We also find a significant market and industry component in individual firms' order flow. In contrast to quote‐driven results, we do not find a positive relation between firm size and sensitivity to changes in marketwide bid‐ask spreads.     

A new approach to measuring riskiness in the equity market: Implications for the risk premium

We introduce a new approach to measuring riskiness in the equity market. We propose option implied and physical measures of riskiness and investigate their performance in predicting future market returns. The predictive regressions indicate a positive and significant relation between time-varying riskiness and expected market returns. The significantly positive link between aggregate riskiness and market risk premium remains intact after controlling for the S&P 500 index option implied volatility (VIX), aggregate idiosyncratic volatility, and a large set of macroeconomic variables. We also provide alternative explanations for the positive relation by showing that aggregate riskiness is higher during economic downturns characterized by high aggregate risk aversion and high expected returns.     

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.     

Adverse selection and the presence of informed trading

We combine two concepts of informed trading – contrarian trades and stealth trading – to develop proxies for the probability of informed trading. These proxies are used to test the link between informed trading and adverse selection as measured by bid–ask spreads and stock illiquidity. The estimation results show that these proxies, which are based on the probability of contrarian trading (PC) and progressively refined thereon, are all highly significantly positive in various empirical specifications of the cross-sectional determinants of spreads and illiquidity across stocks, and after controlling for important firm characteristics and trading factors. The robustness of our PC-based proxies for informed trading in these analyses, especially for the further refined measures, suggests that they successfully capture the adverse selection component of bid–ask spreads and illiquidity due to information asymmetry.     

Illiquidity Premium in the MILA

This article analyzes the illiquidity premium in the MILA. Using seven proxies for illiquidity, we find a positive and significant illiquidity premium for our sample. A microstructure bias-free portfolio weighting based on past returns is critical in our finding of an illiquidity premium, which is robust to several methodological changes in our portfolio simulations. We also document that the premium is present only in small and high book-to-market stocks. Nonetheless, when we control for size and distress effects, the difference and significance in risk-adjusted returns between portfolios of high and low illiquidity stocks remains.     

Average correlation and stock market returns

If the Roll critique is important, changes in the variance of the stock market may be only weakly related to changes in aggregate risk and subsequent stock market excess returns. However, since individual stock returns share a common sensitivity to true market return shocks, higher aggregate risk can be revealed by higher correlation between stocks. In addition, a change in stock market variance that leaves aggregate risk unchanged can have a zero or even negative effect on the stock market risk premium. We show that the average correlation between daily stock returns predicts subsequent quarterly stock market excess returns. We also show that changes in stock market risk holding average correlation constant can be interpreted as changes in the average variance of individual stocks. Such changes have a negative relation with future stock market excess returns.     

The Volatility of Bid‐Ask Spreads

This study tests whether the volatility of bid‐ask spreads is positively related to expected returns. After controlling for market‐risk factors, we find that the average risk‐adjusted excess return for stocks in the highest spread volatility quintile is around 50 basis points per month. In a variety of multivariate tests, we find robust evidence of a return premium associated with spread volatility that is both statistically significant and economically meaningful. Our results are robust to controls for a variety of stock characteristics, different tick‐size regimes, and other measures of liquidity volatility.     

Portfolio risk,adjustment costs,and security dealers' bid/ask spreads

This article notes that dealers' bid/ask spreads should vary directly with their costs of adjusting to inventory imbalances. Thus, well-diversified dealers are expected to quote lower bid/ask spreads on stocks with substantial total risk caused by undiversifiable risk. Furthermore, the effect of systematic risk on bid/ask spreads should be negligible if dealers are compensated for systematic risk by market returns. This article shows that, empirically, bid/ask spreads of OTC stocks are insensitive to the systematic risk of individual stocks—even when only stocks with stable betas are considered. Furthermore, bid/ask spreads are not sensitive to changes in market variance, as would be expected if systematic risk affected spreads. While unsystematic risk affects bid/ask spreads, its effect is pronounced for stocks traded by small, undiversified dealers. If stocks are only traded by large dealers with low diversification costs, unsystematic risk does not affect bid/ask spreads.     

Accounting Ratios and the Cross‐section of Expected Stock Returns

Under clean‐surplus accounting, the log return on a stock can be decomposed into a linear function of the contemporaneous log return on equity, the contemporaneous log dividend–price ratio (if the stock pays a dividend), and both the contemporaneous and lagged values of the log book‐to‐market equity ratio. This paper studies the implications of this decomposition for the cross‐section of conditional expected stock returns. The empirical analysis reveals that the log accounting ratios capture cross‐sectional variation in both the conditional mean and conditional variance of log stock returns, which is consistent with the decomposition. It also brings fresh insights to the relation between firm size (market equity) and conditional expected stock returns. The evidence indicates that the conditional median return increases with firm size, while the conditional return skewness decreases with firm size. Empirically, the skewness effect outweighs the median effect, leading to the well‐documented inverse relation between size and average returns. The results of out‐of‐sample tests suggest that investors could use the information provided by the observed values of the log accounting ratios to formulate more effective portfolio strategies.     

Option trading after the opening bell and intraday stock return predictability

Prior literature finds that information is reflected in option markets before stock markets, but no study has explored whether option volume soon after market open has predictive power for intraday stock returns. Using novel intraday signed option-to-stock volume data, we find that a composite option trading score (OTS) in the first 30 min of market open predicts stock returns during the rest of the trading day. Such return predictability is greater for smaller stocks, stocks with higher idiosyncratic volatility, and stocks with higher bid–ask spreads relative to their options’ bid–ask spreads. Moreover, OTS is a significantly stronger predictor of intraday stock returns after overnight earnings announcements. The evidence suggests that option trading in the 30 min after the opening bell has predictive power for intraday stock returns.     

Market liquidity as a sentiment indicator

We build a model that helps to explain why increases in liquidity—such as lower bid–ask spreads, a lower price impact of trade, or higher turnover–predict lower subsequent returns in both firm-level and aggregate data. The model features a class of irrational investors, who underreact to the information contained in order flow, thereby boosting liquidity. In the presence of short-sales constraints, high liquidity is a symptom of the fact that the market is dominated by these irrational investors, and hence is overvalued. This theory can also explain how managers might successfully time the market for seasoned equity offerings, by simply following a rule of thumb that involves issuing when the SEO market is particularly liquid. Empirically, we find that: (i) aggregate measures of equity issuance and share turnover are highly correlated; yet (ii) in a multiple regression, both have incremental predictive power for future equal-weighted market returns.     

Transparency,Liquidity, and Valuation: International Evidence on When Transparency Matters Most

We examine the relation between firm‐level transparency, stock market liquidity, and valuation across countries, focusing on whether the relation varies with a firm's characteristics and economic environment. We document lower transaction costs and greater liquidity (as measured by lower bid‐ask spreads and fewer zero‐return days) for firms with greater transparency (as measured by less evidence of earnings management, better accounting standards, higher quality auditors, more analyst following, and more accurate analyst forecasts). The relation between transparency and liquidity is more pronounced in periods of high volatility, when investor protection, disclosure requirements, and media penetration are poor, and when ownership is more concentrated, suggesting that firm‐level transparency matters more when overall investor uncertainty is greater. Increased liquidity is associated with lower implied cost of capital and with higher valuation as measured by Tobin's Q. Finally, a mediation analysis suggests that liquidity is a significant channel through which transparency affects firm valuation and equity cost of capital.     

The Risk‐Return Relation in International Stock Markets

We investigate the risk‐return relation in international stock markets using realized variance constructed from MSCI (Morgan Stanley Capital International) daily stock price indices. In contrast with the capital asset pricing model, realized variance by itself provides negligible information about future excess stock market returns; however, we uncover a positive and significant risk‐return tradeoff in many countries after controlling for the (U.S.) consumption‐wealth ratio. U.S. realized variance is also significantly related to future international stock market returns; more importantly, it always subsumes the information content of its local counterparts. Our results indicate that stock market variance is an important determinant of the equity premium.     

Marketwide Private Information in Stocks: Forecasting Currency Returns

We present a model of equity trading with informed and uninformed investors where informed investors trade on firm‐specific and marketwide private information. The model is used to identify the component of order flow due to marketwide private information. Estimated trades driven by marketwide private information display little or no correlation with the first principal component in order flow. Indeed, we find that co‐movement in order flow captures variation mostly in liquidity trades. Marketwide private information obtained from equity market data forecasts industry stock returns, and also currency returns.     

Predicting Stock Market Returns with Aggregate Discretionary Accruals

We find that the positive relation between aggregate accruals and one‐year‐ahead market returns documented in Hirshleifer, Hou, and Teoh [2009] is driven by discretionary accruals but not normal accruals. The return forecasting power of aggregate discretionary accruals is robust to choices of sample periods, return measurements, estimation methods, business condition and risk premium proxies, and accrual models used to isolate discretionary accruals. Our extensive analysis shows that aggregate discretionary accruals, in sharp contrast to aggregate normal accruals, contain little information about overall business conditions or aggregate cash flows and display little co‐movement with ICAPM‐motivated risk premium proxies. Our findings imply that aggregate discretionary accruals likely reflect aggregate fluctuations in earnings management, thereby favoring the behavioral explanation that managers time aggregate equity markets to report earnings.