Cross-section Of Equity Returns Research Articles

Macroeconomic perceptions, financial constraints, and anomalies

This paper studies the heterogeneous effects of subjective macroeconomic expectations on the cross-section of equity returns. We argue that an upward revision in expectations of macroeconomic productivity might be accompanied by an excessive increase in investment and external financing, inflated current equity prices, and thus lowered subsequent returns, particularly for financially constrained firms. Thus, following upward revisions in expectations of macroeconomic productivity, subsequent returns are relatively low for small firms, value firms, low-investment firms, risky firms, unprofitable firms, low-quality firms, and financially distressed firms—all of which are more financially constrained. In sharp contrast, following downward revisions in expectations of macroeconomic productivity, these categories of firms earn relatively high subsequent returns. We find that revisions in subjective macroeconomic expectations induce strong predictable time variation in a large set of anomalies. In particular, favorable revisions in expectations of macroeconomic productivity predict significantly stronger profitability, quality, distress, and low-risk anomalies but weaker value, investment, and size anomalies.

Financial Anomalies in Asset Allocation: Risk Mitigation with Cross-Sectional Equity Strategies

There is a myriad of financial anomalies in the cross-section of equity returns. They have been widely studied in the literature, which gives investors a large choice in terms of investment styles. In this article, the authors show a perhaps unappreciated quality of financial anomalies: They exhibit strong countercyclical behavior. Specifically, some anomalies (e.g., profitability and investment) perform particularly well when traditional portfolios (e.g., 60/40 or risk parity portfolios) exhibit prolonged periods of negative drawdowns and during National Bureau of Economic Research (NBER) recessions. With the exception of momentum strategies, the authors do not find evidence that financial anomalies are inflation hedging. Last, the authors examine whether financial anomalies lead to better portfolio performance. The results show that combining anomalies based on their style and then adding them to a traditional portfolio leads to higher Sharpe ratios overall, while also limiting portfolio losses during recessions.

The Real Response to Uncertainty Shocks: The Risk Premium Channel

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty increases risk and elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant equity risk premia in bad times, which in turn, exacerbate the decline of macroeconomic aggregates and equity prices. Moreover, in the cross-section of equity returns, investors demand a risk premium for stocks that perform poorly in times of high uncertainty and elevated risk aversion. In a model with endogenously time-varying RA, uncertainty shocks lead to large falls in investment and equity prices that closely match state-dependent data responses. This paper was accepted by Tomasz Piskorski, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4335 .

Inflation Surprises in the Cross-section of Equity Returns

Inflation Surprises in the Cross-section of Equity Returns

Cybercrime and the Cross-Section of Equity Returns

Cybercrime and the Cross-Section of Equity Returns

The cross section of the monetary policy announcement premium

Using the expected option-implied variance reduction to measure the sensitivity of stock returns to monetary policy announcement surprises, this paper shows monetary policy announcements require significant risk compensation in the cross section of equity returns. We develop a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve’s private information about its interest-rate target, which affects the private sector’s expectation about the long-run growth-rate of the economy. Our model accounts for the dynamics of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days.

Equity return anomalies in Turkish markets

Purpose- The purpose of this study is to investigate the predictive power of various anomalies in the cross-section of equity returns in Borsa Istanbul. Methodology- Covering a sample period between 1988 and 2018, this study implements univariate portfolio analyses. Specifically, each month, stocks are sorted into quintile portfolios based on one anomaly at a time. Next, the one-month-ahead equal- and value-weighted portfolio returns are calculated for each quintile to test whether the return spread between the extreme anomaly portfolios is economically and statistically significant. Findings- The findings using the whole sample document that market beta, firm size, lagged return and lottery demand have a significant and negative relation with future stock returns. In contrast, book-to-market ratio, investment and profitability have a strong positive relation with expected equity returns. Conclusion- All anomalies that are shown to predict U.S. equity returns are not documented in Turkey. Except for the investment anomaly, the directions of these anomalies are in line with the existing literature in the U.S.

Financial Constraints, Monetary Policy Shocks, and the Cross-Section of Equity Returns

Abstract We analyze the impact ofa unanticipated monetary policy changes on the cross-section of U.S. equity returns. Financially constrained firms earn a significantly lower (higher) return following surprise interest rate increases (decreases) as compared to unconstrained firms. This differential return response between constrained and unconstrained firms appears after a delay of 3 to 4 days. Further, unanticipated Federal funds rate increases are associated with a larger decrease in expected cash flow news, but not discount rate news, for constrained firms relative to unconstrained firms. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Expected Jumps and the Cross-Section of Equity Returns

We investigate how individual equity prices react to stock specific expected jump components. We find that a portfolio buying stocks with negative expected jump component and selling stocks with positive expected jump component earns significant returns, equal to 51 basis points per month. The returns of the spread portfolio cannot be explained by traditional risk factors and are robust to different model specifications. Furthermore, the associated risk premium is very close to the average monthly return, and remains significant after controlling for portfolio characteristics.

Global downside risk and equity returns

This paper reexamines the relation between various downside risk measures and future equity returns in a global context that spans 26 developed markets. We find that there is no significantly positive relation between systematic downside risk and the cross-section of equity returns, and in fact, this relation is mostly negative. Moreover, stock-specific risk measures such as lower partial moment or extreme left tail risk measures such as value-at-risk and expected shortfall have a negative predictive relation with future equity returns. These negative relations are weaker but still observable for value-weighted portfolios. Focusing on additional test assets indicates a significantly negative relation between downside risk and future returns at the portfolio level whereas this relation is flat at the equity index level.

The Cross-Section of Monetary Policy Announcement Premium

Using the expected option-implied variance reduction to measure the sensitivity of stock returns to monetary policy announcement surprises, this paper shows that monetary policy announcements require significant risk compensation in the cross section of equity returns. We present evidence that our sensitivity measure captures the exposure of stock returns with respect to growth rate expectations. We develop a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve's interest rate target, which affects the expected growth rate of the economy. Our model accounts for the dynamics of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days.

The Value Uncertainty Premium

This paper investigates whether the time-series volatility of book-to-market (BM), called value uncertainty (UNC), is priced in the cross-section of equity returns. A size- adjusted value-weighted factor with a long (short) position in high-UNC (low-UNC) stocks generates an annualized alpha of 6-8%. This value uncertainty premium is driven by outperformance of high-UNC firms and is not explained by established risk factors or firm characteristics, such as price and earnings momentum, investment, profitability, or BM itself. At the aggregate level, UNC is correlated with macroeconomic fundamentals and predicts future market returns and market volatility. We provide a rational asset- pricing explanation of the uncovered UNC premium.

The Leading Premium

In this paper, we compute conditional measures of lead-lag relationships between GDP growth and industry-level cash-flow growth in the US. Results show that firms in leading industries pay an average annualized return 4% higher than that of firms in lagging industries. The difference in the returns of leading and lagging firms is priced in the cross section of equity returns, even after we adjust for the Fama-French three-factor model. This finding can be rationalized in a model in which (a) agents price growth news shocks, and (b) leading industries provide valuable resolution of uncertainty about the growth prospects of lagging industries.

Informed Traders, Long-Dated Options, and the Cross Section of Stock Returns

Option prices predict the cross section of equity returns. We show that, unconditionally, the prices of long-dated options contain all the information relevant for predicting returns. Information, however, shifts towards short-dated options when an earnings announcement is imminent and when options are cheap to trade. The difference between short- and long-dated options also predicts the timing of merger announcements. Our results are consistent with option prices reflecting the actions of informed traders, and with these traders optimally choosing option maturities to maximize the value of their information.

Robust Test of Long Run Risk and Valuation Risk Model

This paper tests the long run risk and valuation risk model using a robust estimation procedure. The persistent long run component of consumption growth process is proxied by a news based index that is created using a random forest algorithm. This news index is shown to predict aggregate long term consumption growth with an R-square of 57% and is robust to inclusion of other commonly used predictors. I theoretically derive an estimatable bias term in adjusted Euler equation of the model that arises due to measurement error in consumption data and show that this bias term is non-zero. Using a three pass estimation procedure that accounts for this bias, I show that the long run risk and valuation risk model fails to explain cross section of equity returns. This contrasts to the results from regular two pass Fama-MacBeth estimation procedure that implies that the same model explains the cross section of asset returns with statistically significant risk premia estimates.

Buy Global, Sell Local. Consumption Heterogeneity, Regional Risk-Sharing, and the Cross-Section of Equity Returns

We study the effect of the geographical concentration of the consumption of different product categories on the equity returns of the associated industries. We find that industries that produce goods for which the consumption is more spread-out across U.S. regions earn an excess return of about 4% per year over the industries producing goods whose consumption is more localized in specific regions.

Leverage and the Cross-Section of Equity Returns

Building on the theoretical asset pricing literature, we examine the size, book-to-market (BTM), and volatility anomalies in the cross-section of unlevered equity returns. Consistent with theory, the unlevered market beta helps explain the cross-section of unlevered equity returns even when we control for the size and BTM factors. The value premium and the volatility puzzle disappear for unlevered returns, but the size discount remains. We revisit the relation between leverage and levered stock returns, which is highly nonlinear. When we account for the resulting heteroskedasticity patterns, we confirm the empirical findings from unlevered returns.

Commodity risks and the cross-section of equity returns

The article examines whether commodity risk is priced in the cross-section of global equity returns. We employ a long-only equally-weighted portfolio of commodity futures and a term structure portfolio that captures phases of backwardation and contango as mimicking portfolios for commodity risk. We find that equity-sorted portfolios with greater sensitivities to the excess returns of the backwardation and contango portfolio command higher average excess returns, suggesting that when measured appropriately, commodity risk is pervasive in stocks. Our conclusions are robust to the addition to the pricing model of financial, macroeconomic and business cycle-based risk factors.

Exploring the benefits of using stock characteristics in optimal portfolio strategies

I examine the benefits of using stock characteristics to model optimal portfolio weights in stock selection strategies using the characteristic portfolio approach of Brandt, Santa-Clara, and Valkanov. [2009. “Parametric Portfolio Policies: Exploiting Characteristics in the Cross-section of Equity Returns.” Review of Financial Studies 22: 3411–3447]. I find that there are significant out-of-sample performance benefits in using characteristics in stock selection strategies even after adjusting for trading costs, when investors can invest in the largest 350 UK stocks. Imposing short selling restrictions on the characteristic portfolio strategy leads to more consistent performance. The performance benefits are concentrated in the earlier part of the sample period and have disappeared in recent years. I find that there no performance benefits in using stock characteristics when using random subsets of the largest 350 stocks.

Financial Constraints, Monetary Policy Shocks, and the Cross-Section of Equity Returns

We analyze the impact of unanticipated monetary policy changes on equity returns and document that financially constrained firms earn a significantly lower return following rate increases as compared to unconstrained firms. Trading volume is significantly lower for constrained firms on FOMC announcement days but the differential return response manifests with a delay. Further, unanticipated increases in Federal funds rate are associated with a larger decrease in expected cash flow news, but not of discount rate news, for constrained firms relative to unconstrained firms. Our results highlight how monetary policy shocks have a disproportionate real impact on financially constrained firms.