Cross-section Of Asset Returns Research Articles

A comparative study of the CAPM and extended models in the Indian stock market

To explain the cross section of asset returns, there are numerous asset pricing models being used which require ideal conditions in the markets around the world. An attempt has been made in the present study to estimate and compare the different versions of capital asset princing model (CAPM) using the data of sectoral indices listed in S&P BSE in the Indian stock market. The two widely used approaches i.e. Fama-MacBeth (1973) and Pettengil et al. (1995) for conditional versions have been adopted in the study. The models were compared on the basis of Akaike Information Criterion (AIC) and it was obtained that the AIC value of the Unconditional higher moment CAPM was obtained minimum among other models. Hence it can be said as the better model than other models estimated.

Extreme downside risk in the cross-section of asset returns

Extreme movements in financial markets are not always reflected equally in individual stocks. Identifying which firms are unable to absorb shocks is a challenge. This paper considers extreme downside risk, an extension to Ang et al.’s (2006) downside risk framework, and the value in separating the sensitivity between extreme and non-extreme downside risk. I find that the cross-sectional average annual excess return between high and low extreme downside exposure stocks is around 3.9%. The extension differentiates itself for young firms or firms that have not experienced a severe crisis, where the risk premium ranges from 2.4% to 10.4%.

Factor Mimicking Portfolios and the Cross-section of Asset Returns

Factor Mimicking Portfolios and the Cross-section of Asset Returns

Nonlinear effect of sentiment on momentum

I study a Lucas exchange economy with many trees and a representative agent who forms extrapolative beliefs on market returns (market-wide sentiment). As a result of sentiment spillovers, the agent believes that there is momentum in the cross section of asset returns. However, from the point of view of an outside econometrician, the market price of risk relates negatively to sentiment. This, together with the subjective momentum, causes returns on momentum strategies to be a concave function of sentiment, leading to a downside risk of momentum. I find empirical evidence consistent with model predictions.

Nonlinear Effect of Sentiment on Momentum

I study a Lucas economy with many trees and a representative agent with market-wide sentiment. As a result of sentiment spillovers, the agent believes that there is momentum in the cross section of asset returns. However, from the point of view of an outside econometrician, the market price of risk relates negatively to sentiment. This, together with the subjective momentum, causes returns on momentum strategies to be a concave function of sentiment, leading to a downside risk of momentum. I find empirical evidence consistent with model predictions.

Frequency-Dependent Higher Moment Risks

Based on intraday data for a large cross-section of individual stocks and exchange traded funds, we show that short-term as well as long-term fluctuations of realized market and average idiosyncratic higher moments risks are priced in the cross-section of asset returns. Specifically, we find that market and average idiosyncratic volatility and kurtosis are significantly priced by investors mainly in the long-run even if controlled by market moments and other factors, while skewness is mostly short-run phenomenon. A conditional pricing model capturing the time-variation of moments confirms downward-sloping term structure of skewness risk and upward-sloping term structure of kurtosis risk, moreover the term structures connected to market skewness risk and average idiosyncratic skewness risk exhibit different dymanics.

Financial Intermediary Leverage, Volatility, and the Cross-Section of Asset Returns

Society needs financial intermediaries to create orderly efficient markets, to have informative prices, and to best allocate resources. However, when trust is eroded with high volatility and unpredictable events, financial crises are amplified and prices are distorted as financial intermediaries struggle to hold rapidly depreciating assets that are essential for economic recovery. Using a multi-factor model, I find that intermediary leverage, volatility, and more importantly their interaction, explain cross-sectional variations in expected returns. I propose an advancement based on the joint interaction between intermediary leverage and volatility to enable financial intermediaries to better manage their leverage in a rapidly evolving risk environment.

Oops! I Shrunk the Sample Covariance Matrix Again: Blockbuster Meets Shrinkage

Abstract Existing shrinkage techniques struggle to model the covariance matrix of asset returns in the presence of multiple-asset classes. Therefore, we introduce a Blockbuster shrinkage estimator that clusters the covariance matrix accordingly. Besides the definition and derivation of a new asymptotically optimal linear shrinkage estimator, we propose an adaptive Blockbuster algorithm that clusters the covariance matrix even if the (number of) asset classes are unknown and change over time. It displays superior all-around performance on historical data against a variety of state-of-the-art linear shrinkage competitors. Additionally, we find that for small- and medium-sized investment universes the proposed estimator outperforms even recent nonlinear shrinkage techniques. Hence, this new estimator can be used to deliver more efficient portfolio selection and detection of anomalies in the cross-section of asset returns. Furthermore, due to the general structure of the proposed Blockbuster shrinkage estimator, the application is not restricted to financial problems.

Oops! I Shrunk the Sample Covariance Matrix Again: Blockbuster Meets Shrinkage

Existing shrinkage techniques struggle to model the covariance matrix of asset returns in the presence of multiple-asset classes. Therefore, we introduce a Blockbuster shrinkage estimator that clusters the covariance matrix accordingly. Besides the definition and derivation of a new asymptotically optimal linear shrinkage estimator we propose an adaptive Blockbuster algorithm that clusters the covariance matrix even if the (number of) asset classes are unknown and change over time. It displays superior all-around performance on historical data against a variety of state-of-the-art linear shrinkage competitors. Additionally, we find that for small and medium-sized investment universes the proposed estimator outperforms even recent nonlinear shrinkage techniques. Hence, this new estimator can be used to deliver more efficient portfolio selection and detection of anomalies in the cross-section of asset returns. Furthermore, due to the general structure of the proposed Blockbuster shrinkage estimator the application is not restricted to financial problems.

Tax Risk and Asset Prices: Evidence from Dual-class Corporate Bonds in the Early 19th Century

This paper exploits a natural experiment from the late 1800s in which many U.S. firms had inadvertently issued both taxable and tax-exempt bonds. Investors paid income tax on taxable bonds, but firms covered income tax on investors' behalf on tax-exempt bonds. Using a unique data-set of these `dual-class' corporate bonds, we derive a novel, market-based measure for tax risk, examine its time-series properties, and investigate if tax risk is priced in asset returns. We find that tax risk is pro-cyclical, is priced in the cross-section of asset returns, and commands a statistically and economically significant positive risk premium.

Downside risks and the cross-section of asset returns

In an intertemporal equilibrium asset pricing model featuring disappointment aversion and changing macroeconomic uncertainty, we show that besides the market return and market volatility, three disappointment-related factors are also priced: a downstate factor, a market downside factor, and a volatility downside factor. We find that expected returns on various asset classes reflect premiums for bearing undesirable exposures to these factors. The signs of estimated risk premiums are consistent with the theoretical predictions. Our most general, five-factor model is very successful in jointly pricing stock, option, and currency portfolios, and provides considerable improvement over nested specifications previously discussed in the literature.

Downside Risks and the Cross-Section of Asset Returns

In an intertemporal equilibrium asset pricing model featuring disappointment aversion and changing macroeconomic uncertainty, we show that besides the market return and market volatility, three disappointment-related factors are also priced: a downstate factor, a market downside factor, and a volatility downside factor. We find that expected returns on various asset classes reflect premiums for bearing undesirable exposures to these factors. The signs of estimated risk premiums are consistent with the theoretical predictions. Our most general, five-factor model is very successful in jointly pricing stock, option, and currency portfolios, and provides considerable improvement over nested specifications previously discussed in the literature.

The Macroeconomic Shock with the Highest Price of Risk

I propose a new method of constructing a macroeconomic shock based on its ability to explain the cross-section of asset returns. The only identifying assumption is that this λ-shock demands the highest risk price per unit of exposure, or equivalently, minimises the associated sum of squared pricing errors, when pricing a given asset portfolio. When applying the method to the stock portfolios studied by Fama-French, a robust economic feature of the λ-shock is the delayed effect on aggregate quantities such as output and consumption and a sharp impact on the short-term interest rate and the term spread. The estimated λ-shock bears strong resemblance both with monetary policy shocks and with technology news shocks studied by the macroeconomic literature.

Recession Risk and the Cross-Section of Asset Returns

Recession Risk and the Cross-Section of Asset Returns

Term Structure of Recession Probabilities and the Cross Section of Asset Returns

Business cycle duration changes over time, generating time-varying investor concern over future recessions. This paper introduces ex-ante measures of recession concern based on term structure of recession probability forecasts by the Survey of Professional Forecasters. The slope of the recession term structure is negatively priced in a wide range of assets, and negatively predicts economic activity and labor income growth. A belief-augmented CAPM with the market factor and innovation to the slope largely explains size, book-to-market, and asset growth-sorted portfolios. This model's factor-mimicking portfolios also help reconcile index options and carry trade strategies. My evidence suggests that the slope of the term structure is a recession state variable of special hedging concern (Cochrane, 2005, Ch.9), and an important source of asset premia can be attributed to exposure to investors' recession concern that is priced.

Funding Risk, Market Liquidity, Market Volatility and the Cross-Section of Asset Returns

We find strong evidence of a funding risk premium in the cross-section of asset returns. Our estimate for the price of funding risk is robust across Treasury bonds, corporate bonds, equities, and hedge funds. Funding shocks pose a risk to investors because they exacerbate the illiquidity and volatility of securities, increase the dispersions of asset illiquidity and volatility, and decrease contemporaneous returns. Our price-of-risk estimates are also robust to using mimicking portfolio returns, alternative portfolio sorts, traditional test assets, monthly returns or quarterly returns. Funding shocks are not subsumed by common proxies for market-wide illiquidity or dealers' balance sheet risk.

News Shocks, Long-Run Risk, and Asset Returns

I study the long-run consumption risk reflected in news shock, a shock to expectations about future productivity. I identify news shock using a structural Vector Autoregression analysis. News shocks cause persistent future consumption growth and explain a large share of consumption movements in the long-run. Consistent with the long-run consumption risk hypothesis, I find that news shocks have a significantly positive risk premium in the cross section of asset returns. I also find that news shocks explain the size premium.

The Self-fulfilling Prophecy of Popular Asset Pricing Models

The assumption that asset prices are determined by the efforts of end investors to maximize intertemporal utility supports a pricing theory that is both elegant and intuitive. Unfortunately, the assumption is counterfactual. End investors, with few exceptions, lack the capacity to behave in a fashion consistent with the theory. More to the point, they don’t try. Instead, investment decision-making is delegated. Thus, it is important to understand the investment management ecosystem. Is it a simple pass-through mechanism? We do not believe so and argue, instead, that the lack of alignment implies the cross-section of asset returns is significantly influenced by active money managers and deviates from the predictions of the consumption-based model. Using a simple thought experiment, we demonstrate that the widely adopted discounted cash flow model is likely both to drive prices and to determine the cross section of average returns. This leads to a self-fulfilling feedback loop in which once an asset pricing model is adopted by active managers as a means of estimating the discount rate, it becomes a determinant of expected returns.

Myths and Facts About the Alleged Over-Pricing of U.S. Real Estate. Evidence from Multi-Factor Asset Pricing Models of REIT Returns

This paper uses a multi-factor pricing model with time-varying risk exposures and premia to examine whether the 2003-2006 period has been characterized, as often claimed by a number of commentators and policymakers, by a substantial mispricing of publicly traded real estate assets (REITs). The estimation approach relies on Bayesian methods to model the latent process followed by risk exposures and idiosynchratic volatility. Our application to monthly, 1979-2009 U.S. data for stock, bond, and REIT returns shows that both market and real consumption growth risks are priced throughout the sample by the cross-section of asset returns. There is weak evidence at best of structural mispricing of REIT valuations during the 2003-2006 sample.

Myths and Facts about the Alleged Over-Pricing of U.S. Real Estate

This paper uses a multi-factor pricing model with time-varying risk exposures and premia to examine whether the 2003–2006 period has been characterized, as often claimed by a number of commentators and policymakers, by a substantial mispricing of publicly traded real estate assets (REITs). The estimation approach relies on Bayesian methods to model the latent process followed by risk exposures and idiosynchratic volatility. Our application to monthly, 1979–2009 U.S. data for stock, bond, and REIT returns shows that both market and real consumption growth risks are priced throughout the sample by the cross-section of asset returns. There is weak evidence at best of structural mispricing of REIT valuations during the 2003–2006 sample.