Multifactor Asset Pricing Models Research Articles

Country Selection Strategies Based on Value, Size and Momentum

This study provides convincing evidence that stock markets with low capitalisation, low valuation ratios and high momentum tend to outperform country markets with high capitalisation, high valuation ratios and low momentum. Based on sorting procedures and cross-sectional tests conducted across 78 countries over the period 1999–2014, it has been found out that value, size and momentum effects at the country level are stronger across small and medium country markets than large ones. Thus, bearing in mind the declining benefits of international diversification observed in recent decades, it is recommended that investors include country-level factor premiums in their strategic asset allocation, without postponing them to further stages of an investment process. In addition, it has been shown that inter-market value, size and momentum effects may be used in multifactor asset pricing models, which well explain the variation in stock returns at the country level.

The dynamics of returns on renewable energy companies: A state-space approach

The renewable energy sector has accomplished remarkable growth rates over the last decade. This paper examines the dynamics of excess returns for the WilderHill New Energy Global Innovation Index, which lists firms in the renewable energy sector and is used as a global benchmark. We propose a multi-factor asset pricing model with time-varying coefficients to study the role of energy prices and stock market indices as explanatory factors. Our results suggest a strong influence of the MSCI World index and technology stocks throughout the sample period. The influence of changes in the oil price is significantly lower, although oil has become more influential from 2007 onwards. We also find evidence for underperformance of the renewable energy sector relative to the considered pricing factors after the financial crisis.

Corporate sustainability in asset pricing models and mutual funds performance measurement

This study explores whether corporate sustainability is a relevant factor in multifactor asset pricing models. It contributes to the literature on asset pricing, as well as to the literature that examines how sustainability impacts capital markets, by constructing a new factor that captures differences in the returns of sustainable and non-sustainable firms. Specifically, it examines whether an additional sustainability factor has explanatory power in asset pricing models that include size, book-to-market equity, and momentum factors. This research has practical implications for the performance measurement of portfolios and mutual funds that are managed in accordance with sustainability criteria in that it disentangles general stock-picking skills from the differences in returns between sustainable and non-sustainable stocks.

Diversification Risk Premium

A long criticism on the usefulness of the traditional CAPM model has been raised in the vast literature of arbitrage pricing models that propose several risk factors on firm fundamentals or investigate the stochastic properties of stock returns’ distributions, (Fama and French (2004)). However, our paper provides evidence of misspecification issues in the empirical formulations of most of these multifactor models. We reveal that existing self-financing strategies on size, value, momentum, liquidity and financial distress may contain residual idiosyncratic risk because of the existence of asymmetric diversification effects. Using data from the main US exchanges, there is strong evidence of over- and under-estimation of factor risk premia relevant to their intrinsic values. We propose an amended multifactor asset pricing model, the diversification risk premium model, to control for the intertemporal asymmetric idiosyncratic risk. Overall, our results suggest that portfolios formed on size and liquidity suffer from diversification asymmetries. Specifically, the size effect dies out when the asymmetric effect on idiosyncratic risk is accounted for. Moreover, investing on valued and financially distressed firms yields consistently positive returns associated with the systematic component of risk of the corresponding risk factors. Finally, there is evidence that the presence of risk factors is enhanced during periods of low inter-dependencies between securities’ returns.

Is consumption risk priced in the stock market?

Abstract The paper examines whether the risk in the consumption of stockholders caused by incomplete consumption insurance is priced in the cross-section of average stock returns. Using Taylor series expansion of the average marginal utility of consumption, we show that the risk in the consumption of stock market participants can be decomposed into two components, insurable (hedgeable using financial assets) and uninsurable (caused by incomplete consumption insurance) consumption risks. We argue that the growth rate of average consumption may be viewed as a proxy for the insurable component of consumption risk, while the growth rates of the rescaled higher-order cross-sectional consumption distribution moments may be regarded as a multivariate proxy for uninsurable risk in consumption. Exploiting microlevel household quarterly consumption data from the US Consumer Expenditure Survey, we find that both components of consumption risk are significantly priced when the limited stock market participation is taken into account. Neither the insurable and uninsurable components of consumption risk nor the Fama–French risk factors are rejected as capturing important components of systematic risk when tested against each other in an integrated multifactor asset pricing model.

The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds

The authors study a unique data set in order to examine the performance of a sample of 169 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001–2011). We employ a multifactor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, managerial skill measured by Jensen’s alpha, leverage and, for the first time, managerial skill as it relates to timing leverage decisions to anticipated future market trends. find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) there is evidence for systematic underperformance as measured by Jensen’s alpha, possibly related to market frictions, iii) leverage cannot be viewed as a long-term strategy to enhance performance, and iv) timing leverage choices to the expected future market environment does not appear to add significantly to fund excess returns. <b>TOPICS:</b>Private equity, real estate, global, manager selection

Conditional multifactor asset pricing model and market anomalies

Purpose – The purpose of this paper is to investigate the firm-specific anomaly effect and to identify market anomalies that account for the cross-sectional regularity in the Indian stock market. The paper also examines the cross-sectional return predictability of market anomalies after making the firm-specific raw return risk adjusted with respect to the systematic risk factors in the unconditional and conditional multifactor specifications. Design/methodology/approach – The paper employs first step time series regression approach to drive the risk-adjusted return of individual firms. For examining the predictability of firm characteristics on the risk-adjusted return, the panel data estimation technique has been used. Findings – There is a weak anomaly effect in the Indian stock market. The choice of a five-factor model (FFM) in its unconditional and conditional specifications is able to capture the book-to-market equity, liquidity and medium-term momentum effect. The size, market leverage and short-run momentum effect are found to be persistent in the Indian stock market even with the alternative conditional specifications of the FFM. The results also suggest that it is naï argue for disappearing size effect in the cross-sectional regularity. Research limitations/implications – Constrained upon the data availability, certain market anomalies and conditioning variables cannot be included in the analysis. Practical implications – Considering the practitioners' prospective, the results indicate that the profitable investment strategy with respect to the small size effect is still persistent and warrants close-ended mutual fund investment portfolio strategy for enhancing the long-term profitability. The short-run momentum effect can generate potential profits given a short-term investment horizon. Originality/value – This paper provides the first-ever empirical evidence from an emerging stock market towards the use of alternative conditional multifactor models for the complete explanation of market anomalies. In an attempt to analyze the anomaly effect in the Indian stock market, this paper provides further evidence towards the long-short hedge portfolio return variations in terms of a wide set of market anomalies that have been documented in prior literature.

The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds

We study a unique data set in order to examine the performance of a sample of 169 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001-2011). We employ a multi-factor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, managerial skill measured by Jensen’s alpha, leverage and, for the first time, managerial skill as it relates to timing leverage decisions to anticipated future market trends. We find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) there is evidence for systematic underperformance as measured by Jensen’s alpha, possibly related to market frictions, iii) leverage cannot be viewed as a long-term strategy to enhance performance, and iv) timing leverage choices to the expected future market environment does not appear to add significantly to fund excess returns.

Global Integration of African Stock Markets

Financial market integration has significant implications for risk sharing and diversification, cost of capital, market efficiency, financial decisions and macro-economic policy. This paper investigates the integration of 11 African markets relative to the world and emerging markets over the period, March 1997 to January, 2013. The investigation is conducted using a multifactor asset pricing model. The paper explores whether a world or emerging market factor commands a premium over a pure African factor. It relies on the returns to a world, emerging and African market indices as risk factors. The factors used in this study are orthogonal to each other. The factors and their associated risk premia are concurrently estimated. Evidence is provided that the world, emerging and African market factors command significant risk premium on the African markets. The findings support partially integrated African market. The evidence shows that both world and emerging market factors are pertinent on the African markets. The evidence is generally sensitive to the period of investigation suggesting changing integration through time.

Multifactor Asset Pricing Models and Industry Portfolio Investment Strategies

This paper examines the effectiveness of six risk factors when applied to a selection of twenty industry-specific portfolios in explaining those portfolios’ returns. The explanatory power of each risk factor, as well as its statistical significance, is judged with respect to the explanatory power provided by the Fama-French Three Factor Model. The three additional factors are the Momentum, and Short and Long-Term price reversal factors. Results indicate that, of the three additional factors, Momentum has the most explanatory power on average. Nevertheless, several exceptions were identified in which the inclusion of the Momentum factor destroys explanatory power, or in which the Short or Long-Term reversal factor yielded significant explanatory power. Results demonstrate the differences of these factors’ behavior among the industries tested.

New return anomalies and new-Keynesian ICAPM

I propose a new multi-factor asset pricing model with new-Keynesian factors to explain stock return anomalies from 1972Q1 to 2009Q2. This new model explains the average returns across testing portfolios formed on financial distress, momentum, and standardized unexpected earnings with misspecification-robust statistics. Test portfolios formed on net stock issues and total accruals are also partly explained by new-Keynesian factors. Two monetary policy factors play an important role in explaining these new anomalies. The credit aspect of these new anomalies suggests an economic rationale for the model through capital market imperfections and the credit channel of monetary policy mechanism.

Evidence to Support Multifactor Asset Pricing Models: The Case of The Istanbul Stock Exchange

The objective of this study is to test, instead of the single factor CAPM, the power of three factor, four factor and five factor models to explain stock returns for the Istanbul Stock Exchange (ISE). The test results of all models in the ISE indicate that the models are applicable. During the period covering July 1992-June 2011 it is consequently established that, in addition to the market risk, size, book to market ratio, momentum and liquidity factors also constitute significant risk factors that affect the expected stock returns in the ISE and that the risk premiums belonging to these five factors are priced by the market.

The Role of Financial Leverage in the Performance of Core, Value-Add and Opportunistic Private Equity Real Estate Funds

We examine the performance of 162 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001-2011). We employ a multi-factor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, broad managerial skill captured by Jensen’s alpha, leverage and, for the first time, specific managerial skill as it relates to timing leverage decisions to anticipated future market trends. We find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) managerial skill as measured by Jensen’s alpha can be virtually fully explained by fund style, leverage, sector and geography, iii) leverage cannot be viewed as a long-term strategy to enhance performance, but iv) in the short term, managers do seem to add significantly to fund excess returns by effectively timing leverage choices to the expected future market environment.

On the Fundamental Relation between Equity Returns and Interest Rates

This paper uses contingent claim asset pricing and exploits capital structure priority to better understand the relation between corporate security returns and interest rate changes (i.e., duration). We show theoretically and, using a novel dataset, confirm empirically that lower priority securities in the capital structure, such as subordinated or distressed debt and equity, have low or even negative durations because these securities are effectively short higher priority, high duration fixed rate debt. This finding has important implications for interpreting existing results on (i) the time-varying correlation between the aggregate stock market and government bonds, (ii) the use of bond factors for multifactor asset pricing models and forecasting bond and stock returns, (iii) the Fisher effect and inflation, and (iv) the betas of corporate bonds.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

On the Fundamental Relation between Equity Returns and Interest Rates

This paper uses contingent claim asset pricing and exploits capital structure priority to better understand the relation between corporate security returns and interest rate changes (i.e., duration). We show theoretically and, using a novel dataset, confirm empirically that lower priority securities in the capital structure, such as subordinated or distressed debt and equity, have low or even negative durations because these securities are effectively short higher priority, high duration fixed rate debt. This finding has important implications for interpreting existing results on (i) the time-varying correlation between the aggregate stock market and government bonds, (ii) the use of bond factors for multifactor asset pricing models and forecasting bond and stock returns, (iii) the Fisher effect and inflation, and (iv) the betas of corporate bonds.

Bank Risk Factors and Changing Risk Exposures of Banks: Capital Market Evidence Before and During the Financial Crisis

Banks have been at the center-stage of the recent financial crisis due to their significant exposures to real estate and sovereign risks. In this paper we analyze the magnitude and changes in risk exposures that are reflected in bank stock returns within the European Monetary Union (EMU) and the United States (US) between 1990 and 2011. We use this period first to investigate bank risk in different economic environments including the introduction of the Euro and the recent financial and sovereign debt crisis. Second we examine whether banks have experienced a change in their risk exposures during the last two decades when the Basel regulatory framework with different bank capital regulations was introduced. In our multi-factor asset-pricing model we include the traditional bank risk factors such as interest-rate and foreign exchange rate risk. However, we extend the literature by including credit, sovereign, and real estate risk. We analyze the associated factor exposures and variance shares in a time-varying framework and draw inferences on their bank specific determinants in pooled regression setups with balance sheet characteristics. Our empirical findings indicate that banks’ risk factors are multi-dimensional but well reflected in stock prices. Sub-period analyses point towards the existence of pronounced time-variation in betas and variance shares. Changes in the banking business and in the crisis period are reflected in the form of dynamic risk exposures. Moreover, bank specific characteristics such as asset size and equity-to-asset ratios provide relevant information for identifying banks with economically significant risk exposures. Overall, our results yield valuable insights into the dynamics underlying bank risk, the associated exposures, and their reflection in equity prices. Understanding the sources of a banks’ riskiness may also help enhancing the bank supervisory process within the pillar of market discipline in the Basel regulatory framework.

On the Risk Exposure of Asia Pacific Banking Industry

Despite its potential benefits, financial globalization also carries some risks, especially for developing countries. The recent 1997 Asian financial crisis is such episode associated with a globalized financial system. In this paper, I examine whether there is any significant impact of the 1997 Asian crisis on the risk exposures of the banking sector for a group of Asia Pacific emerging markets. Using a conditional multi-factor asset-pricing model that allows time variation in the risk premiums, I find that the risk exposure increased during the crisis, with the greatest increase occurring for the crisis countries. However, the incremental increase in the risk exposure has diminished after the crisis. The evidence provided here indicates that the 1997 Asian crisis does not appear to have a permanent effect on the riskiness international banking industries, implying that the financial globalization is still beneficial, at least in the long run. Consequently, the main challenge for policy makers is to manage the integration process as to take full advantage of the opportunities, while minimizing its risks.

Comparative analyses of hotel REITs: examining risk‐return and performance characteristics

PurposeThis study aims to compare the risk‐return characteristics and performance of real estate investment trust (REIT) hotel companies (hotel REITs hereafter) with those of C‐corporation hotel companies (hotel C‐corps hereafter).Design/methodology/approachThe risk‐return characteristics and performance of hotel REITs and C‐corps were examined by estimating single‐factor and Fama‐French three‐factor asset pricing models for each portfolio. Differences between the hotel REIT and C‐corp estimations were tested using Wald test statistics.FindingsLittle evidence was found that hotel REITs have significantly different risk‐return characteristics and performance than hotel C‐corps, which suggests that hotel REITs and C‐corps are not significantly different in terms of market risk‐return characteristics and performance. The market portfolio had a significantly positive effect on the returns of both hotel REITs and C‐corps. The size and book‐to‐market factors of common stock also had a significant explanatory power for the returns of hotel REITs and C‐corps. Both hotel REITs and C‐corps performed similarly to the market portfolio, on a risk‐adjusted basis, during the 2000s.Research limitations/implicationsDespite the fact that the three‐factor asset pricing model explains a significantly greater proportion of the variation in the hotel firms' returns than the single‐factor asset pricing model, approximately 30 percent of the total variation still remains unexplained.Practical implicationsThe risk‐return characteristics and performance of hotel REITs and C‐corps revealed by this study will render hotel investors' decisions between the two organizational structures less complicated. In addition, the findings can be used by portfolio managers to construct a well‐diversified portfolio.Originality/valueA multifactor asset pricing model was used for the first time in this article to examine the risk‐return characteristics and performance of hotel companies. In addition, the importance of understanding differences between REIT and C‐corp structures in the lodging industry is emphasized.

Do Idiosyncratic Risks in Multi-Factor Asset Pricing Models Really Contain a Hidden Non-Diversifiable Factor? A Diagnostic Testing Approach

This paper employs a new approach to analyze potentially omitted non-diversifiable factors in the idiosyncratic risks from multi-factor asset pricing models. It is shown that if there is an omitted non-diversifiable hidden factor, the idiosyncratic risks will contain persistent cross-sectional memory. An extended Rescaled Variance test generalized from L. Giraitis, P. Kokoszaka, R. Leipus, and G. Teyssiere [1] with finite forecast horizon is provided to investigate the cross-sectional memory of forecast errors in multifactor pricing models. Under the null hypothesis that idiosyncratic risks contain only short memory when there is no hidden non-diversifiable factor, we demonstrate that the extendedT-sample Rescaled Variance test statistic approximates a functional of weighted Brownian Bridge, which is distributed asymptotically as the T-sample Watson’s statistic presented by Maag [2]. Using this approach, our empirical tests that compare forecast errors from the CAPM and Fama-French [3] model with the excess returns of 1391 firms indicate that there is a strong likelihood that the CAPM may require further identification of hidden non-diversifiable factor(s). Yet, there lacks convincing evidence that the Fama-French [3] model has an omitted non-diversifiable factor in idiosyncratic risks.

New Return Anomalies and New-Keynesian ICAPM

I propose a new multi-factor asset pricing model with new-Keynesian factors to explain stock return anomalies from 1972Q1 to 2009Q2. This new model explains the average returns across testing portfolios formed on financial distress, momentum, and standardized unexpected earnings with misspecification-robust statistics. Test portfolios formed on net stock issues and total accruals are also partly explained by new-Keynesian factors. Two monetary policy factors play an important role in explaining these new anomalies. The credit aspect of these new anomalies suggests an economic rational for the model through capital market imperfections and the credit channel of monetary policy mechanism.