Return Premium Research Articles

The Murder-Suicide of the Rentier: Population Aging and the Risk Premium

Population aging has been linked to global declines in real interest rates. A similar trend is seen for equity risk premia, which are on the rise. An existing literature can explain part of the declining trend in safe rates using demographics, but has no mechanism to speak to trends in relative returns on different assets. We calibrate a heterogeneous agent life-cycle model with equity markets and aggregate risk, and we show that aging demographics can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing the return premium attached to risky assets. This is because the life-cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Term structure determinants of time‐varying risk of 1‐year bond returns

AbstractTerm structure drivers of 1‐year bond premia and conditional bond return risk are distinct. Consequently, the Cochrane–Piazzesi factor captures aggregate price of risk and not the amount of risk in 1‐year bond returns. One linear combination of forward rates captures most of the variation in bond return risk across maturities. Interest rate level captures substantial amount of variation in the conditional return risk, a finding consistent with rising inflation uncertainty with level of inflation and interest rates. The 4‐5 yield spread, an important positive predictor of bond return premia, has an opposing but limited impact on the conditional volatility.

The High-Volume Return Premium: Does it Really Exist in the Chinese Stock Market?

In this paper, we construct long-position portfolios and zero-investment portfolios to study the returns of stocks with high-or-low trading volume. Distinct from previous literature, this study finds that both high-volume return premium and discount effect exist in the Chinese market while the discount effect seems to be more prevalent. However, the dominance of the low volume return premium is not persistent, suggesting that the Chinese stock market is moving from undeveloped towards developed markets.

Does Probability Weighting Drive Lottery Preferences?

We propose a test of the theory of skewness preferences. The probability weighting feature that is the basis of their theory relies on investors overweighting the probability of extreme, positive returns. The resulting investor preferences for positive skewness in return distributions will lead to excess demand, contemporaneous price premiums, and negative expected returns. We use the well-documented 52-week high bias as a method to truncate investors’ weighted probability of expected right-tail events. We find evidence supporting the theoretical framework of Barberis and Huang as the negative return premiums associated with positive skewness is driven almost entirely by stocks that are farther away from the their 52-week high. No negative premiums related to skewness are detected when stock prices are close to the 52-week high.

Expected stock return and mixed frequency variance risk premium data

Motivated by the research of the variance risk premium (VRP) and MIDAS model, we employ the VRP with different maturities and the ADL-MIDAS regression model to forecast the expected stock return in Standard & Poor 500 market. The VRP is defined as the difference between the realized variance and the implied variance of the options. By using Standard & Poor 500 index options, we provide the empirical tests of the forecasting performance provided by the VRP with different maturities to the expected stock returns in the Standard & Poor 500 stock index market. Based on the empirical results, we know the VRP with 1-month and 2-month maturities can provide the best out-of-sample forecast.

China to account for 44% of Asia's crude oil refining capacity in 2023

We examine the relationship between cultural attitudes towards gambling and investor preferences for skewness across 45 countries. Our results show that countries with higher gambling losses per adult, countries with legalized online gambling, and countries with the most Catholics relative to Protestants tend to display the most significant (negative) return premiums associated with return skewness. We do not find that other macroeconomic characteristics, such as economic development, GDP per capita, or per capita consumption explain the presence of skewness premiums.

Do Growth Expectations Help Explain Characteristic-Sorted Portfolio Returns?

We find that accounting ratios (asset and sales growth, profitability, and equity dilution) that predict stock returns are associated with errors in analyst long-term growth forecasts. Specifically, accounting information that is associated with favorable long-term growth forecasts tends to predict negative analyst forecast errors and negative future excess returns. This and other evidence we present is consistent with the idea that biased long-term growth forecasts generate the observed return premia of popular characteristic-sorted portfolios.

Skewness preferences and gambling cultures

We examine the relationship between cultural attitudes towards gambling and investor preferences for skewness across 45 countries. Our results show that countries with higher gambling losses per adult, countries with legalized online gambling, and countries with the most Catholics relative to Protestants tend to display the most significant (negative) return premiums associated with return skewness. We do not find that other macroeconomic characteristics, such as economic development, GDP per capita, or per capita consumption explain the presence of skewness premiums.

Low-volume return premium in the Korean stock market

We propose a new mechanism with which we explain an exceptional phenomenon in the Korean stock market, wherein the post-event return of an abnormally low-volume stock is larger than that of an abnormally high-volume stock, in contrast to what happens in other major stock markets. This mechanism is a combination of two market characteristics: one is the mean-reversion of trading volume; the other is the dominance of stocks with a positive correlation between return and change in trading volume. Using evidence from the Korean stock market, we show that the return generated by this mechanism has a highly concentrated distribution with a negative average and that the value has a scale higher than that of positive returns generated by other factors. We conclude that our suggested mechanism can explain the low-volume return premium in the Korean stock market. This finding presents a new way to explain how trading volume change affects future returns.

Hedging Macroeconomic and Financial Uncertainty and Volatility

We study the pricing of shocks to uncertainty and volatility using a wide-ranging set of options contracts covering a variety of different markets. If uncertainty shocks are viewed as bad by investors, they should carry negative risk premia. Empirically, however, uncertainty risk premia are positive in most markets. Instead, it is the realization of large shocks to fundamentals that has historically carried a negative premium. In other words, we find that the return premium for gamma is negative while that for vega is positive. These results imply that it is jumps, for which exposure is measured by gamma, not forward-looking uncertainty shocks, measured by vega, that drive investors' marginal utility. In further support of the jump interpretation, the return patterns are more extreme for deeper out of the money options.

Are Economic Uncertainty Expectations Rational?

This study analyzes whether expectations about uncertainty of the global and U.S. economy emanate from the natural dynamics of the U.S. based rational economic fundamentals, or stem from irrational outlook not attributable to any known risk factors. The findings suggest that both the U.S. and the global economic uncertainty expectations are significantly driven by the U.S. economy and stock market related rational factors namely, economic growth, economic risk premium and excess returns. The three Fama and French factors have significant impact on the U.S. economic uncertainty expectations but insignificant role for global economic uncertainty expectations. Foreign currency movements play a significant role for the global economic uncertainty. The impact of the rational factors is higher for the U.S. economic uncertainty expectations than on the global economic uncertainty expectations. Lastly, there exists a positive feedback effect of the U.S. and global and economic uncertainty expectations. Overall, to a significant extent, the expectations of the U.S. economic uncertainty are well captured by the risk factors suggested in the asset pricing literature.

A Novel Template for Understanding Priced Factors

Asset managers are increasingly incorporating equity factors that deviate from traditional academic definitions in their stock selection process. We show that these factors frequently exhibit strong industry biases, making it crucial to understand the interaction between factor exposure and traditional industry exposure. Industry exposure plays a major role in the risk profile of a portfolio, making unintended industry exposures costly. For an extensive set of 21 equity factors, beyond the standard academic factors, we examine which equity factors are rewarded for their industry allocation. This set spans the value, quality, momentum, low volatility, and size investment styles. We use a global and liquid investment universe, as is commonly used by large institutional asset managers. We find that equity factors from the same investment style, most notably momentum and quality, exhibit strong differences in their returns from industry allocation. Understanding the interaction between factors and industry exposures can lead to higher return premiums, and lower portfolio volatility without harming performance.

Explaining Disparities in AH Stock Premium Returns with Chinese Economic Policy Uncertainty: Evidence Based on a Non-Parametric Analysis

This paper empirically investigates the AH share premium puzzle considering the impact of economic policy uncertainty (EPU) in China, using Hang Seng AH premium (HSAHP) index data from March 2011 to June 2018. Specifically, the index of Baker, Bloom, and Davis is used as a proxy for EPU in China. The data has been divided into two periods: 0 and 1. Period 0 includes data before the launch of the stock connect program and spans from March 2011 to October 2014, while period 1 represents data from after the launch of stock connect program and spans from November 2014 to June 2018. To more robustly test the change in AH premiums after the “connect” is launched; we evaluate the impact of Chinese EPU using non-parametric kernel density estimation. The empirical results show that parameter uncertainty explains variations in price disparity and can significantly reduce the returns of the AH share premium index.

Dynamic Risk Factors in Carry Trades

The authors decompose a simple cross-country interest rate differential into three cross-country differential factors, originated from the Nelson–Siegel model. Results suggest that return premiums for carry trades are highly associated with parallel yield curve shifts in investment currencies against the US yield curve. Currency portfolios based on cross-country yield curve gap can be profitable, with lowest tercile portfolios yielding sizable risk-adjusted returns adjusted for transaction costs. The authors’ model identifies higher currency carry returns for hedge funds when cross-country yield curves exhibit a wide interest gap over all maturities and finds that investment currency yields have greater curvature relative to funding currency yields. TOPICS:Currency, performance measurement, global markets

Do investors post messages differently from mobile devices? The correlation between mobile Internet messages posting and stock returns

Mobile Internet has become a popular channel for investors to share their information and ideas about investment. This paper investigates the relation between frequency of mobile Internet messages and subsequent stock returns. We find that firms with higher proportion of mobile Internet messages on average earn a significant return premium even after controlling for well-known risk factors. Moreover, the marginal effect of mobile Internet messages is more pronounced among stocks in weaker information environments (i.e., higher fraction of individual ownership and lower analysts following). Further results suggest this correlation is more likely to be driven by “noise” rather than “information.” We also provide evidence that the lack of liquidity can explain the persistence of the correlation between mobile Internet messages and stock returns. Our findings highlight the importance for financial market participants to consider the peer-based opinions from mobile Internet.

Factor Premia and Factor Timing: A Century of Evidence

Evaluating how factor premia vary over time and across asset classes is challenging due to limited time series data, especially outside of U.S. equities. We examine four prominent factors across six asset classes over a century. We find little evidence for arbitrage activity influencing returns, though some novel evidence of overfitting biases. We identify meaningful time variation in factor risk-adjusted returns that appears unrelated to macroeconomic risks, supporting other theories of dynamic return premia. Attempting to capture this variation, we evaluate various factor timing strategies, but find relatively modest predictability that likely fails to overcome implementation frictions.

The Offshoring Return Premium

We use 10-K filings to construct novel text-based measures of the extent to which U.S. firms are exposed to three offshore activities: the sale of output, purchase of input, and ownership of producing assets. Our main result is that selling output abroad is associated with higher stock returns, especially when output is sold to more central nations in the real trade network. In contrast, offshore input serves as a hedge. Our findings are consistent with the conclusion that aggregate quantity shocks are the primary source of the return premium we document in the global trade network. The online appendix is available at https://doi.org/10.1287/mnsc.2017.2929 . This paper was accepted by Lauren Cohen, finance.

The Value at Risk of Selling Option on Crude Oil West Texas Intermediate

The Value at Risk (VaR) of selling option on crude oil WTI has not been widely known, whereas this trade is the largest transactions in the world. This study aimed to analyze the Value at Risk (VaR) of the far out of the money (FOTM) and the in the money (ITM) strike position of selling option on crude oil WTI investment. The monthly option premium return data ranging from April 1984 to May 2017 was analyzed by the ARCH-GARCH and VaR method to get the risk of FOTM and ITM strike position. Empirical results indicate that the risk of the FOTM strike was much lower than the ITM strike positions. It meant that selecting the FOTM strike position of the selling option on crude oil WTI investment could be considered by stakeholders because its risk was much lower than the ITM strike position.

What Is Quality?

Unlike standard factors, such as value, momentum, and size, “quality” lacks a commonly accepted definition. Practitioners, however, are increasingly gravitating to this style factor. They define quality to be various signals or combinations of signals—some that have been thoroughly explored in the academic literature and others that have received limited attention. Among a comprehensive group of the quality categories used by practitioners, we find that profitability, accounting quality, payout/dilution, and investment tend to be associated with a return premium whereas capital structure, earnings stability, and growth in profitability show little evidence of a premium. Profitability and investment-related characteristics tend to capture most of the quality return premium.

Behavioral-related firm characteristics, risks and determinants of stock returns

PurposeThis paper aims to investigate a relatively new anomaly of investment growth and revisits well-known anomalies of size and value. It aims to answer two main research questions. First, can covariance risks (i.e. factor loadings) be excluded from being determining variables that drive return premiums and explain stock returns? Second, from a behavioral finance standpoint, the authors examine whether using firm characteristics is a more practical and accessible approach and also meets the necessary and sufficient conditions to analyze stock returns.Design/methodology/approachThe authors create the investment-growth-based factor (LMH) which is defined as the return difference between low and high investment growth portfolios. The authors then incorporate the LMH factor along with other characteristic-based factors and their loadings into characteristic-balanced portfolio and three-factor model tests.FindingsThe authors find that covariance risks on investment growth, size and value are not necessary as determining variables. Instead, they find that behavioral-related firm characteristics of investment growth, size and value are necessary and sufficient as determinants of return premiums and stock returns.Practical implicationsThe results have practical and useful implications for investors in their stock portfolio analysis and selection because firm characteristics are relatively more available than covariance risks that need estimation and typically contain measurement errors.Originality/valueThe paper has practical value to investors in their stock portfolio analysis and selection. Methodologically, in contrast to prior studies that do not directly use the investment growth to control for portfolio characteristics, the use of the newly created LMH factor and its loadings allows us to directly and properly test if the investment growth anomaly is related to the investment growth characteristic that is hypothesized to drive return premiums and determine stock returns from behavioral finance perspectives.