Factor Risk Premia Research Articles

On the Tests on Factor Risk Premiums in Beta Estimation Methods

In order to see whether an asset pricing factor is priced, we often test the null hypothesis that a factor risk premium is zero in estimation method. By theoretical analysis and Monte-Carlo study, this paper provides evidence that unless the constant term (average pricing error) is indistinguishable from zero (i.e., unless the model is believed to be correctly specied by other evidence), this test may not provide meaningful information in the sense that even a useless factor (which does not have any cross-sectional information and should be out of the model) may reject this hypothesis just like a true, priced factor. Further, it is shown that a source of Menzly's (2003) is related to this failure to detect useless factors, so infuential observations may signal that the assumed factor is useless. In addition, if assumed factors are excess returns, additional tests of hypotheses related to beta equals one for those factors can be a good remedy to this problem. A new statistic to test this hypothesis is derived using the GMM specification equivalent to the estimation procedure.

Information, Diversification, and Cost of Capital

We investigate the effects of information and diversification on cost of capital in a noisy rational expectations model. Assuming a factor structure for risky asset payoffs and two classes of investors, informed and uninformed, we show that in large economies the APT (Ross, 1976) holds and i) information from private signals about idiosyncratic shocks has no effect on cost of capital and ii) information from private signals about systematic factors affects cost of capital only through factor risk premiums; there is no effect on factor loadings. These results imply that there are no cross-sectional effects of information on cost of capital within large economies.

Risk Premium Factors in Investment in Farming Land for Farming Purposes

Following the Uruguay Round Agreements on Agriculture, the price stabilization policy for agricultural products has been reduced gradually in Japan and will be so in the future, which will have significant impact on the agricultural structure in Japan.This paper examines the relationship between the price fluctuation rate of agricultural products and the risk premium in investment in farming land, in order to clarify how the price stabilization policy affects future trend of agricultural production in Japan.Using the multiple regression analysis, this paper analyses the correlation of the risk premium in investment in farming land as a criterion variable with the price fluctuation rate, the ratio of business farm household, and an agricultural area-classified dummy as explanatory variables.Consequently, there is a tendency that the risk premium is higher if 1) the price fluctuation rate in a certain area is higher, 2) the ratio of business farm household is higher, and 3) when (or if) it is in the mountainous areas.The result indicates that farmers tend to choose the risk premium according to the price fluctuation rate of agricultural products in an attempt to avoid risk of price change. In addition, instability in farmer's income affected by the price fluctuation rate is likely to differ, depending on the population of part-time farmers or geographical conditions.The result is also consistent with the “relationship between the expected rate of return and the risk premium” in terms of the asset pricing theory. Theoretically, farmland price is determined as a result of division of net return of land by expected rate of return. In this regard, our finding of this paper indicates that the smaller the price fluctuation rate of products is, the smaller the expected rate of return, therefore, the higher the farmland price tends to be.This paper suggests, therefore, that the price stabilization policy of agricultural products tends to raise farmland price, hindering the distribution of farmland; thus, we can conclude that abolishing the price stabilization policy contributes into fall of farmland price.

The Role of Currency Risk in Industry Cost of Capital

In this paper we test the hypotheses that previous studies fail to find a significant role for currency risk in industry returns because of methodological shortcomings or because of hedging. Using a Fama-French three-factor model augmented with an exchange rate factor in which both the factor exposures and risk premiums are time varying, we find that 35 of 36 U.S. industries are significantly exposed to a broad currency index (containing the currencies of developed and developing economies). In sharp contrast, only 14 industries display significant time-invariant exchange rate exposure using ordinary least squares. More important, the sample means of the time-varying exposures are economically large, with 27 (75%) being greater than 0.10. This resolves the puzzle that previous research finds significant exposure at the aggregate stock market level, but fail to identify the firm or industry level as the source of this aggregate exposure. In addition, currency risk premium is an economically large component of the cost of equity, with 21 industries having a mean currency premium of over 100 basis points per year. Compared to an average cost of equity of 15% per year, the annualized (absolute) currency risk premium is 2.10% for the average industry and is substantially more for some industries. Moreover, 31 of the 36 industries have a mean absolute currency risk premium that is at least one-tenth of the industry's total risk premium. Contrary to the above, an index of the currencies of the developed countries substantially understates the economic importance of currency risk premium. Overall, we find strong support for the methodological, but not the hedging, hypothesis.

The Mechanism of Stock Market Integration: Evidence for the Taiwan and U.S. Stock Markets

This study investigates the sources of the comovement of the Taiwan and U.S. stock market. The empirical evidence shows that both economic fundamentals and equity risk premiums can act as transmission mechanisms of both markets. In the meantime, the financial integration is much stronger than real economic integration. Moreover, the deregulation of foreign investments in Taiwan and the Southeast Asian financial crisis in 1997 did not alter the transmission mechanisms of real economic and equity risk premium factors.

Conditional Factor Models and Return Predictability

This paper develops a new approach to examining the time variation of risk premia within the framework of conditional asset pricing models. By combining conditional factor models with approximate present-value relationships we derive a linear relationship between the log stock price and investors' expectations of future factor loadings, risk premia, and cashlows. This framework allows us to estimate conditional risk premia from a cross-sectional regression of log prices on proxies for expected factor loadings and cashflows. We apply this technique to various factor specifications including the CAPM, the three factors advocated by Fama and French (1996), and a five-factor model with economically motivated factors similar to Chen et al. (1986). Consistent with rational pricing we find that, for the majority of the risk factors, the estimated risk premia contain significant information about the future expected returns of the factor portfolios over the sample 1938-2004. Our framework abstracts from the use of ad-hoc conditioning variables, and offers a theoretically appealing approach to modelling the predictable components of stock returns. In recent samples (1978-2004) our estimates of the market risk premium prove to be better forecasters of market returns than the dividend-price ratio and other commonly used forecasting variables. Results from the economic factor model provide evidence that current levels of treasury and corporate bond yields are embedded in the cross section of equity market prices.

Risks and Portfolio Decisions Involving Hedge Funds

This article characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. Our results show that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional value-at-risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance. It is well accepted that the world of financial securities is a multifactor world consisting of different risk factors, each associated with its own factor risk premium, and that no single investment strategy can span the entire ‘‘risk factor space.’’ Therefore investors wishing to earn risk premia associated with different risk factors need to employ different kinds of investment strategies. Sophisticated investors, like endowments and pension funds, seem to have recognized this fact as their portfolios consist

Analysis of Linear Factor Models with Multivariate Stochastic Volatility for Stock and Bond Returns

We explore high-dimensional linear factor models in which the covariance matrix of excess asset returns follows a multivariate stochastic volatility process. We test crosssectional restrictions suggested by the arbitrage pricing theory, compare competing stochastic volatility specifications for the covariance matrix, test for the number of factors, and analyze possible sources of model misspecification. Estimation and testing of these models is feasible due to recent advances in Bayesian Markov chain Monte Carlo (MCMC) methods. We find that five latent factors with multivariate stochastic volatility best explain excess returns for a sample of seventeen stock and bond portfolios. Analysis of cumulative latent factor shocks suggests that APT pricing restrictions, coupled with constant factor risk premia, do not adequately explain cross-sectional variation in average portfolio excess returns.

Hot and Cold Market Cycle and IPO Performance: Theory and Evidence

The study develops a theoretical model, which describes the mechanism and causation of hot and cold market and their relationship to IPO underpricing. Empirical tests are conducted on a sample of 1,382 IPOs issued in the United States from 1st January 1988 to 30th June 1999. The empirical tests examine the propositions derived from the model, namely underpricing behavior and role of risk premium factor as well as risk-free interest rates in the hot and cold markets. The study demonstrates that interest rates and bond rating spread are highly correlated to the hot/cold markets thus can be used as a proxy of hot/cold market cycle. The study concludes that both interest rate and percentage of underpriced issues in the cold market are significantly higher than that in the hot market. It is also concluded that underpricing is higher in the hot market than in the cold market.

Efficiency in the Pricing of the FTSE 100 Futures Contract

This paper studies the pricing efficiency in the FTSE 100 futures contract by linking the predictable movements in futures returns to the time‐varying risk and risk premia associated with prespecified factors. The results indicate that the predictability of the FTSE 100 futures returns is consistent with a conditional multifactor model with time‐varying moments. The dynamics of the factor risk premia, combined with the variation in the betas, capture most of the predictable variance of returns, leaving little variation to be explained in terms of market inefficiency. Hence the predictive power of the instruments does not justify a rejection of market efficiency.

Economic Conditions and Stock Pricing

In this article, we show that the risk premiums associated with key asset allocation risk factors often change significantly over varying stages of the stock market and business cycle. Their findings point out the dangers for portfolio managers setting allocation targets assuming factor risk premiums are constant over time. The findings of this article have implications for investors using stock market sector analysis or business cycle strategies. The results also suggest further research into modeling risk premiums conditioned on economic phases.

Industry costs of equity

Estimates of the cost of equity for industries are imprecise. Standard errors of more than 3.0% per year are typical for both the CAPM and the three-factor model of Fama and French (1993). These large standard errors are the result of(i) uncertainty about true factor risk premiums and (ii) imp ecise estimates of the loadings of industries on the risk factors. Estimates of the cost of equity for firms and projects are surely even less precise.

International arbitrage pricing theory: Relating risk premia

It is elementary that in a world of certain exchange rates, the factor risk premia of different economies must be identical. Using standard arbitrage arguments, this paper demonstrates that when exchange rates become uncertain, the factor risk premia not only must be different, but more importantly, risk premia (of different economies) associated with the same underlying factor must differ by a particular amount. There are three immediate implications of this result: (1) the slopes of the CAPM (capital- asset-pricing-model) lines in different economies must be different, (2) no factor risk, including exchange-rate risk, can have a zero price in more than one economy, and (3) when making cost-of- capital comparisons, simply adjusting for differences in riskfree rates and comparing risk premia is not sufficient; one must also take into account these arbitrage-determined differences between the factor risk premia.

Macroeconomic Risk and Asset Pricing: Estimating the APT with Observable Factors

This paper develops and applies a new maximum likelihood method for estimating the Arbitrage Pricing Theory (APT) model with observable risk factors. The approach involves simultaneous estimation of the factor loadings and risk premiums and can be applied to return panel with more securities than time series observations per security. Observable economic factors are found to account for 25 to 40 percent of the covariation in U.S. equity returns, and the APT pricing restrictions cannot be rejected for most sample periods. A significant "firm size anomaly" is measured, but it may be partly due to sample selection bias.

Intertemporal asset pricing: An Empirical Investigation

The conditional efficiency of an unspecified portfolio of a value-weighted stock index and a long-term government bond index is rejected in a framework that permits the factor risk-premia, asset betas, and residual variances to vary with the levels of observable state variables. Both the level and volatility of one-month T-bill rates are found to be associated with economically important shifts in the investment characteristics of size and industry portfolios and stock and bond indexes. January seasonals in equity variance and small-firm interest rate risk are also observed.

Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory

ABSTRACTThe APT is represented as a multivariate regression model with across‐equations restrictions. Both observed and unobserved (latent) macroeconomic factors are included, thus generalizing and unifying two previous strands of literature. Large portfolios representing unobserved factors are treated as endogenous, and nonlinear 3SLS estimates are shown to differ sharply from estimates that ignore this endogeneity. Using monthly stock returns and six factors, we cannot reject January effects. The following results are invariant with respect to the inclusion of January effects: we reject the CAPM in favor of the APT; however, we cannot reject the APT restrictions on the linear factor model.

Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory: Discussion

Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory: Discussion

Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory

The APT is represented as a multivariate regression model with across-equations restrictions. Both observed and unobserved (latent) macroeconomic factors are included, thus generalizing and unifying two previous strands of literature. Large portfolios representing unobserved factors are treated as endogenous, and nonlinear 3SLS estimates are shown to differ sharply from estimates that ignore this endogeneity. Using monthly stock returns and six factors, we cannot reject January effects. The following results are invariant with respect to the inclusion of January effects: we reject the CAPM in favor of the APT; however, we cannot reject the APT restrictions on the linear factor model.

Exact Arbitrage Pricing and the Minimum-Variance Frontier

The author examines the relationship between the Arbitrage Pricing Theory of Ross and mean-variance analysis. In particular, conditions are derived on the vector of the factor risk premia that are equivalent to the existence of a strictly positively weighted portfolio on the minimum-variance frontier. Also, a sufficient condition is given under which the existence of a positive minimum-variance portfolio of all the assets in the economy will imply the existence of a positive minimum-variance portfolio on a subset. This means that rejection of the hypothesis of the existence of a positive minimum-variance portfolio on a subset satisfying this condition implies rejection for the whole set. A GROWING BODY OF literature explores the relationship between the Arbitrage Pricing Theory (APT) of Ross [13, 14] and the mean-variance model. Among the early work in this direction were the papers of Chamberlain and Rothschild [2] and Chamberlain [1]. These papers examine a sequence of economies and characterize the relationship in the limit between the mean and portfolio cost functionals and the minimum-variance frontier. Chamberlain [1] also gives a condition under which exact arbitrage pricing will hold. Dybvig [4] and Grinblatt and Titman [7] examine equilibrium models in an APT context for a finite economy. They derive sharp bounds on the deviation from exact arbitrage pricing. Recent papers by Huberman, Kandel, and Stambaugh [9] and Grinblatt and Titman [8] explore the relationship between the APT and the mean-variance model by studying portfolios that can be used as proxies for the factors and examining the relationship these portfolios bear to the minimum-variance frontier. These two papers also deal with equilibrium models. In spite of the number and variety of equilibrium-APT models, the question of the pricing of factor risk in equilibrium remains largely unexplored. This paper makes some progress in addressing that issue by looking at a given equilibrium restriction and studying the constraints it imposes on the vector of factor premia itself. The most familiar equilibrium restriction we might study is the central implication of the Capital Asset Pricing Model (CAPM), that the market portfolio is efficient. In particular, no portfolio with the same expected return as the market portfolio has a smaller variance. The restriction we actually study is weaker than