Discount Rate Shocks Research Articles

News-based sentiment and the value premium

The literature has documented that growth stocks are long-duration assets that are sensitive to shocks to the market discount rate, and value stocks, being short-duration assets, are sensitive to shocks to future cash flows. However, there is an ongoing debate as to whether the co-movement of value stocks with other value stocks and growth stocks with other growth stocks is due to similarities in cash-flow characteristics (i.e., the fundamental-based view) or due to a time-varying discount rate applied to cash flows (i.e., the sentiment-based view). While most studies take a fundamental approach to answer this question, we provide a sentiment-based explanation of the value premium by using the sentiment of news articles pertaining to cash-flow risks and discount-rate shocks. Our findings are consistent with the literature for the main drivers of the value premium but in support of the sentiment-based view, not through a rejection of the fundamental view but through a novel method for quantifying the time-varying discount rate that investors apply to cash flows.

The fiscal roots of inflation

Unexpected inflation devalues nominal government bonds. It must therefore correspond to a decline in expected future surpluses, or a rise in their discount rates, so that the real value of debt equals the present value of surpluses. I measure each component using a vector autoregression, via responses to inflation, recession, surplus and discount rate shocks. Discount rates account for much inflation variation, for the cyclical pattern of inflation, and why persistent deficits often do not cause inflation. Long-term debt is important. In response to a fiscal shock, smooth inflation slowly devalues outstanding long-term bonds.

Market Power and Systematic Risk

We investigate the impact of product market competition on firms' systematic risk. Using a measure of total product market similarity, we document a strong negative link between market power and market betas. There is a more than threefold increase in the effect during the most recent low-competition period. Announcements of anti-competitive mergers lead to a significant reduction in market betas, underlining the causality of the market power--systematic risk relationship. Firms that face less competition appear to be partly insulated from systematic discount-rate shocks. Lower equity costs therefore mean that market power is in part self-reinforcing.

Market news co-moments and currency returns

We propose three co-moments of the market returns’ cash-flow, and discount-rate shocks and examine empirically an intertemporal capital asset pricing model using the co-moments on currency returns as well as stock returns during Dec. 1983 to Dec. 2017. We find that our proposed model has explanatory power for both currency and stock portfolios. We find several common sources of market risk in currency and stock returns that are reflected in market news. Our findings show that the co-moments are related to currency risk premiums and outperform the well-known liquidity, dollar and HML risk factors.

Oil price shocks, global financial markets and their connectedness

Abstract This paper extends the literature on the relationship between oil price shocks and financial markets by examining the effect of oil shocks on the sovereign bond markets of a large number of advanced and emerging economies and exploring the impact of oil shocks on the degree of connectedness among international financial markets. We show that the effect of oil price shocks is not only limited to stock market returns, but also extends to bond markets, even after controlling for discount rate shocks as well as aggregate capital market effects. Unlike the case for stock markets, the effect on sovereign bonds is found to be rather heterogeneous (in terms of size and sign) and primarily driven by demand related shocks. We also show that oil price shocks serve as a driver of connectedness patterns across global financial markets, although the effect on connectedness depends on the nature of the oil market shock and the economic characteristics of the countries. Overall, the findings highlight the role of crude oil as a driver of not only of return dynamics in global stock and bond markets, but also of global financial connectedness patterns.

What Drives Anomaly Returns?

ABSTRACTWe decompose the returns of five well‐known anomalies into cash flow and discount rate news. Common patterns emerge across the five factor portfolios and their mean‐variance efficient (MVE) combination. Whereas discount rate news predominates in market returns, systematic cash flow news drives the returns of anomaly portfolios and their MVE combination with the market portfolio. Anomaly cash flow and discount rate shocks are largely uncorrelated with market cash flow and discount rate shocks and with business cycle fluctuations. These rich empirical patterns restrict the joint dynamics of firm cash flows and the pricing kernel, thereby informing models of stocks' expected returns.

Oil Price Shocks, Global Financial Markets and Their Connectedness

This paper extends the literature on the relationship between oil price shocks and financial markets by examining the effect of oil shocks on the sovereign bond markets of a large number of advanced and emerging economies and exploring the impact of oil shocks on the degree of connectedness among international financial markets. We show that the effect of oil price shocks is not only limited to stock market returns, but also extends to bond markets, even after controlling for discount rate shocks as well as aggregate capital market effects. Unlike the case for stock markets, the effect on sovereign bonds is found to be rather heterogeneous (in terms of size and sign) and primarily driven by demand related shocks. We also show that oil price shocks serve as a driver of connectedness patterns across global financial markets, although the effect on connectedness depends on the nature of the oil market shock and the economic characteristics of the countries. Overall, the findings highlight the role of crude oil as a driver of not only of return dynamics in global stock and bond markets, but also of global financial connectedness patterns.

Discount Shock, Price-Rent Dynamics, and the Business Cycle

The price-rent ratio is highly volatile and predicts future returns for commercial real estate. Price-rent variations in commercial real estate also tend to comove with investment and output. We develop a general equilibrium model that explicitly introduces a rental market and incorporates collateral constraints on production as a key ingredient. Our estimation identifies discount-rate shocks as the most important factor in (1) driving price-rent variations, (2) producing the long-horizon predictability of real estate returns, and (3) linking the dynamics in commercial real estate to those in the production sector.

The Fiscal Roots of Inflation

Unexpected inflation devalues nominal government bonds. It must therefore correspond to a decline in expected future surpluses, or a rise in their discount rates, so that the real value of debt equals the present value of surpluses. I measure each component using a vector autoregression, via responses to inflation, recession, surplus and discount rate shocks. Discount rates account for much inflation variation, for the cyclical pattern of inflation, and why persistent deficits often do not cause inflation. Long-term debt is important. In response to a fiscal shock, smooth inflation slowly devalues outstanding long-term bonds.

Financial risk exposure of returns to education: Panel evidence from Korea*

The present study examined financial market risk exposure of human capital returns, which are represented by the returns to education, using panel data for Korea. Overall, financial market shocks seem to be irrelevant to returns to education. However, when we divide a financial market shock into cash flow news and discount rate news leading to a negative risk premium, returns to education increase after positive news about future cash flows and unexpected increases in discount rates Therefore, the risk exposure to cash flow shocks is offset by the exposure to discount rate shocks. The returns to education of low‐income workers were significantly exposed to the cash flow risk as compared to those with a high income, but they were offset by the positive correlation to discount rate shocks. In contrast, considering the gap between generations, the old generation was not only less exposed to the cash flow risk compared to the young generation regarding returns to education but also positively correlated with the discount rate shock, resulting in less exposure to financial market risks.

Global Portfolio Diversification for Long-Horizon Investors

This paper conducts a theoretical and empirical investigation of global portfolio diversification for long-horizon investors in the presence of permanent cash flow shocks and transitory discount rate shocks to asset prices and returns. An increase in the cross-country correlations of cash flow shocks raises the risk of a globally diversified portfolio at all horizons. By contrast, an increase in the cross-country correlations of discount rate shocks has a muted effect on portfolio risk at long horizons and does not diminish the benefits of global portfolio diversification to long-term investors. Empirically, we find that increased correlations of discount rate shocks resulting from financial globalization appear to be the main driver of an estimated secular increase in the cross-country correlations of both stock and bond returns since the late 1990’s. Increased correlations of inflation shocks are also an important source of the shift in bond correlations. By contrast, we don’t find evidence of an increase in the cross-country correlations of equity cash flow news or stock market volatility shocks. Our findings imply that the benefits of global equity diversification have not declined for long horizon investors despite the secular increase in global stock correlations, while the benefits of global bond diversification have declined.

What Drives Anomaly Returns?

We provide novel evidence on which theories best explain stock return anomalies. Our estimates reveal whether anomaly returns arise from variation in the underlying firms' cash flows or their discount rates. For each of five well-known anomalies, we find that cash flow shocks explain more variation in anomaly returns than discount rate shocks. The cash flow and discount rate components of each anomaly's returns are negatively correlated. Most correlations between anomaly and market return components are small. Our evidence is inconsistent with theories of time-varying risk aversion and theories of common shocks to investor sentiment. It is most consistent with theories in which investors overextrapolate firm-specific cash flow news and those in which firm risk increases following negative cash flow news.

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Option-Based Credit Spreads

We propose a non-parametric empirical benchmark for credit risk analysis. We build fictitious “pseudo firms” that purchase real traded assets by issuing equity and zero-coupon bonds. By no-arbitrage, these bonds equal Treasuries minus put options on the firms’ assets, whose values are all observable. We exploit our pseudo firms as a laboratory, and empirically show that their credit spreads are large and countercyclical, illiquidity and corporate frictions are unlikely determinants of bonds’ credit spreads, infrequent rating changes and idiosyncratic asset uncertainty greatly increase spreads, and, in a banking application, discount rate shocks substantially increase banks’ tail risks and default correlations.

Corporate Social Performance and Idiosyncratic Risk: A Variance Decomposition Analysis

I investigate the relationship between corporate social responsibility and idiosyncratic risk using a 17 year panel of over 3,269 US listed companies. Following Vuolteenaho (2002), I use a three state vector autoregressive model of expected returns and decompose the residuals into earnings and discount rate shocks. Using optimally scaled principal components analysis to generate aggregate measures of CSR strengths and concerns, I find higher concerns are related to higher volatility of unexpected earnings and discount rates. Higher CSR strengths are associated with lower idiosyncratic variance. Partitioning the sample into positive and negative earnings shocks, I find that CSR strengths decrease the variance of negative returns, but increase the variance of positive returns, consistent with the notion that investments in social responsibility provide insurance against negative earnings shocks. My results are robust to the endogeneity of CSR and financial performance and also control for firm size and the presence of informed investors. My results show the influence of CSR on firm value through a relatively unexplored channel, and explain why the influence will be obscured when examining well-diversified portfolios. Finally, the evidence suggests that CSR concerns are more value relevant than CSR strengths.

Aggregate News Tone, Stock Returns, and Volatility

This paper is the first to exploit linguistic analysis of firm-specific news to measure aggregate disagreement, based on the premise that investors disagree more when news tone is highly dispersed across firms. Consistent with theory, we find that news tone dispersion i) is positively related to volatility and turnover, ii) is negatively related to aggregate discount-rate shocks, and iii) predicts returns negatively on the aggregate market, on high-beta stocks, and on short-sales constrained stocks. Using news dispersion to measure disagreement is advantageous as it can be measured over any interval, even days, and reflects new information in a timely fashion.

Temporal Profiles of Cash Flows: Implications for Financial Leverage

This paper investigates empirically the impact on leverage of the two temporal dimensions of cash flows: duration and persistence. We propose a novel estimation of these temporal characteristics, utilizing the return decomposition based on the vector autoregressive (VAR) method and the data on the market values of firms' assets. The key intuition for the estimation is that persistence is the sensitivity of market prices to cash flow shocks and duration is the sensitivity to discount rate shocks. Using these novel measures, we find evidence supporting recent developments in capital structure theory such as Gorbenko and Strebulaev (2010) and Hennessy (2004). First, firms with temporary shocks have low leverage, especially for small and financially constrained firms. Although less important unconditionally, permanent shocks' effect on leverage can be amplified, if they covary negatively with future discount rate shocks. Second, firms with long duration cash flow streams maintain low leverage and invest less in fixed assets, consistent with the notion that long asset life exacerbates debt overhang problems because default truncates future cash flows.

Stock returns, aggregate earnings surprises, and behavioral finance

We study the stock market's reaction to aggregate earnings news. Prior research shows that, for individual firms, stock prices react positively to earnings news but require several quarters to fully reflect the information in earnings. We find a substantially different pattern in aggregate data. First, returns are unrelated to past earnings, suggesting that prices neither underreact nor overreact to aggregate earnings news. Second, aggregate returns correlate negatively with concurrent earnings; over the last 30 years, for example, stock prices increased 5.7% in quarters with negative earnings growth and only 2.1% otherwise. This finding suggests that earnings and discount rates move together over time and provides new evidence that discount-rate shocks explain a significant fraction of aggregate stock returns.

Takeovers and the Cross-Section of Returns

This paper considers the impact of takeover (or acquisition) likelihood on firm valuation. If firms are more likely to acquire during times when they have free cash and/or when the required rate of return is low, takeover targets become more sensitive to shocks to aggregate cash flows and/or to the price of risk. Thus, ceteris paribus, firms that are exposed to takeovers will have a different rate of return from firms that are protected from takeovers. Using estimates of the likelihood that a firm will be acquired, we create a takeover-spread portfolio that buys firms with a high likelihood of being acquired and shorts firms with low likelihood of being acquired. Relative to the Fama-French model, the takeover-spread portfolio generates annualized abnormal returns of up to 12% between 1980 and 2004. Further, the takeover-spread portfolio is shown to be important in explaining cross-sectional differences in equity returns. Additionally, using a two-beta model that distinguishes cash flow shocks from discount rate shocks, we show that firms more likely to be taken over have higher betas on the aggregate cash factor. Finally, we provide an explanation for the existence of abnormal returns associated with governancespread portfolios (Gompers, Ishii and Metrick, 2003 and Cremers and Nair, 2005), and relate the takeover-spread portfolio returns to takeover activity in the economy.

Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns

The cash flows of growth are particularly sensitive to temporary movements in aggregate stock prices (driven by movements in the equity risk premium), while the cash flows of value are particularly sensitive to permanent movements in aggregate stock prices (driven by market-wide shocks to cash flows.) Thus the high betas of growth with the market's discount-rate shocks, and of value with the market's cash-flow shocks, are determined by the cash-flow fundamentals of growth and value companies. Growth are not merely glamour stocks whose systematic risks are purely driven by investor sentiment. More generally, accounting measures of firm-level risk have predictive power for firms' betas with market-wide cash flows, and this predictive power arises from the behavior of firms' cash flows. The systematic risks of with similar accounting characteristics are primarily driven by the systematic risks of their fundamentals.