Abstract
We propose a theoretical measure of income hedging demand and show that it affects asset prices. We focus on the value factor and first demonstrate that our demand estimates are correlated with the actual demands of retail and mutual fund investors. Then, we show that the aggregate HML demand predicts HML returns. Exploiting the state-level variation in income risk, we demonstrate that state-level hedging demands predict state-level HML returns. Our evidence of predictability is strong over short horizons (1-3 months) and disappears after one quarter. A trading strategy that exploits this hedging-induced predictability earns an annualized risk-adjusted return of 6%.
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