Return Premium Research Articles

The Perception of Dependence, Investment Decisions, and Stock Prices

ABSTRACTHow do investors perceive dependence between stock returns; and how does their perception of dependence affect investments and stock prices? We show experimentally that investors understand differences in dependence, but not in terms of correlation. Participants invest as if applying a simple counting heuristic for the frequency of comovement. They diversify more when the frequency of comovement is lower even if correlation is higher due to dependence in the tails. Building on our experimental findings, we empirically analyze U.S. stock returns. We identify a robust return premium for stocks with high frequencies of comovement with the market return.

A Global Macroeconomic Risk Model for Value, Momentum, and Other Asset Classes

AbstractValue and momentum returns and combinations of them across both countries and asset classes are explained by their loadings on global macroeconomic risk factors. These loadings describe why value and momentum have positive return premia, although being negatively correlated. The global macroeconomic risk factors also perform well in capturing the returns on other characteristic-based portfolios. The findings identify a global macroeconomic source of the common variation in returns across countries and asset classes.

Instability in Risk Premia

We apply a new methodology for identifying pervasive and discrete changes (``breaks'') in cross-sectional risk premia and find empirical evidence that these are economically important for understanding returns on US stocks. Size and value risk premia have fallen off to the point where they are insignificantly different from zero at the end of the sample. The market risk premium has also declined systematically over time but remains significant and positive as does the momentum risk premium. We construct a new instability risk factor from cross-sectional differences in individual stocks' exposure to time-varying risk premia and show that this factor earns a premium comparable to that of commonly used risk factors. Using industry- and characteristics-sorted portfolios, we show that some breaks to the return premium process are broad-based, affecting all stocks regardless of industry- or firm characteristics, while others are limited to stocks with specific style characteristics. Moreover, we identify distinct lead-lag patterns in how breaks to the risk premium process impact stocks in different industries and with different style characteristics.

Broker Network Connectivity and the Cross-Section of Expected Returns

We examine the relationship between broker network connectivity and stock returns in an order-driven market. Considering all stocks traded in Borsa Istanbul between January 2006 and November 2015, we estimate the monthly density, reciprocity and average weighted clustering coefficient as proxies for the broker network connectivity. Our firm-level cross-sectional regressions indicate a negative and significant predictive relationship between connectivity and one-month ahead stock returns. Our analyses also show that stocks in the lowest connectivity quintile earn 1.0% - 1.6% monthly return premiums. The connectivity premium is stronger in terms of both economic and statistical significance for small size stocks.

The pricing of the illiquidity factor’s conditional risk with time-varying premium

We test the pricing of the conditional systematic risk (β) of IML, a traded liquidity factor of the return premium on illiquid-minus-liquid stocks, with its risk premium varying over time. We find a positive and significant risk premium on conditional βIML, which rises in times of financial distress, measured by the corporate bond yield spread or broker–dealer loans (including margin loans). The conditional βIML remains significantly priced across individual stocks after controlling for the unconditional and conditional βs of the Fama-French and Carhart factors, as well as some common liquidity-based factors.

The high volume return premium and economic fundamentals

Extending Kaniel et al. (2012) and many others, we present the first empirical evidence that indicates the high volume return premium is linked to economic fundamentals. The volume premium has strong predictive power for future industrial production growth and other macroeconomic indicators with or without controls for common equity pricing factors and business cycle variables. However, only a small portion of the volume premium can be attributed to its comovement with equity return factors and economic risk factors. Mispricing-based factor models also fail to adequately explain the return anomaly.

Information Consumption and Asset Pricing

ABSTRACTWe study whether firm and macroeconomic announcements that convey systematic information generate a return premium for firms that experience information spillovers. We use information consumption to proxy for investor learning during these announcements and construct ex ante measures of expected information consumption (EIC) to calibrate whether learning is priced. On days when there are information spillovers, affected stocks earn a significant return premium (5% annualized) and the capital asset pricing model performs better. The positive effect of the Federal Reserve Open Market Committee announcements on the risk premia of individual stocks appears to be modulated by EIC. Our findings are most consistent with a risk‐based explanation.

The Rewards for Meeting or Beating Managers' Own Earnings Guidance

SYNOPSIS This study documents a stock return premium for meeting or beating management's own earnings guidance (MBMG) that is separate and distinct from the premium for meeting or beating analysts' earnings forecasts (MBAF) documented in prior literature. Cross-sectional analyses reveal that the MBMG premium relative to the MBAF premium increases when management guidance is more informative. We also find that MBMG is incrementally informative about a firm's future performance after considering MBAF. Our findings suggest that investors consider management earnings guidance to be a performance threshold in addition to analyst earnings forecasts when forming earnings expectations. Data Availability: All data are available from public databases identified in the paper. JEL Classifications: D84; G14; G17; M41.

The Fama-French Five-Factor Model Plus Momentum: Evidence for the German Market

We implement the Fama-French five-factor model and enhance it with a momentum factor for the German market using recent monthly data from 2002 to 2019. We construct the factors associated with the market, size, value, profitability, investment, and momentum for the CDAX constituents and examine to what extent this six-factor model captures the return premia in the German market. Our preliminary analysis does not document any significant evidence on the profitability or investment premium.The results on the six-factor model compared with the three-factor model reveal that the additional factors do not add significant explanatory power to the analysis. We conclude that the relevance of the profitability and investment factors within the context of international asset pricing studies cannot be transferred to the country- specific case of the German market.

Economic policy uncertainty and illiquidity return premium

In this study, we examine the relation between the price of liquidity, or illiquidity return premium, and the economic policy uncertainty (EPU). On average, an illiquid portfolio earns a 0.597% higher monthly return than a liquid portfolio. The results further show that the EPU index has a positive relationship with the illiquidity return premium. This indicates that investors require higher compensation for holding illiquid stocks when there is a higher economic uncertainty. We also show that EPU affects the illiquidity return premium through the market illiquidity channel. The rise of EPU could increase the risk of illiquid stocks and make investors more risk-averse, thereby requiring higher compensation for illiquidity. Finally, it is found that the relationship between EPU and the illiquidity return premium is stronger when market liquidity is impaired and during crises.

Composite-asset-risk approach to solving the equity premium puzzle

We demonstrate that the equity premium puzzle can be explained by a combination of modern portfolio theory (MPT) and a consumption capital asset pricing model (CAPM). We assume that an investor maximizes her/his utility as determined by the expected return and risk for a composite asset portfolio including purchasing an equity and selling a riskless asset jointly. If the variance of the composite asset is greater than that expected by the CAPM, then the equity premium puzzle can be resolved according to the MPT. The intrinsic bubbles may explain the observed excessive expectation and variance of equity return premium.

Return Premium of Financial Distress and Negative Book Value: Emerging Market Case

The purpose of this paper is to examine a financial distress premium in the emerging market. A risk-return trade-off of negative book equity (NBE) and distress firms is empirically analyzed using data from the Stock Exchange of Thailand. This research employs Ohlson’s (1980) bankruptcy model as a measurement of distress risk. The results indicate that distress firms outperform solvent firms in the Thai market and deny distress anomaly often found in the developed market. Fama-Frech (1993) three-factor model and Carhart (1997) four-factor model verify the existence of a distress premium in the Thai capital market. Risk-seeking investors demand greater compensation for bearing risks of distress firms’ going concern. This paper provides fresh evidence that default risk is a significant explanatory factor in pricing stocks in the emerging market. Also, this study sheds light on the role of NBE firms in asset pricing. Most studies eliminate NBE firms from their sample. However, NBE firms yield superior average cross-sectional returns, albeit with higher volatility. Investors are rewarded with distress risks associated with NBE firms. The outperformance of NBE firms is statistically significant when compared to the overall market. The NBE premium disappears when factoring size, value, and momentum in time-series analysis.

Small-Cap Allocations: Timing the Entry

This article examines the behavior of the small-capitalization stock return cycle. The authors compare the period 1980–2020 with a study for the period 1960–1995. They find that in the earlier period small-cap stocks earned a return premium when the economy was rising, long-term rates were rising, the US dollar was rising, and market volatility was falling. During the last decade, a strong move in large-cap stocks dwarfed the small-cap premium. The authors conjecture that a change in the character of economic growth, rising long-term rates, and oversold small-cap conditions may reverse this. TOPICS:Portfolio theory, portfolio construction, wealth management Key Findings • The small-cap premium appears to have waned in the last 20 years. • The premium is, however, still related to economic cycles. • Economic conditions and valuations now favor a small-stock premium.

An Overview of Stock Portfolio Returns and Return Premia in Japan: The Case of Size and Book-to-Market Portfolios

This article explores Japanese stock portfolio returns and return premia by focusing on size- and book-to-market (BM)-sorted portfolios over the period of 1990 to 2020. As a result of our investigations, we derive the following useful findings. (1) In general, the value and/or size effects are continuously seen in the Japanese stock market. However, (2) these effects much depend on the economic and business background: for the performance of size- and BM-sorted portfolios in Japan, the value effect is stronger in some sub-periods; while the size effect is clearer in other sub-periods. Furthermore, (3) this study employs the data in US dollars, and computes various statistics and measures for both our full sample period and many different sub-periods, whose economic circumstances are rather different. Therefore, not only for academic researchers but also for international investors, our findings shall be highly beneficial for enriching the understanding of Japanese stock portfolio returns and return premia.

Stock Price Prediction and Portfolio Selection Using Artificial Intelligence

Stock markets are popular investment avenues to people who plan to receive premium returns compared to other financial instruments, but they are highly volatile and risky due to the complex financial dynamics and poor understanding of the market forces involved in the price determination. A system that can forecast, predict the stock prices and automatically create a portfolio of top performing stocks is of great value to individual investors who do not have sufficient knowledge to understand the complex dynamics involved in evaluating and predicting stock prices. In this paper the authors propose a Stock prediction, Portfolio Generation and Selection model based on Machine learning algorithms, Artificial neural networks (ANNs) are used for stock price prediction, Mathematical and Statistical techniques are used for Portfolio generation and Un-Supervised Machine learning based on K-Means Clustering algorithms are used for Portfolio Evaluation and Selection which take in to account the Portfolio Return and Risk in to consideration. The model presented here is limited to predicting stock prices on a long term basis as the inputs to the model are based on fundamental attributes and intrinsic value of the stock. The results of this study are quite encouraging as the stock prediction models are able predict stock prices at least a financial quarter in advance with an accuracy of around 90 percent and the portfolio selection classifiers are giving returns in excess of average market returns.

News coverage and portfolio returns: Evidence from China

We investigate the news coverage effect in explaining and predicting the portfolio returns. We find that stocks with more news coverage yield higher abnormal returns. The news coverage effect is still robust even after controlling for firm characteristics and industry sectors. Furthermore, the return premium on news coverage is particularly large in small-cap stocks due to the information dissemination role of news coverage. Then we construct a news coverage factor to explain the abnormal returns. We also confirm the predictability of news coverage. This indicates news coverage has a daily momentum effect. Finally, we propose three investment strategies and verify their profitabilities.

The Risk in Value

This article provides evidence consistent with the hypothesis that the value risk premium results, at least in part, from investors’ incremental forecast difficulty for value stocks. The evidence includes the findings that (1) analysts’ uncertainty about earnings is consistently higher and their earnings forecast accuracy is consistently lower for value stocks, (2) value returns are higher when relative forecast difficulty for value stocks is greater, and (3) trading volume is greater for value stocks. If the relative difficultly in forecasting earnings for value stocks is consistent over time, the value stock premium should also be fairly consistent over time. Indeed, using a more refined definition of value, the author finds that the value stock return premium is far more consistent over time than is commonly believed and that it has been positive in recent years. TOPICS:Performance measurement, style investing, statistical methods Key Findings • Earnings are more difficult to predict for value stocks than for growth stocks. • The difficulty in forecasting earnings for value stocks is related to the value stock premium. • The value stock premium is larger and more consistent after controlling for industry.

Industrial Tail Exposure Risk and Cross-Section of Returns in REIT Market

We examine whether systematic tail risk premium exists in the cross-section of real estate investment trusts. Using US equity REITs data from 1993 to 2018, we obtain systematic tail risk of REITs by estimating their industrial tail exposure risk (ITER) based on extreme value theory. We find that REITs in highest ITER decile outperforms REITs in lowest ITER decile by 11.5% per annum. The impact of ITER remains significant after controlling for well-kwon firm and return factors. The positive return premium is not explained by traditional systematic tail risk based on left-tail market return. Thus, our results suggest that REITs investors are averse to crash events, especially associated with multiple industries rather than aggregate market alone.

The High-Volume Return Premium and Economic Fundamentals

Extending Kaniel, Ozoguz, and Starks (2012, J. Financ. Econ.) and many others, we present first empirical evidence that indicates the high volume return premium is linked to economic fundamentals. The volume premium has strong predictive power for future industrial production growth and other macroeconomic indicators with or without controls for common equity pricing factors and business cycle variables. However, only a small portion of the volume premium can be attributed to its co-movement with equity return factors and economic risk factors. Mis-pricing-based factor models also fail to adequately explain the return anomaly.

Information Flows and Systematic Risk

The arrival of new information is a source of systematic risk for the holder of a financial security. Using several measures of information flows, we show that a stock’s sensitivity to market-wide information flow is associated with a robust cross-sectional return premium that is distinct from other return premia. We find that the amount of information impounded in prices through trading has increased in recent years consistent with declining trading costs and the rise of algorithmic trading. Consequently, the information flows risk premium is increasing through time.