Standard Asset Pricing Theory Research Articles

Recessions and the stock market

An event study approach is adopted to investigate the drivers of the stock market around recessions. First, stock prices and dividends drop contemporaneously when accounting for different timing conventions. Accordingly, stock prices do not anticipate recessions due to an economic mechanism (cash flow news). Second, the variance of price changes increases at least as much as the variance of dividend growth during recessions. This result suggests that changes in the price of risk (discount rate news) play an essential role. Implications and opportunities for standard asset pricing theories and recently proposed alternatives are also discussed.

Betting against Quant: Examining the Factor Exposures of Thematic Indexes

The performance characteristics of recently introduced thematic indexes are examined using standard asset pricing theory. The main finding is that thematic indexes generally exhibit strong negative exposures to the profitability and value factors, indicating that they hold growth stocks that invest now for future profitability. As such, investors in thematic indexes are effectively trading against quant investors, who prefer stocks that are currently cheap and profitable. If the negative factor exposures of thematic indexes persist, then from an asset pricing perspective this implies low expected returns. As there is clearly a clientele for thematic indexes, the author discusses how investing in these strategies may be rationalized despite their unfavorable factor exposures.

Betting Against Quant: Examining the Factor Exposures of Thematic Indices

We examine the performance characteristics of recently introduced thematic indices using standard asset pricing theory. We find that thematic indices generally have strong negative exposures towards the profitability and value factors, indicating that they hold growth stocks that invest now for future profitability. As such, investors in thematic indices are effectively trading against quant investors, who prefer stocks that are currently cheap and profitable. From an asset pricing perspective, the negative factor exposures of thematic indices imply low expected returns. As there is clearly a clientele for thematic indices, we discuss how investing in these strategies may be rationalized despite their unfavorable factor exposures.

The disappearing pre-FOMC announcement drift

Lucca and Moench (2015) document large average excess returns in U.S. equities before scheduled Federal Open Market Committee (FOMC) meetings from September 1994 to March 2011, leading to a puzzle not explained by standard asset pricing theory. We extend the sample to December 2019. We find that after first appearing before FOMC announcements accompanied by the Fed Chair press conferences, the pre-FOMC drift essentially disappeared after 2015 in both announcements accompanied by press conferences and announcements not accompanied by press conferences. We discuss a possible explanation for this change: reduced uncertainty.

Investor and market overreaction: a retrospective

PurposeAre the capital markets of leading industrialized nations rational and efficient? This powerful hypothesis was badly dented by the work of De Bondt and Thaler (1985) on stock market overreaction and by subsequent research on momentum and reversals in prices and earnings.Design/methodology/approachHuman psychology, at times predictably irrational, drives the markets. This paper investigates this issue.FindingsThe author reviews the origins of the idea of overreaction, how behavioral insights modify standard asset pricing theory and how they contribute to our understanding of the world of finance.Originality/valueThe paper reveals the origins of the idea of overreaction, how behavioral insights modify standard asset pricing theory and how they contribute to our understanding of the world of finance.

What Happens When Equity Investors Disagree with the FOMC?

This research explores an alternative explanation for the equity premium associated with Federal Open Market Committee (FOMC) announcement days that accounts for a sizable fraction of annual equity returns. My evidence shows that investor expectations formulated prior to FOMC announcements have a significant impact on equity prices, particularly when these expectations are not aligned with the FOMC decision. Furthermore, I document an even larger impact around FOMC announcements where the level of interest rates remained unchanged. When monetary policy is neutral, the observed investors’ disagreement towards the FOMC decisions represents a further layer of uncertainty in the dynamics of equity markets. My results reconcile past findings on the monetary policy surprise literature and more recent empirical findings on the effect of FOMC announcements, which are difficult to explain with standard asset pricing theories. Moreover, as I find little effects on equity returns when the FOMC decision is anticipated by the market, a practical implication of my study is that monetary policy authorities should take into account market expectations when formulating disclosure policy in order to improve alignment with financial market expectations and smooth out their economic consequences.

Does idiosyncratic risk matter? Evidence from mergers and acquisitions

PurposeThis paper aims to investigate whether idiosyncratic volatility is a priced risk factor in the Australian stock market.Design/methodology/approachThe authors use the change in idiosyncratic volatility around acquisition announcements and the related stock price revaluation to test whether the idiosyncratic risk is priced. If the idiosyncratic risk is priced, increases (decreases) in idiosyncratic volatility should be associated with decreases (increases) in the acquirer’s stock price, as the latter’s future cash flows are discounted at a higher (lower) rate. The sample consists of 2,656 completed acquisitions by Australian listed firms over the period January 1990 to October 2014 for which deal value represents more than 5 per cent of the acquirer’s market value.FindingsIncreases (decreases) in idiosyncratic risk are associated with significant decreases (increases) in firm value. This negative relationship is robust to the presence of outliers; is unaffected by the incidence of the 2007-2008 financial crisis; holds using alternative measures of idiosyncratic risk; and is more significant after excluding the resources sector. Firms with a higher idiosyncratic risk prior to the acquisition, and firms avoiding stock to pay for the acquisition, experience a more significant stock price increase in relation to a decrease in idiosyncratic risk.Research limitations/implicationsConsidering the small size of the Australian economy, investors may have less scope to mitigate idiosyncratic risk. As a consequence, idiosyncratic risk is associated with the positive excess return, contrary to what standard asset pricing theory assumes. The results support Merton’s (1987) hypothesis that investors are exposed to idiosyncratic risk due to imperfect portfolio diversification and receive compensation for bearing that risk.Practical implicationsThe pricing of idiosyncratic risk may also explain why the Australian stock market has historically offered a high equity risk premium. A practical implication would be for international investors to take advantage of the diversification constraints of local investors to capture higher risk premiums and achieve superior returns.Originality/valueWhile prior studies demonstrate that stocks with higher idiosyncratic risk are associated with higher subsequent returns, the authors show that an increase in idiosyncratic risk is associated with a decrease in stock prices using acquisition announcements as shocks to a firm’s idiosyncratic risk. In other words, the results arise from within-firm variations rather than from cross-sectional differences in stock returns.

Investor Sentiment and the Pricing of Macro Risks for Hedge Funds

Hedge funds with larger macroeconomic-risk betas do not earn higher returns, contrast to the theoretically predicted risk-return tradeoff. Meanwhile, high macro-beta funds deliver higher returns than low macro-beta funds following low-sentiment months, whereas the risk-return relation is flat following high-sentiment months. Our findings are consistent with the conjecture that standard asset pricing theory is still at work when market participants are rational. On the other hand, sophisticatedly managed portfolios including hedge funds are possibly affected by sentiment-induced mispricing, especially for those with high macro-risk loadings.

The Utility of Finance

Public Utilities Commissions (PUCs) are charged with regulating a public utility’s rates at levels that serve the public’s interest while allowing the utility’s investors to earn a rate commensurate with that expected by businesses facing similar risks. Although the process of adjusting rates for risk is a staple of modern finance, we know surprisingly little about how well accomplish their regulatory mandate when judged against the benchmarks of financial economics. This article analyzes a dozen years’ worth of gas and electric rate-setting decisions from PUCs in the United States and Canada, demonstrating empirically that allowed returns on equity (ROE) diverge significantly and systematically from the predictions of accepted asset pricing methodologies in finance. Our analysis suggests that current regulatory practice more plausibly reflects an amalgam of other non-finance desiderata, including political goals, incentive provision, and regulatory capture. For example, elected PUCs award significantly lower ROEs than appointed ones. We nevertheless conjecture that the divergence of observed regulatory behavior from asset-pricing fundamentals may be due (in part) to a lack of financial valuation expertise among regulators. To test this conjecture, we study a unique field experiment that exposed commissioners and their staffs to immersion training in finance. We find evidence that treated PUCs began to issue ROE rulings that were (moderately) more aligned with standard asset pricing theory than those of untreated placebo groups. Our results suggest that it is possible to train non-expert legal and regulatory decision-makers to exhibit greater fidelity to principles of financial economics.

The Disappearing Pre-FOMC Announcement Drift

Lucca and Moench (2015) document large average excess returns in U.S. equities before scheduled Federal Open Market Committee (FOMC) meetings from September 1994 to March 2011, leading to a puzzle not explained by standard asset pricing theory. We extend the sample to December 2019. We find that after first appearing before FOMC announcements accompanied by the Fed Chair press conferences, the pre-FOMC drift essentially disappeared after 2015 in both announcements accompanied by press conferences and announcements not accompanied by press conferences. We discuss a possible explanation for this change: reduced uncertainty.

News‐Specific Price Discovery in Credit Default Swap Markets

We examine the lead and lag relation between equity and credit default swap (CDS) markets. We find that price discovery in equity markets only leads CDS markets following aggregate positive news and not so following other news. While difficult to reconcile with standard asset pricing theories, asymmetric price adjustment is common in goods markets, arising from intermediary power. We provide an explanation for this asymmetry based on dealers exploiting informational advantages vis‐à‐vis investors with hedging motives. Consistent with this explanation, we find that the patterns we document are related to firm‐level proxies for hedging demand, as well as economy‐wide measures of information asymmetries.

The Pre‐FOMC Announcement Drift

ABSTRACTWe document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre‐FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre‐FOMC returns, we find no such effect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic news announcements also do not give rise to preannouncement excess equity returns. We discuss challenges in explaining these returns with standard asset pricing theory.

Asset pricing: A tale of two days

We show that asset prices behave very differently on days when important macroeconomic news is scheduled for announcement. In addition to significantly higher average returns for risky assets on announcement days, return patterns are much easier to reconcile with standard asset pricing theories, both cross-sectionally and over time. On such days, stock market beta is strongly related to average returns. This positive relation holds for individual stocks, for various test portfolios, and even for bonds and currencies, suggesting that beta is after all an important measure of systematic risk. Furthermore, a robust risk–return trade-off exists on announcement days. Expected variance is positively related to future aggregated quarterly announcement day returns, but not to aggregated non-announcement day returns. We explore the implications of our findings in the context of various asset pricing models.

When is Distress Risk Priced? Evidence from Recessionary Failure Prediction

Using firm fundamentals, we develop a forward-looking measure of systematic risk associated with corporate failure. Our measure is consistent with standard asset pricing theory and is equal to the ratio of probabilities of failure in recession to failure in expansion. We validate the measure using two predictions from a stylized model. First, for a given probability of failure, expected returns should increase in our measure. Second, the resulting spread in returns should be larger for more distressed stocks. We find support for both predictions. For stocks in the top quintile of distress, a median hedge portfolio based on our measure generates 10%-12% per annum, suggesting that our approach successfully extracts risk information from accounting data. Our findings have important implications for the literature on distress risk that, despite compelling theoretical arguments, finds little evidence of a distress risk premium. Instead, it documents the distress anomaly — a negative correlation between the probability of failure and future stock returns. Our results suggest that distress risk is priced. However, a firm’s risk exposure depends on the phase of the business cycle in which a firm is more likely to fail.

Returns from Trading Call Options

While much work has been done on pricing of options and expected returns theory, far less has been written on the actual returns that investors receive from trading options. In the case of call options on equity, standard asset pricing theory suggests large, positive average returns, while articles and comments in the popular press suggest that many investors lose money trading options. Empirical results in the academic literature are few, and results are mixed. In this article, I study call option returns, analyzing how returns vary by levels of moneyness and different holding periods for both equity index and individual stock call options. I find a general and consistent result that call option returns are low on average and decreasing in the strike price. Only in-the-money options held for a month exhibit positive returns. Deep out-the-money options deliver large negative returns on average, consistent with risk-seeking investing on the part of buyers. I discuss the implications for some common options trading strategies. <b>TOPICS:</b>Options, performance measurement

Variable Information Quality, Ambiguity, and Stock Returns

Prevailing theories suggest that the quality of information about the macroeconomy is an important determinant of the equity premium. However, the empirical relationship between information quality and the equity premium has been obscured by the difficulty of measuring time-varying information quality, which is dynamically intertwined with uncertainty. By solving a nonlinear filtering problem, I extract the time series of information quality from data on professional forecasters, while differentiating information quality from uncertainty, volatility, and heterogeneity. Surprisingly, I find that the equity premium increases with information quality in contrast to standard asset pricing theory. In the U.S. stock market, a one-standard-deviation increase in information quality predicts a 3% increase in quarterly excess market returns with R2 up to 7.4% (and out-of-sample R2 up to 6.1%). Furthermore, information quality outperforms all the predictors studied in Goyal and Welch (2008) both in-sample and out-of-sample, while improving the return predictability by the dividend-price ratio. This strong evidence of return predictability is very robust to various specifications. Also, information quality is negatively correlated with the real risk-free rate, as opposed to the predictions of standard asset pricing theory. I propose a stylized consumption-based model of ambiguity aversion to future signals. This new model can simultaneously account for all these empirical findings and the equity premium puzzle, unlike the existing preferences: CRRA, Epstein-Zin, and ambiguity aversion to the mean growth rate, introduced by Ju and Miao (2012). Three components of the model-implied stochastic discount factor --- information quality, uncertainty, and aggregate signal --- explain up to 83% of the cross-sectional variation in the average returns on size, book-to-market, and momentum-sorted portfolios.

Stock Market Beta and Average Returns on Macroeconomic Announcement Days

We show that asset prices behave very differently on days when important macroeconomic news is scheduled for announcement relative to other trading days. In addition to significantly higher average returns for risky assets on announcement days, return patterns are also much easier to reconcile with standard asset pricing theories, both cross-sectionally and across time. On such days, stock market beta is strongly related to average returns. This positive relation holds for individual stocks, for various test portfolios, and even for bonds and currencies, suggesting that beta is after all an important measure of systematic risk. Furthermore, a robust risk-return trade-off exists on announcement days. Expected variance is positively related to future aggregated quarterly announcement day returns, in contrast to market or aggregated non-announcement day returns where there is no evidence of predictability. We explore the implications of our findings in the context of various asset pricing models.

The Pre-FOMC Announcement Drift

We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre-FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre-FOMC returns, we find no such eff ect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic news announcements also do not give rise to pre-announcement excess equity returns. Pre-FOMC returns are higher in periods when the slope of the Treasury yield curve is low, implied equity market volatility is high, and when past pre-FOMC returns have been high. We discuss challenges at explaining these returns with standard asset pricing theory.

Investor behaviour in a nascent capital market: Scottish bank shareholders in the nineteenth century

This article uses the records of nineteenth‐century Scottish banks in an attempt to understand investor behaviour in the early British capital market. It presents four main findings, some of which do not conform to the basic assumptions of standard asset pricing theories. First, in an era when efficient portfolio diversification was not possible, the intrinsic risk of an equity security was an important input into investor decision‐making. Second, our evidence suggests that businesspeople initially regarded bank stock as a consumption good, as being a stockholder gave them privileged access to bank finance. When bank lending practices changed in the middle of the century, this access‐to‐credit advantage associated with owning bank stock largely disappeared. Third, investors typically exhibited a bias towards banks that conducted business in the areas where they resided. Fourth, a sizeable proportion of investors were stockholders in more than one bank.

An analysis of pricing and returns in the market for French Canadian paintings

The valuation of French Canadian paintings is analysed empirically. Using a sample of auction prices for major French Canadian painters for the period 1968 to 2005, we run hedonic regressions to determine the influence of various factors, including painter identity, on auction prices, as well as to construct a market price index. This is then used in a second stage analysis of the properties of these art works viewed as investment assets. We consider the extent to which standard asset pricing theory, as represented by the capital asset pricing model, can account for price movements in the market for French Canadian paintings.