Expected Equity Returns Research Articles

Price of Value and Divergence Factor

Value-to-Price, the ratio of Residual-Income-Model-based valuation to market price, subsumes the power of book-to-market and to a large extent of various quality measures in predicting stock returns. A natural hedge against momentum, long-short Value-to-Price strategies resuscitate the value premium and generate significant returns even after adjusting for common factors. The value-price-divergence (VPD) factor, constructed from the average returns of the long-short Value-to-Price portfolios within small and big stocks, is not spanned by known factor models. Max-Sharpe-ratio and constrained R-squared tests reveal that factor models replacing the traditional value factor with the VPD Factor better explain the cross-section of expected equity returns.

Share issuance and equity returns in Borsa Istanbul

This paper investigates the predictive power of share issuance on equity returns in BIST. The share issuance measure which is the annual logarithmic change in shares outstanding that is adjusted for distribution events is not significantly related to expected equity returns in a univariate setting. This is due to the prevalence of rights offerings in BIST and the consequent mechanical relation between the issuance measure and the book-to-market effect. After controlling for book-to-market, size and momentum factors, there is a significantly negative relation between share issuance and expected returns, especially for longer return horizons. The results from the portfolio analysis confirm this finding and show that the portion of share issuance that cannot be explained by the book-to-market effect has a strong negative cross-sectional relation with expected equity returns in BIST.

What Do Stock Markets Tell Us about Exchange Rates? *

The sign of the correlation between equity returns and exchange rate returns can be positive or negative in theory. Using data for a broad set of forty-two countries, we find that exchange rate movements are in fact unrelated to differentials in country-level equity returns. Consequently, a trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial returns and Sharpe ratios. These returns partially reflect compensation for global equity volatility risk, but significant excess returns remain after controlling for exposure to standard risk factors.

What Explains the Dynamics of 100 Anomalies?

Are anomalies strongest when investor sentiment or limits of arbitrage are considered to be greatest? We empirically explore these theoretically deducted predictions. We first identify, categorize, and replicate 100 long-short anomalies in the cross-section of expected equity returns. We then comprehensively study their interaction with popular proxies for time-varying market-level sentiment and arbitrage conditions. We find a powerful (relatively weak) role of the variation in proxies for sentiment (arbitrage constraints). In this context, the predictive power of sentiment is mostly restricted to the short leg of strategy returns. Our insights collectively suggest that the dynamics of sentiment combined with the base level (and not primarily the variations) of limits to arbitrage provide at least a partial explanation for inefficiencies.

What explains the dynamics of 100 anomalies?

Abstract Are anomalies strongest when investor sentiment or limits of arbitrage are considered to be greatest? We empirically explore these theoretically deducted predictions. We first identify, categorize, and replicate 100 long-short anomalies in the cross-section of expected equity returns. We then comprehensively study their interaction with popular proxies for time-varying market-level sentiment and arbitrage conditions. We find a powerful (relatively weak) role of the variation in proxies for sentiment (arbitrage constraints). In this context, the predictive power of sentiment is mostly restricted to the short leg of strategy returns. Our insights collectively suggest that the dynamics of sentiment combined with the base level (and not primarily the variations) of limits to arbitrage provide at least a partial explanation for inefficiencies.

Country risk and the cost of equity in emerging markets

We test whether the country risk variable is a significant risk factor in several CAPM based models of expected equity returns in Argentina, Brazil, Mexico, South Africa, Russia, Turkey and Venezuela. We also test the usual assumption that country risk can be added with a coefficient value of one. Only in Brazil and Mexico the risk premium associated with the country risk factor is significant. Adding country risk with a coefficient value of one is not generally valid and moreover, in Brazil and Mexico the risk premium for country risk takes a negative value. This shows that international investors may look for exposure to country risk.

Share Issuance and Equity Returns in BIST

This paper investigates the predictive power of share issuance on equity returns in BIST. The share issuance measure which is the annual logarithmic change in shares outstanding that is adjusted for distribution events is not significantly related to expected equity returns in a univariate setting. This is due to the prevalence of rights offerings in BIST and the consequent mechanical relation between the issuance measure and the book-to-market effect. After controlling for book-to-market, size and momentum factors, there is a significantly negative relation between share issuance and expected returns, especially for longer return horizons. The results from the portfolio analysis confirm this finding and show that the portion of share issuance that cannot be explained by the book-to-market effect has a strong negative cross-sectional relation with expected equity returns in BIST between 1992 and 2011.

What Do Stock Markets Tell Us About Exchange Rates?

The sign of the correlation between equity returns and exchange rate returns can be positive or negative in theory. Using data for a broad set of 42 countries, we find that exchange rate movements are in fact unrelated to differentials in country-level equity returns. Consequently, a trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial returns and Sharpe ratios. These returns partially reflect compensation for global equity volatility risk, but significant excess returns remain after controlling for exposure to standard risk factors.

Expected Returns and (the Limits of) the Limits of Arbitrage: Insights from the Dynamics of 100 Anomalies

Are anomalies strongest when limits of arbitrage are widely considered to be greatest? We empirically explore this theoretically deducted prediction. We first identify, categorize, and replicate 100 anomalies in the cross-section of expected equity returns. We then comprehensively study their dynamic interaction with popular proxies for time-varying market-level arbitrage conditions as well as with recently proposed measures for time-varying anomaly-level arbitrage activity. Our findings reveal a surprisingly weak role of commonly employed measures of market-wide arbitrage risks and constraints. Collectively, and in line with recent work, our insights indicate that the limits of arbitrage rationale for the survival of alleged mispricings sometimes might have its limits. These findings present a challenge to our understanding of the price discovery process and have important implications for practitioners.

The Relationship between Default Risk, Size and Financial Performance from Korean Firms

Studies of factors affecting the expected equity returns have long been a theme in capital market research. Contrary to theoretical predictions, it is argued that realized returns are too noisy to detect the true relation between default risk and expected returns. Therefore, this study uses the weighted average cost of capital (WACC) as a proxy of expected return. This study hypothesizes that the WACC has decreased the redemption of outstanding debt, but the financial performance is positively related to the outstanding debt as a alternative variable of default risk, using Korean firms during 2001-2010 period. The empirical results indicate that the WACC would be smaller for the period subsequent to a capital structure change than for the period the change, when outstanding debt is retired. Overall, these findings provide evidence in support of the hypothesis that the firm"s value is a negative function of the firm"s default risk as measured by the redemption of outstanding debt.

Interactive effect of changes in the shape of the yield curve and conditional term spread on expected equity returns

Recent research has noted that the change in the shape of the yield curve can serve as a proxy for economic activity and contains economic information not present in other explanatory variables. This article extends previous research by examining the combined effect of changes in the shape of the yield curve (yield pattern) and term spread on ex ante equity returns. We find specific yield patterns do affect future equity returns, that changes in the expected long rate is a significant factor, and that, when conditioned on the change in yield curve, the term spread is time variant and significant in specific yield pattern environments and insignificant in others. Specifically, we find that average ex ante equity returns are significant and positive when the yield pattern shows signs of the expected long rate declining. In addition, we find the efficacy of the conditional term spread to predict future equity returns increased after 1980. Our results are consistent with the Expectation Theory of interest rat...

Product Market Competition and Equity Returns

We develop an analytically tractable equilibrium model to examine the link between competition in product markets and stock returns. Firms maximize pro fits from the sale of their products to consumers. Investors receive firm profi ts as investment returns. We characterize fi rms' ’optimal production plans and expected equity returns, and show that firm heterogeneity within an industry leads to differences in expected returns across firms. In particular, we demonstrate that the expected returns of firms with reliable products can decrease with competition. This is a distinguishing feature of our model with endogenous production which standard models of exogenous production will not deliver. We show empirically that the compensation for bearing cash flow risk resulting from competition in output markets is economically significant and that product market competition is associated with average returns in ways that are consistent with the model.

How Does a Firm's Default Risk Affect its Expected Equity Return?

How Does a Firm's Default Risk Affect its Expected Equity Return?

The Relative Leverage Premium

The existing empirical evidence does not yet provide a clear understanding of how leverage and expected equity returns are related. While some studies show a positive relationship between financial leverage and returns, others conclude that returns are either insensitive or decrease with leverage, after controlling for size and book-to-market. We re-examine this evidence by explicitly accounting for the dynamic nature of a firm’s optimal leverage policy in the presence of frictions. Specifically, consistent with recent dynamic models of capital structure, we allow firms to temporarily deviate from their optimal capital structure due to adjustment costs. For each firm we estimate target leverage, and compute relative leverage as the difference between observed and target leverage. We find that relative leverage is positively and significantly related to expected equity returns, and has a dominant effect over size and book-to-market. The relative leverage premium shows a remarkable symmetry for over- and under-leveraged firms. Finally, the relative leverage premium is not captured by Fama and French’s three-factor model, and it appears to be consistent with rational asset pricing. We conjecture that risk-averse investors require a higher expected return for over-leveraged stocks than for under-leveraged ones because the former are counter-cyclical, while the latter are cyclical.

Net Leverage, Risk, and Credit Spreads

This paper proposes a risk-based explanation of the negative relation between credit spreads and expected equity returns found in the data. In a model where issuing equity is costly and debt has a tax advantage, firms optimally choose a lower net leverage if their cash flows are more correlated to a source of aggregate fluctuations (i.e. if the firm is riskier), all else being equal. The model predicts that riskier firms have a lower net leverage and a lower credit spreads. I test these two predictions using data on U.S. public companies and I find that: (i) low net leverage firms earn a higher risk-adjusted return than high net leverage ones; (ii) risk-adjusted returns on net leverage sorted portfolios are negatively correlated to credit ratings (a proxy for credit spreads); and (iii) a net leverage-based factor has the potential to explain the variation in equity returns across portfolios sorted according to credit ratings.

Cash holdings, risk, and expected returns

In this paper I develop and empirically test a model that highlights how the correlation between cash flows and a source of aggregate risk affects a firm's optimal cash holding policy. In the model, riskier firms (i.e., firms with a higher correlation between cash flows and the aggregate shock) are more likely to use costly external funding to finance their growth option exercises and have higher optimal savings. This precautionary savings motive implies a positive relation between expected equity returns and cash holdings. In addition, this positive relation is stronger for firms with less valuable growth options. Using a data set of US pubic companies, I find evidence consistent with the model's predictions.

Nominal Bonds, Real Bonds, and Equity

We decompose the term structure of expected equity returns into (1) the real short rate, (2) a premium for holding real long-term bonds, or the real duration premium, the excess returns of nominal long-term bonds over real bonds which reflects (3) expected inflation and (4) inflation risk, and (5) a real cashflow risk premium, which is the excess return of equity over nominal bonds. The shape of the nominal and real bond yield curves are upward sloping due to increasing duration and inflation risk premiums. The term structures of expected equity returns and equity risk premiums, in contrast, are downward sloping due to the decreasing effect of short-term expected inflation, or trend inflation, across horizons. Around 70% of the variation of expected equity returns at the 10-year horizon is due to variation in the output gap and trend inflation.

How Does a Firm's Default Risk Affect its Expected Equity Return?

How Does a Firm's Default Risk Affect its Expected Equity Return?

The Relative Leverage Premium

The existing empirical evidence does not yet provide a clear understanding of how leverage and expected equity returns are related. While some studies show a positive relationship between financial leverage and returns, others conclude that returns are either insensitive or decrease with leverage, after controlling for size and book-to-market. We re-examine this evidence by explicitly accounting for the dynamic nature of a firm’s optimal leverage policy in the presence of frictions. Specifically, consistent with recent dynamic models of capital structure, we allow firms to temporarily deviate from their optimal capital structure due to adjustment costs. For each firm we estimate target leverage, and compute relative leverage as the difference between observed and target leverage. We find that relative leverage is positively and significantly related to expected equity returns, and has a dominant effect over size and book-to-market. The relative leverage premium shows a remarkable symmetry for over- and under-leveraged firms. Finally, the relative leverage premium is not captured by Fama and French’s three-factor model, and it appears to be consistent with rational asset pricing. We conjecture that risk-averse investors require a higher expected return for over-leveraged stocks than for under-leveraged ones because the former are counter-cyclical, while the latter are cyclical.

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.