Distress risk premia in expected stock and bond returns

Prior studies find that shareholders’ strategic actions over debtholders are significant for stock prices but not for bond prices. I find that for firms with private and public debt, strategic default has no significant effect on distress risk premia in expected stock or bond returns, suggesting that the dispersion of bondholders greatly weakens the shareholder advantage effect. The shareholder advantage effect on stock prices is only significant for firms with only private debt and to some degree affected by the dispersion of stockholders and complexity in capital structure. Overall, renegotiation friction helps explain the cross-sectional implications of strategic default for stock and bond prices.     

Idiosyncratic risk and the cross-section of expected stock returns

Theories such as Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang [2006. The cross-section of volatility and expected returns. Journal of Finance 61, 259–299], however, find that monthly stock returns are negatively related to the one-month lagged idiosyncratic volatilities. I show that idiosyncratic volatilities are time-varying and thus, their findings should not be used to imply the relation between idiosyncratic risk and expected return. Using the exponential GARCH models to estimate expected idiosyncratic volatilities, I find a significantly positive relation between the estimated conditional idiosyncratic volatilities and expected returns. Further evidence suggests that Ang et al.'s findings are largely explained by the return reversal of a subset of small stocks with high idiosyncratic volatilities.     

Endogenous leverage and expected stock returns

This note clarifies conditions under which endogenous choice of debt induces a negative relation between leverage or default risk and expected stock returns. In the context of the model of George and Hwang [2009. Journal of Financial Economics 96, 56–79], we correct the contention that variation in bankruptcy costs across firms is sufficient. Variation in asset risk parameters can lead to the desired relation, but may not when also controlling for variation in book-to-market ratios. A simple parameterization of cross-sectional heterogeneity in risk and profitability implies a negative association of expected return with leverage and distress risk and a positive association with book-to-market.     

The impact of risk and uncertainty on expected returns

We study asset pricing in economies featuring both risk and uncertainty. In our empirical analysis, we measure risk via return volatility and uncertainty via the degree of disagreement of professional forecasters, attributing different weights to each forecaster. We empirically model the typical risk-return trade-off and augment these models with our measure of uncertainty. We find stronger empirical evidence for an uncertainty-return trade-off than for the traditional risk-return trade-off. Finally, we investigate the performance of a two-factor model with risk and uncertainty in the cross section.     

Sell-order liquidity and the cross-section of expected stock returns

We estimate buy- and sell-order illiquidity measures (lambdas) for a comprehensive sample of NYSE stocks. We show that sell-order liquidity is priced more strongly than buy-order liquidity in the cross-section of equity returns. Indeed, our analysis indicates that the liquidity premium in equities emanates predominantly from the sell-order side. We also find that the average difference between sell and buy lambdas is generally positive throughout our sample period. Both buy and sell lambdas are significantly positively correlated with measures of funding liquidity such as the TED spread as well option implied volatility.     

News and the cross-section of expected corporate bond returns

We study the cross-section of expected corporate bond returns using an inter-temporal CAPM (ICAPM) with three-factors: innovations in future excess bond returns, future real interest rates and future expected inflation. Our test assets are a broad range of corporate bond market index portfolios. We find that two factors – innovations about future inflation and innovations about future real interest rates – explain the cross-section of expected corporate bond returns in our sample. Our model provides an alternative to the ad hoc risk factor models used, for example, in evaluating the performance of bond mutual funds.     

Liquidity risk and expected corporate bond returns

This paper studies the pricing of liquidity risk in the cross section of corporate bonds for the period from January 1994 to March 2009. The average return on bonds with high sensitivities to aggregate liquidity exceeds that for bonds with low sensitivities by about 4% annually. The positive relation between expected corporate bond returns and liquidity beta is robust to the effects of default and term betas, liquidity level, and other bond characteristics, as well as to different model specifications, test methodologies, and a variety of liquidity measures. The results suggest that liquidity risk is an important determinant of expected corporate bond returns.     

World market risk,country-specific risk and expected returns in international stock markets

This paper determines whether the world market risk, country-specific total risk, and country-specific idiosyncratic risk are priced in an international capital asset pricing model (ICAPM). Portfolio-level analyses, country-level cross-sectional regressions, stacked time-series, and pooled panel regressions indicate that the world market risk is not, but country-specific total and idiosyncratic risks are significantly priced in an ICAPM framework with partial integration. This result is robust to different methods for estimating risk measures, different investment horizons, and after controlling for the countries’ aggregate dividend yield, earnings-to-price ratios, inflation risk, exchange rate uncertainties, aggregate volatility risk, and past return characteristics. The main findings turn out to be insensitive to the choice of one-factor vs. multifactor models used to estimate systematic and idiosyncratic risk measures.     

Asymmetric stock market volatility and the cyclical behavior of expected returns

Recent explanations of aggregate stock market fluctuations suggest that countercyclical stock market volatility is consistent with rational asset evaluations. In this paper, I develop a framework to study the causes of countercyclical stock market volatility. I find that countercyclical risk premia do not imply countercyclical return volatility. Instead, countercyclical stock volatility occurs if risk premia increase more in bad times than they decrease in good times, thereby inducing price–dividend ratios to fluctuate more in bad times than in good. The business cycle asymmetry in the investors’ attitude toward discounting future cash flows plays a novel and critical role in many rational explanations of asset price fluctuations.     

Accounting-based downside risk and expected stock returns: Evidence from China

We document that earnings downside risk contains information on firms' future operating performance and is positively associated with expected stock returns in Chinese stock markets, and the return predictability of earning downside risk mainly comes from its accrual downside risk component. The pricing of earnings downside risk is especially evident among firms with more transparent information environment and stronger governance efficacy, such as large firms, non-high-tech firms, old firms, and firms with high analyst coverage. Lastly, we show that aggregated earnings downside risk and its components at the market level are all significantly and positively associated with subsequent stock market returns, which is consistent with the notion that the accounting-based downside risk measures contain information about future macroeconomic conditions.     

Time-varying rare disaster risk and stock returns

This study provides empirical support for theoretical models that allow for time-varying rare disaster risk. Using a database of 447 international political crises during the period 1918-2006, we create a crisis index that shows substantial variation over time. Changes in this crisis index, our proxy for changes in perceived disaster probability, have a large impact on both the mean and volatility of world stock market returns. Crisis risk is positively correlated with the earnings-price ratio and the dividend yield. Cross-sectional tests also show that crisis risk is priced: Industries that are more crisis risk sensitive yield higher returns.     

A novel downside beta and expected stock returns

A number of studies have found that the cross-section of stock returns reflects a risk premium for bearing downside beta; however, existing measures of downside beta have poor power for predicting returns. This paper proposes a novel measure of downside beta, the ES-implied beta, to improve the prediction of the cross-section of asset returns. The ES-implied beta explains stock returns over the same period as well as the widely used downside beta, but improves the prediction for future returns due to its high persistence. In the empirical analysis, the widely used downside beta shows a weak relation with future expected returns, but the ES-implied beta implies a statistically and economically significant risk premium of 0.6% per month and explains 0.6% of the variation in the cross-sectional returns. The effect cannot be explained by traditional cross-sectional effects and is different from the CAPM beta, the downside beta in Ang et al. (2006), coskewness, and cokurtosis.     

The intertemporal relation between expected returns and risk

This paper explores the time-series relation between expected returns and risk for a large cross section of industry and size/book-to-market portfolios. I use a bivariate generalized autoregressive conditional heteroskedasticity (GARCH) model to estimate a portfolio's conditional covariance with the market and then test whether the conditional covariance predicts time–variation in the portfolio's expected return. Restricting the slope to be the same across assets, the risk-return coefficient is highly significant with a risk–aversion coefficient (slope) between one and five. The results are robust to different portfolio formations, alternative GARCH specifications, additional state variables, and small sample biases. When conditional covariances are replaced by conditional betas, the risk premium on beta is estimated to be in the range of 3% to 5% per annum and is statistically significant.     

Liquidity risk and stock returns around the world

The recent global financial crisis demonstrates that market liquidity is a prominent systematic risk globally. We find that local liquidity risk, in addition to the local market, value and size factors, demands a systematic premium across stocks in 11 developed markets. This local pricing premium is smaller in countries where the country-level corporate boards are more effective and where there are less insider trading activities. We also discover that global liquidity risk is a significant pricing factor across all developed country market portfolios after controlling for global market, value, and size factors. The contribution of this risk to the return on a country market portfolio is economically and statistically significant within and across regions.     

Stock market crashes,firm characteristics,and stock returns

A number of studies have investigated the causes and effects of stock market crashes. These studies mainly focus on the factors leading to a crash and on the volatility and co-movements of stock market indexes during and after the crash. However, how a stock market crash affects individual stocks and if stocks with different financial characteristics are affected differently in a stock market crash is an issue that has not received sufficient attention. In this paper, we study this issue by using data for eight major stock market crashes that have taken place during the December 31, 1962–December 31, 2007 period with a large sample of US firms. We use the event-study methodology and multivariate regression analysis to study the determinants of stock returns in stock market crashes.     

A careful re-examination of seasonality in international stock markets: Comment on sentiment and stock returns

In questioning Kamstra, Kramer, and Levi’s (2003) finding of an economically and statistically significant seasonal affective disorder (SAD) effect, Kelly and Meschke (2010) make errors of commission and omission. They misrepresent their empirical results, claiming that the SAD effect arises due to a “mechanically induced” effect that is non-existent, labeling the SAD effect a “turn-of-year” effect (when in fact their models and ours separately control for turn-of-year effects), and ignoring coefficient-estimate patterns that strongly support the SAD effect. Our analysis of their data shows, even using their low-power statistical tests, there is significant international evidence supporting the SAD effect. Employing modern, panel/time-series statistical methods strengthens the case dramatically. Additionally, Kelly and Meschke represent the finance, psychology, and medical literatures in misleading ways, describing some findings as opposite to those reported by the researchers themselves, and choosing selective quotes that could easily lead readers to a distorted understanding of these findings.     

Conditional interest rate risk and the cross‐section of excess stock returns

Differences in excess stock returns can be rationalized by their sensitivities to conditional interest rate risk. Value stocks are particularly sensitive to upside movements in interest rate growth, while growth stocks react strongly to downside movements in interest rate growth. Consistent with the basic asset pricing theory, the upside interest rate risk commands a negative premium which is higher than the premium associated with the downside interest rate risk. Upside beta pertains its explanatory power after controlling for exposure to regular unconditional interest rate and various sources of financial and conditional macroeconomic risk.     

Liquidity risk of corporate bond returns: conditional approach

We study the exposure of the US corporate bond returns to liquidity shocks of stocks and Treasury bonds over the period 1973–2007 in a regime-switching model. In one regime, liquidity shocks have mostly insignificant effects on bond prices, whereas in another regime, a rise in illiquidity produces significant but conflicting effects: Prices of investment-grade bonds rise while prices of speculative-grade (junk) bonds fall substantially (relative to the market). Relating the probability of these regimes to macroeconomic conditions we find that the second regime can be predicted by economic conditions that are characterized as “stress.” These effects, which are robust to controlling for other systematic risks (term and default), suggest the existence of time-varying liquidity risk of corporate bond returns conditional on episodes of flight to liquidity. Our model can predict the out-of-sample bond returns for the stress years 2008–2009. We find a similar pattern for stocks classified by high or low book-to-market ratio, where again, liquidity shocks play a special role in periods characterized by adverse economic conditions.     

Omitted debt risk, financial distress and the cross-section of expected equity returns

The study of Ferguson and Shockley (2003) shows that, if the Merton (1974) model can reflect reality, the omission of debt claims from the market portfolio proxy may explain the poor pricing ability of the CAPM in empirical tests. We critically re-assess this argument by first reviewing existing, but also new avenues through which the Merton (1974) model can point to a systematic bias in market beta estimates. However, we also show that some avenues are diversifiable, and that they all rely on excessive economy-wide default risk to create a non-negligible bias. We then use the Merton (1974) model to proxy for the total debt portfolio, but find that its application in empirical tests cannot improve pricing performance. We conclude that there are (so far) no valid theoretical reasons to believe that omitted debt claims undermine CAPM tests.     

Predicting stock returns

This paper studies whether incorporating business cycle predictors benefits a real time optimizing investor who must allocate funds across 3,123 NYSE-AMEX stocks and cash. Realized returns are positive when adjusted by the Fama-French and momentum factors as well as by the size, book-to-market, and past return characteristics. The investor optimally holds small-cap, growth, and momentum stocks and loads less (more) heavily on momentum (small-cap) stocks during recessions. Returns on individual stocks are predictable out-of-sample due to alpha variation, whereas the equity premium predictability, the major focus of previous work, is questionable.