Positive Risk Premium Research Articles

US Funds’ returns-based ESG extraction and implementation: a multifaceted quantile regression approach

ABSTRACT This study introduces a novel ESG intrinsic-based return factor and its application in asset pricing. This factor is extracted using a parallelized rolling window estimation and extreme value-weighted quantile portfolios. It carries a positive risk premium, indicating that investors are willing to assess its risk exposure. We further show that higher returns can be obtained in the top 30% quantiles using a long-only trading strategy. We apply a Monotone Composite Quantile Regression Neural Network (MCQRNN) model to explain US fund returns and address the needs of investors seeking to optimize their investment strategies. This model surpasses traditional benchmark models by performing deep quantile estimation and considering the nonlinear relationships between fund returns and six firm-based characteristics. This approach empowers investors by explaining the core principles of impact investing and highlighting how our constructed ESG risk factor can generate competitive returns even in volatile markets when its risk is well assessed. Highlights A sustainable smart beta factor construction is ensured ESG Long-only trading strategy grants higher returns in the top 30% quantiles Using ML, we further assessed the need to implement ESG factors into asset pricing Positive ESG risk premium reveals the investors’ interest in impact investing US market remains promising for positive ESG investment signals

Control risk premium: Dual‐class shares, family ownership, and minority investor returns

AbstractDespite exhibiting significant valuation discounts, dual‐class shares surged from 1% of initial public offerings in 1980 to nearly half in recent years. This study investigates the potential harm of such structures by examining the identity and returns of minority shareholders. We find that sophisticated investors predominantly hold low‐voting shares. Furthermore, outside shareholders earn a positive risk premium rather than suffering low returns, consistent with the hypothesis that market prices compensate for the risk associated with dual‐class structures. Our analysis reveals that such structures are confounded with family control, which is present in 89% of dual‐class firms in the Russell 3000. Interestingly, single‐class firms with family shareholders also enjoy positive abnormal returns, implying minority shareholders care more about the presence of a controlling shareholder than a specific voting structure. This research contributes to the ongoing debate on restricting dual‐class structures by highlighting the complex relationship between ownership, control, and shareholder returns.

Is firm-level political risk priced in the corporate bond market?

We investigate whether political risk is priced in the cross-section of corporate bond returns by using a text-based measure of firm-level political risk. We document a positive and significant political risk premium after controlling for bond and firm characteristics, conventional risk factors, and exposure to aggregate economic policy uncertainty. Bonds with higher political and credit risk, as well as smaller, more illiquid, and longer maturity corporate bonds exhibit a larger political risk premium. Time-series analysis indicates that monetary policy shocks and common shocks in the equity and bond market exhibit a statistically significant and positive association with the political risk premium. Our findings reveal the importance of idiosyncratic political risk beyond common risk factors and aggregate economic policy uncertainty.

Financial Distress Premium or Discount? Some New Evidence

This study investigates the contradiction in the finding of a positive distress risk premium in Vassalou and Xing’s study and the finding of a negative distress risk premium, i.e., a distress risk discount, in several other studies. Using the default likelihood measure calculated following Vassalou and Xing’s procedure for 1965–2023, we show that excluding outliers and including the time period beyond the end of Vassalou and Xing’s sample period in 1999 makes a difference in the results. Overall, using portfolio sorting and Fama-MacBeth regressions, this study supports the existence of a distress risk discount. This study also documents that the financial distress risk is negatively reflected in security prices even after accounting for size and book-to-market risk factors. Furthermore, it demonstrates that the negative distress risk premium is strong and persistent across economic expansions, recessions, and the COVID-19 pandemic.

Comprehensive Asset Pricing Tests in the Korean Stock Market

AbstractWe examine the empirical performance in the Korean stock market of three new asset pricing factor models: the Stambaugh–Yuan (2017) mispricing factor model, the Daniel et al. (2020) three‐factor model, Barillas‐Shanken (2018) six‐factor model and the Hou et al. (2021) q5‐factor model. We find that all factors in these factor models have significantly positive risk premiums and are not explained by the Fama–French six‐factor model. Compared to other prevalent models, the q5 model shows the highest maximum Sharpe ratio, mainly due to its profitability and expected growth factors. Further, the q5 model exhibits superior performance in explaining the returns of 97 anomaly portfolios in the Korean market.

Capital risk, fiscal policy, and the distribution of wealth

We develop a dynamic model economy where self-employed entrepreneurs allocate their net worth to their firm capital and risk-less government bonds, facing borrowing constraints, uninsurable labour endowment and capital depreciation risk. We derive a numerical approximation of the model’s equilibrium and compare it with a benchmark economy with no capital risk. Unlike labour endowment risk, capital risk reduces aggregate capital accumulation and wages and generates a positive risk premium. Low- (high-) net-worth entrepreneurs, whose consumption depends primarily on labour (financial) income, hold higher (lower) capital risk exposure. These patterns exacerbate inequality by increasing the share of financially constrained individuals and fattening the tails of the net worth distribution. Fiscal policy affects these outcomes by redistributing resources and affecting the risk premium. Capital tax cuts benefit more low- or high-net-worth entrepreneurs, depending on whether taxes on bonds or labour income finance them.

Risk premium in a real business cycle framework

A real business cycle framework with financial and informational frictions is developed for a small open economy in order to analyze the implications of risk premium shocks for aggregate fluctuations. The frictions in the dynamic, stochastic, general equilibrium model necessitate financial intermediation and the uncertainty in the production process requires collateralized borrowing in the economy. Sovereign risk exists in the model due to a government that borrows domestically with a partial default risk. The associated risk premium that the government is subject to is captured both endogenously and exogenously, which constitutes one of the major contributions of this study to the literature. It is shown that a positive, temporary risk premium shock leads to an increase in government borrowing and a decrease in government spending due to the rise in the cost of borrowing for the government. The model also predicts a fall in output, labor supply and loans as well as a rise in the default probability of the government. The results confirm the findings of the literature with respect to the expected effects of a positive risk premium shock on a small open economy in a novel framework, where financial and informational frictions as well as sovereign risk as key features of emerging economies are captured and analyzed.

Economic and financial consequences of water risks: The case of hydropower

Reduced water availability poses risks for many economic activities. This paper studies how water risks affect hydroelectricity generation in Europe and the US and whether these risks are priced in by financial markets. To this end, we build a novel dataset for the period 2015–2022, which combines plant-specific hydroelectricity generation with geo-specific water physical risks and equity returns. We find that water risks, measured using model-based aggregate water risk metrics as well as precipitation anomalies, are significantly associated with reduced electricity generation, although the effect disappears after two months. We then link the power plants in our sample to the equity returns of their owners to investigate whether financial markets adequately price water risks. Using a portfolio sorts approach, we find weak evidence of a negative risk premium. Given the real negative effect of water risks on generation, we conclude that the lack of a positive risk premium amounts to mispricing of water risks by financial markets.

The asset‐pricing implications of carbon risk in Korea

AbstractThis study examines the relationship between carbon risk and stock returns for listed firms in Korea, where firms are legally obligated to disclose their carbon emissions. While previous research mostly focuses on major markets like the United States and the European Union, demonstrating the impact of climate change on asset prices, there is a scarcity of studies examining emerging markets. Using data from Korean‐listed firms from 2011 to 2021, we investigate the association between a firm's exposure to carbon risk and cross‐sectional stock returns. We find that stocks with high exposure to carbon risk exhibit higher average returns and the abnormal returns associated with carbon risk are statistically significant and cannot be explained by the Fama‐French three‐ or five‐factor models. Furthermore, this phenomenon is more evident among stocks with high foreign ownership. Finally, the carbon factor commands a significantly positive risk premium, suggesting that carbon risk is an important risk factor even in emerging markets like Korea.

Modelling Stock Market Volatility During the COVID-19 Pandemic: Evidence from BRICS Countries

The objective of the research paper is to identify the stock market volatility pattern of BRICS countries during the outbreak of the COVID-19 pandemic. The study is based on the time series data, which consists of the daily closing price of the BRICS countries' index for a two-year (pandemic) period from 1st January 2020 to 31st December 2021. Both the symmetric and asymmetric models of Generalized Autoregressive Conditional Heteroscedasticity (GARCH) have been employed in the study to investigate whether volatility changes over the pandemic period. The result of the GARCH-M (1,1) model evidenced the presence of a positive and insignificant risk premium. Based on the empirical work carried out using the market index of BRICS countries, it was found from EGARCH (1,1), and TGARCH (1,1) models that there exists a leverage effect in the countries, viz. Brazil, Russia, India, China and South Africa. Since the stock price during the pandemic period triggered the entire financial market, the investors, fund managers and portfolio managers should be more aware of the uncertainty and need to adjust their investments accordingly.

Asset pricing tests for pandemic risk

This study examines the relationship between the COVID-19 pandemic and stock returns. We find that pandemic risk is a significant determinant of cross-sectional stock returns. The time-varying effective reproduction number from the susceptible-infectious-recovered epidemic model is introduced as a proxy measure for COVID-19 risk. The two-step generalized method of moments estimation results indicate that the COVID-19 factor commands a significant positive risk premium. The results are robust to different test assets, serial interval parameters, portfolio construction methods and alternative proxy measures, providing strong empirical evidence that the COVID-19 factor is a priced risk factor during the COVID-19 pandemic.

The volatility index and volatility risk premium in China

We introduce the China Volatility Index (CNVIX), a model-free volatility index for the Chinese equity market based on ETF options. To construct the CNVIX, we extend the Chicago Board Options Exchange (CBOE) methodology in the emerging Chinese options market. We examine the leverage effect and volatility feedback effect between the CNVIX and the underlying asset, as well as the CNVIX’s return forecastability. Our findings indicate a significant negative asymmetric leverage effect, insignificant volatility feedback effect in the CNVIX, and a positive mean volatility risk premium (VRP), which can forecast the underlying asset’s returns over various horizons.

Pricing Climate Change Exposure

We estimate the risk premium for firm-level climate change exposure among S&P 500 stocks and its time-series evolution between 2005 to 2020. Exposure reflects the attention paid by market participants in earnings calls to a firm’s climate-related risks and opportunities. When extracted from realized returns, the unconditional risk premium is insignificant but exhibits a period with a positive risk premium before the financial crisis and a steady increase thereafter. Forward-looking expected return proxies deliver an unconditionally positive risk premium with maximum values of 0.5%–1% p.a., depending on the proxy, between 2011 and 2014. The risk premium has been lower since 2015, especially when the expected return proxy explicitly accounts for the higher opportunities and lower crash risks that characterize high-exposure stocks. This finding arises as the priced part of the risk premium primarily originates from uncertainty about climate-related upside opportunities. In the time series, the risk premium is negatively associated with green innovation; Big Three holdings; and environmental, social, and governance fund flows and positively associated with climate change adaptation programs. This paper was accepted by Colin Mayer, Special Section of Management Science on Business and Climate Change. Funding: Funding is provided by the Deutsche Forschungsgemeinschaft [Grant 403041268 – TRR 266] (L. van Lent and R. Zhang), the Institute for New Economic Thinking (L. van Lent), the 111 Project [Grant B18033] (R. Zhang), the Shanghai Pujiang Program (R. Zhang), and the Ministry of Education Project of Key Research Institute of Humanities and Social Science (R. Zhang). Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2023.4686 .

Estimating the Value of Gender- and Race-Specific Job Injury Risk

AbstractThe compensating wage differential (CWD) for nonfatal injury and value of statistical life or injury in occupations have rarely been analysed separately by gender or race. This paper uses individual-level data from the 2012–2015 March Current Population Survey to estimate the CWD as well as the value of statistical injury (VOI) by race and gender. We find male workers command a positive risk premium, and this is higher when they are unionised. We also find a positive risk premium for White unionised workers and a slightly lower risk premium for White males. Like other investigators, we find that nonfatal risk is heterogenous, and its compensation is difficult to estimate using a standard wage equation, even with some smaller subsamples from our dataset that are gender- or race-specific. Our estimates of the VOI show us that male workers who are unionised have the highest VOI, followed by Hispanic union workers, and Black females. This last finding follows from Black females working in jobs that have the highest risk rates compared to White and Hispanic females.

A conditional higher-moment CAPM

This paper investigates whether dynamic and moment extensions to the traditional CAPM can improve its empirical performance and offer some alternative explanation to the cross-section of average returns on portfolios of stocks double sorted on book-to-market ratios and size. We consider three extensions. First, we introduce time-varying factor loadings obtained from a multivariate GARCH and dynamic conditional correlations. Second, we extend the model to a four-moment CAPM, which incorporates coskewness and cokurtosis. Finally, we allow for time-varying risk premia, based on a Markov-switching process. Our results confirm that the higher-moment CAPM does not perform well in its unconditional version, but its performance is significantly improved when we introduce a conditional version that accounts for both time-varying factor loadings and time-varying risk premia. The four-moment CAPM tests lead to a positive total risk premium estimate of 0.67% per month over the period 1926–2021, with all risk premia (beta, coskewness, and cokurtosis) exhibiting the expected theoretical signs.

Consumption risks in option returns

We offer evidence that exposures to consumption growth and consumption volatility are significantly priced in the cross-section of delta-hedged option returns. Consumption growth commands a positive risk premium, whereas consumption volatility commands a negative risk premium. Our results suggest that consumption risk exposures provide rational foundations for well-known relations between options moneyness or idiosyncratic underlying-stock volatility and the cross-section of delta-hedged option returns. Furthermore, those risk premiums can also price stocks. In a representative-agent economy with recursive preferences, our results suggest that investors prefer early resolution of uncertainty. • Exposures to consumption growth and volatility are priced in option returns. • Consumption risk exposures explain well-known relations in the option market. • Consumption growth and volatility premiums are positive and negative respectively. • Option consumption risk premiums can also price stocks. • Empirical results show that investors prefer early resolution of uncertainty.

Commodity futures return predictability and intertemporal asset pricing

We find out-of-sample predictability of commodity futures excess returns using combination forecasts of 28 potential predictors. Such gains in forecast accuracy translate into economically significant improvements in certainty equivalent returns and Sharpe ratios for a mean–variance investor. Commodity return forecasts are closely linked to the real economy. Return predictability is countercyclical, and the combination forecasts of commodity returns have significant predictive power for future economic activity. Two-factor models featuring the market factor and the innovations in each of the combination forecasts explain a substantial proportion of the cross-sectional variation of both commodity and equity returns. The associated positive risk premiums are consistent with Merton’s (1973) intertemporal capital asset pricing model (ICAPM), given how the combination forecasts predict an increase in future economic activity and a decline in stock market volatility in the time-series. Overall, combination forecasts act as state variables within the ICAPM, thus resurrecting a central role for macroeconomic risk in determining expected returns on commodities.

Carbon Risk Factor Framework

This article provides new perspectives on carbon risk factors by using raw carbon footprint data, applying more accurate measurement of carbon footprint data, analyzing the global stock universe, utilizing a long data timeframe, and constructing three unique carbon factors. The research uses both Fama–French and Fama–MacBeth frameworks. All three carbon factors (carbon volume, carbon financial efficiency, and carbon operational efficiency) exhibit strong performance and high Sharpe ratios. There is no discernable return variation within the carbon volume factor along six formed portfolios. Both efficiency factors show a discernable higher performance for higher-carbon-efficiency companies with larger market capitalization. The regression analysis shows all three carbon factors exhibiting statistical significance individually or carbon volume with one of the efficiency factors. In conclusion, companies with relatively higher carbon volume or lower carbon efficiency have a positive risk premium.

Do gold, oil, equities, and currencies hedge economic policy uncertainty and geopolitical risks during covid crisis?

Recent literature extensively studies the safe-haven properties of different asset classes in crisis periods. The magnitude of the economic policy uncertainty index (EPU) and the geopolitical risk (GPR) increases significantly during extreme crisis periods such as covid crisis, but the earlier literature ignores how both risk measures impact on different asset classes during severe economic downturns. In this paper, we contribute by examining the hedging and safe-haven properties of gold, oil, equities, and foreign exchange rates against the United States (US) EPU and GPR by utilizing OLS regression, quantile regression and the quantile connectedness approach for pre-covid (October 1, 2013–March 10, 2020) and post-covid data (March 11, 2020–August 27, 2021). OLS results suggest that only the stock market has positive risk premium for both uncertainty measures. With quantile regression analysis for the pre-covid period, we find that asset returns provide no hedge (hedge) across bearish (bullish) market conditions. Importantly, safe-haven properties suggest that gold is a safe-haven asset at the extreme stress condition (at higher level of USEPU shocks). Other assets also exhibit safe-haven characteristics during extreme uncertain periods with heterogeneity in safe-haven effectiveness across bearish to bullish markets. With the post-covid data, we show that S&P500 stocks and EURO hedge EPU and GPR in bullish market condition, while Oil, S&P500, Great Britain Pound, EURO, Japanese Yen display safe-haven properties at the 99% quantile of USEPU. Specifically, gold lost its safe-haven features during covid. Interestingly, results from quantile connectedness suggest that selected asset returns have the potential to diversify against uncertainty measures considering low volatility transmissions between them across the lower and higher quantiles. Our findings are important for investors and asset managers who aim to hedge EPU and GPR during the stress period.

Conventional and downside CAPM: The case of London stock exchange

Many studies on asset pricing have highlighted the importance of downside risk, in line with the actual losses of investors. In addition, the capital asset pricing model (CAPM), although presented as a universal theory, may provide significantly different rates of return in bull and bear markets. Using the CAPM under different conditions could be regarded as an alternative measurement and valuation approach to downside risk. This paper investigates conventional and downside approaches to risk taking into account different measures of downside beta coefficients. A further contribution of this research is the development of an alternative approach to testing the CAPM relationship. For this purpose, conditional relationships of the CAPM are proposed in which risk premiums are set separately in bull and bear periods. Using equity data and portfolios from the United Kingdom, we obtained positive and statistically significant downside risk premiums. We observed a slight advantage of downside measures over conventional beta measures. Conditional models provide evidence of a positive risk premium in rising markets and a negative risk premium in falling markets. The robustness analysis in subperiods indicates that these findings are largely unchanged for downside beta coefficients, which is not fulfilled by the model in a variance approach.