Priced Risk Factor Research Articles

An examination of U.S. institutional and individual investor sentiment effect on the Turkish stock market

This study examines the effect of rational and irrational components of U.S. institutional and individual investor sentiment on Istanbul Stock Market (ISE) return and volatility. The results show that there is a significant spillover effect of U.S. investor sentiment on stock return and volatility of ISE. A breakdown of sentiment by the type of investor shows that the impact of institutional sentiment is greater than that of individual sentiment. A breakdown of sentiment by rationality shows that the effect of rational sentiment on ISE return is faster though not necessarily greater than that of irrational sentiment. The conclusion from these results is that the effect of U.S. investor sentiment is systemic and cannot be diversified away. U.S. investor sentiment, therefore, constitutes a priced risk factor and must be accounted for accordingly in international asset pricing models. The findings also provide some evidence of a negative relationship between U.S. investor sentiment and ISE return volatility.

Tell It Like It Is: Disclosed Risks and Factor Portfolios

Using new textual analysis techniques to extract a broad set of disclosed risk factors from firms' SEC filings, I examine characteristics of the firms and industries most likely to make each type of disclosure, and investigate the relation between firms' risk disclosures and their stock return volatilities and factor loadings. Finally, I form risk disclosure portfolios and perform a style analysis to examine the disclosed risks associated with commonly used asset pricing risk factors. Disclosed risks about credit markets and constraints explain much of the variation in the Fama-French factors, suggesting small, value firms may be more risky in downturns.

Macroeconomic Factors and Equity Returns in Borsa Istanbul

This paper investigates equity return exposure to various macroeconomic factors and the performance of factor betas in predicting the cross-sectional variation in stock returns. We utilize a two-step procedure to directly test the implications of the Arbitrage Pricing Theory. First, we calculate monthly factor betas and then, we estimate the sensitivity of equity returns towards the factor betas. We find that (i) there exists a negative and significant relation between interest rate betas and future equity returns; (ii) the inclusion of market, book-to-market, size and momentum factor betas does not subsume the predictive power of the interest rate beta; and (iii) these results are driven by the debt-to-equity ratios of individual firms. We conclude that the financial leverage driven sensitivity of returns towards interest rates is a priced risk factor in the Turkish stock market.

Macroeconomic uncertainty and the cross-section of option returns

I empirically investigate whether macroeconomic uncertainty is a priced risk factor in the cross-section of equity and index option returns. The analysis employs a non-linear factor model, estimated with the Fama-MacBeth methodology, where the macroeconomic uncertainty factor is the return on a long/short portfolio of equity options, built on the basis of how implied volatilities change around macroeconomic announcements. I find that macroeconomic uncertainty is priced in the cross-section of option returns, even after controlling for a number of relevant factors. The results are robust to alternative ways of measuring option returns, and to the non-random pattern of missing returns.

Credit Supply, Financial Distress and the Cross Section of Stock Returns

I present empirical evidence that the TED spread is a priced risk factor in the cross sectional stock returns. Stocks with higher exposure to the change in the TED spread require higher returns, and the return difference between the high sensitivity portfolio and the low sensitivity portfolio is a significant 6.6% annually. Individual stocks within the two extreme TED beta portfolios are more likely to be financially distressed, which is consistent with the documented hump-shaped relationship between expected return and default probability in Garlappi, Tao, and Yan (2008). The TED factor shows enhanced forecasting ability within non-crisis periods, and the size effect shows up only within the group of most distressed firms. This paper uncovers a systematic channel to reconcile the positive risk premium and negative risk premium found within the financially distressed stocks, and provide strong empirical evidence for the effect of credit supplying activities on corporate financing behaviors and stock performances.

Credit, Liquidity and the Cross Section of Stock Returns

I present empirical evidence that the TED spread is a priced risk factor in the cross sectional stock returns. Stocks with higher exposure to the change in the TED spread require higher returns, and the value weighted return difference between the high sensitivity portfolio and the low sensitivity portfolio is a significant 6.6% annually. The TED factor exercises better forecasting ability within the non-crisis periods and big stocks. My result provides further empirical support for Garleanu and Pedersen (2011) margin based asset pricing model, in which margin requirement captures the asset’s exposure to the shadow cost of the inter bank borrowing (the TED spread), and stocks with higher exposure require a higher return premium, in addition to their exposures to the conventional systematic risk factors.

Priced risk and asymmetric volatility in the cross section of skewness

We investigate the sources of skewness in aggregate risk factors and the cross section of stock returns. In an ICAPM setting with conditional volatility, we find theoretical time series predictions on the relationships among volatility, returns, and skewness for priced risk factors. Market returns resemble these predictions; however, size, book-to-market, and momentum factor returns are not always consistent with our predictions. We find evidence that size and book-to-market may be priced post-crisis but not in the decade before. Momentum does not appear priced by our test. We link aggregate risk and skewness to individual stocks and find empirically that the risk aversion effect manifests in individual stock skewness. Additionally, we find several firm characteristics that explain stock skewness. Smaller firms, value firms, highly levered firms, and firms with poor credit ratings have more positive skewness.

Tightness of Funding Constraints and Asset Prices: Insights from Mutual Fund Risk Taking

Prior theory suggests that time variation in the degree to which leverage constraints bind affects the pricing kernel. We propose a measure for this leverage constraint tightness by inverting the argument that constrained investors tilt their portfolios to riskier assets. We show that the average market beta of actively managed mutual funds -- intermediaries facing leverage restrictions -- captures their desire for leverage and thus the tightness of constraints. Consistent with theory, it strongly predicts returns of the betting-against-beta portfolio, and is a priced risk factor in the cross-section of mutual funds and stocks. Funds with low exposure to the factor outperform high-exposure funds by 5% annually, and for stocks this difference exceeds 8%. Our results show that the tightness of leverage constraints has important implications for asset prices.

Supply response of coconut cultivation in Kerala

Kerala's agriculture development experience since the last few decades has been characterised by sharp decline in the area under food crops and the substantial expansion in the area under non-food crops. The analysis of the growth trends of area of principal crops in Kerala clearly revealed that the cropping pattern in the state made a significant change from food crops to non-food crops. Coconut came to the first position by pushing rice to the third. There must be certain determinants that motivated the farmers to make such a shift. Supply response in terms of area response and yield response models were used to analyse the determinants. The determinants estimated are lagged area, expected price of the crop, lagged yield, expected yield risk and price risk, average annual rainfall, irrigated area, etc. The analysis revealed that the irrigated area, rainfall and price risk factors are the significant variables affecting the area allocation of coconut in Kerala and the crop's yield response, irrigated area, rainfall and expected price risk are the strong variables.

Some personal observations on the debate on the link between financial reporting quality and the cost of equity capital

Within the last decade there has been much written about the possible link between the quality of a firm’s external financial reporting and its cost of equity capital. In this paper I provide my personal observations about the literature. I make the following points. I find the Francis et al. (2005) paper interesting and innovative. This paper documents a positive association between portfolio returns formed on the basis of accrual quality and firms’ realized returns after controlling for the Fama-French three factors. Francis et al. conclude that accrual quality is a priced risk factor. Second, while this conclusion might be too strong based on their results, I think the Core et al. (2008) critique of the Francis et al. claim is also too strong and does not lead me to reject accrual quality as a priced risk factor. Third, the evidence of an association between financial reporting quality and implied cost of capital estimates is robust. However several papers question the construct validity of these measures which are based on analyst earnings forecasts. I discuss these papers and conclude that the implied cost of capital does have empirical validity. Finally, various papers model the relation between financial reporting quality and cost of capital and, while interesting, mostly restrict themselves to a single factor asset pricing model. However, restricting the model to a single factor model by assumption rules out the possibility of information quality being a separately priced risk factor and further restricts the role information quality to informing about a firm’s covariances (or estimation error in the CAPM beta) because it is assumed that information quality is diversifiable. I think whether something is diversifiable is an empirical question that cannot be resolved by assumption within a theoretical model.

The Variance Swaps based on KOSPI200 Index and the Term Structure of Variance Risk Premium

This study examines whether the variance risk is a priced risk factor in Korea using the over-the-counter variance swap quotes and realized variance data. We also study the term structure of variance risk premium. The empirical results show that the model with 2 stochastic variance risk factors with jumps in return is required to fit the variance swap and realized variance data. The analyses with the estimated models suggest that the variance risk premium in Korea are highly negative and the size of the premium increase with the maturities, meaning that risk averse investors in Korea are willing to pay a premium to hedge variance risk.

Noise as Information for Illiquidity

ABSTRACTWe propose a market‐wide liquidity measure by exploiting the connection between the amount of arbitrage capital in the market and observed “noise” in U.S. Treasury bonds—the shortage of arbitrage capital allows yields to deviate more freely from the curve, resulting in more noise in prices. Our noise measure captures episodes of liquidity crises of different origins across the financial market, providing information beyond existing liquidity proxies. Moreover, as a priced risk factor, it helps to explain cross‐sectional returns on hedge funds and currency carry trades, both known to be sensitive to the general liquidity conditions of the market.

Accruals quality, stock returns and asset pricing: Evidence from the UK

The extent to which accruals quality (AQ) is relevant for asset pricing has been debated widely. Prior research in this area has focused almost exclusively on the US. Using UK data, we investigate whether AQ portfolios exhibit evidence of significant mispricing, and whether an AQ factor is useful in explaining the portfolios' returns. We also investigate whether AQ is a priced risk factor. Using a two stage cross-sectional regression, we show that an AQ measure explains the cross-section of stock returns. AQ also explains the time-series variation in returns for two sets of portfolios: 16 size-BM portfolios, and 20 industry portfolios. Consistent with some recent US evidence, however, we find no evidence that AQ is a priced risk factor for UK stocks.

Corporate Bond Risk Premia

This paper investigates the holding period risk premia of U.S. corporate and Treasury bonds. Using excess return regressions, two priced risk factors are derived from yield and macroeconomic data: a priced term risk factor and a priced credit risk factor explain half of the variation in one-year corporate and Treasury excess returns. The information of the term risk factor is not represented by major yield characteristics but is a hidden risk factor whereas the credit risk factor is not hidden. The term risk premium is earned primarily for exposure to inflation and the yield level and the credit risk premium is earned for an exposure to real growth and the credit spread level. The regression results are usefull for the specification of the market prices of risk in affine credit term structure models: The two-factor representation of the risk premium suggests a rank restriction on the market prices of risk and an additional pricing factor to capture the hidden property of term risk.

Macroeconomic Uncertainty and the Cross-Section of Option Returns

I empirically investigate whether macroeconomic uncertainty is a priced risk factor in the cross-section of equity and index option returns. The analysis employs a non-linear factor model, estimated with the Fama-MacBeth methodology, where the macroeconomic uncertainty factor is the return on a long/short portfolio of equity options, built on the basis of how implied volatilities change around scheduled macroeconomic announcements. I find that macroeconomic uncertainty is priced in the cross-section of option returns, even after controlling for a large set of relevant factors. The results are also robust to alternative ways of measuring option returns, and to the non-random pattern of missing returns.

Illusion of Growth: Merger-Related Transitory Growth and Its Implications for Growth and Accrual Mispricing

Prior literature in accounting and financial economics measures asset growth as year-over-year growth in total assets. Such growth estimates are upward biased when firms engage in mergers and acquisitions. We decompose asset growth into merger-related and organic growth components, and find that merger-related growth is less persistent than organic growth. The merger-related growth is positively associated with analysts’ optimism in earnings forecasts and stock recommendations, and is a strong predictor of future returns. Furthermore, such return predictability is exhibited by firms that do not transparently disclose the merger-related and organic growth components. This finding is consistent with investors with limited attention playing a role in mispricing. Portfolio asset pricing tests reveal that priced risk factors do not explain this growth pricing anomaly. Stocks with high merger-related growth tend to be associated with higher trading costs and arbitrage risk, which contributes to the persistence of this mispricing over time.

The world price of jump and volatility risk

We study international integration of markets for jump and volatility risk, using index option data for the main global markets. To explain the cross-section of expected option returns we focus on return-based multi-factor models. For each market separately, we provide evidence that volatility and jump risk are priced risk factors. There is little evidence, however, of global unconditional pricing of these risks. We show that UK and US option markets have become increasingly interrelated, and using conditional pricing models generates some evidence of international pricing. Finally, the benefits of diversifying jump and volatility risk internationally are substantial, but declining.

Does Sentiment Risk Persist as Priced Risk Factor? A Multifactor Approach for Stock Return

Much of the academic debate has gone in to exploring the better asset pricing model that can explain the quantification of the trade-off between risk and expected return for the cross section of stock return. Nevertheless this intimidating task becomes more pragmatic given the market structure of emerging markets, liquidity effects, market inefficiency, and more significantly the presence of inherent imperfect rationality or sentiment. The basic objective of this paper is to evaluate the pricing implication of unconditional five factor model to explain the cross sectional stock return behaviour in the context of Indian stock market. Our analysis also aims to examine the pricing nature of aggregate market wide sentiment risk in the presence of other risk factors. We employ Fama and French time series regression approach to examine the impact of market risk premium, size, book-to-market equity, momentum and liquidity as risk factors on stock return. Our empirical results show that given the multidimensional nature of risk the choice of a five factor model is apparently persuasive for consideration in investment decisions. However, inconsistent with prior literature book-to-market equity fails to explain the average return in case of large stocks, and pricing evidence of momentum profits fades in case of winner stocks and momentum strategy retains its value only for the sell side transactions i.e., loser portfolios. With the presence of liquidity factor in the five factor model specification, the results suggest that liquidity is priced and explains a cross sectional variation in stock returns. Our results also suggest that it is naive to argue for the universal pricing implication of sentiment risk in a multifactor model framework, and market wide risk factors resume their importance as rational source of priced risk.

Macroeconomic Uncertainty, Risk and its Effect on Stock and Bond Returns: International Evidence

This paper investigates the relation between uncertainty and stock index returns for 15 countries. An innovation is to use macro-uncertainty at both the country and global level. Our results suggest that country-specific GDP uncertainty, but not global GDP uncertainty is positively correlated with country returns. In contrast, we find that global inflation uncertainty, but not country inflation uncertainty, is negatively correlated to country returns. Thus, macro-uncertainty is a priced risk factor and differentiation between specific and common uncertainty important. Our results are robust across various measures of uncertainty and for several different models of volatility.

Can Idiosyncratic Cash Flow Components Explain Asset Pricing Anomalies?

We show that unpriced cash flow shocks contain information about future priced risk. A positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases firm size and idiosyncratic risk. A simple model can therefore explain book-to-market and size anomalies, as well as the negative relation between idiosyncratic volatility and stock returns. Using the model, we identify firms for which anomalies must be stronger and confirm this relation empirically. More generally, our results imply that any economic variable correlated with the history of idiosyncratic shocks can help to explain expected stock returns.