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The Cross-Section of Volatility and Expected Returns
TL;DR: This paper examined the pricing of aggregate volatility risk in the cross-section of stock returns and found that stocks with high sensitivities to innovations in aggregate volatility have low average returns, and that stock with high idiosyncratic volatility relative to the Fama and French (1993) model have abysmally low return.
Abstract: We examine the pricing of aggregate volatility risk in the cross-section of stock returns Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns In addition, we find that stocks with high idiosyncratic volatility relative to the Fama and French (1993) model have abysmally low average returns This phenomenon cannot be explained by exposure to aggregate volatility risk Size, book-to-market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility
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TL;DR: The authors examine how investor attention changes when a firm adopts a modern news dissemination technology, and find that after continental European firms begin using an English-language electronic wire service to disseminate company news, they exhibit a stronger initial reaction to earnings surprises, a lower post earnings announcement stock price drift, and an increase in abnormal trading volume near earnings announcements, compared to when they disseminated their news in non-electronic format and in a continental European language.
Abstract: We examine how investor attention changes when a firm adopts a modern news dissemination technology. We find that after continental European firms begin using an English-language electronic wire service to disseminate company news, they exhibit a stronger initial reaction to earnings surprises, a lower post earnings announcement stock price drift, and an increase in abnormal trading volume near earnings announcements, compared to when they disseminated their news in non-electronic format and in a continental European language. Our results hold for a sub-sample of firms for which the decision to use a wire service was likely exogenous. The effect of wire services on investor attention is due to the format of news (electronic and English-language), not to the increased speed of news transmission.
10 citations
TL;DR: In this article, the authors analyzed whether stock return dispersion (cross-sectional variance of equity portfolio returns) provides useful information about future stock returns, both at the aggregate and portfolio levels.
Abstract: This paper analyzes whether stock return dispersion (cross-sectional variance of equity portfolio returns) provides useful information about future stock returns, both at the aggregate and portfolio levels. Return dispersion consistently forecasts a decline in the (excess) stock market return, and compares favorably with alternative predictors. Furthermore, return dispersion outperforms the alternative variables in forecasting the (excess) market return out-of-sample. The results from both in-sample and out-of-sample regressions show that return dispersion has greater forecasting power for large and growth stocks compared to small and value stocks, respectively. Return dispersion also helps to forecast stock market volatility at short horizons.
10 citations
TL;DR: In this article, the authors calculate monthly probabilities of default (PDs) for a large sample of European firms and break them down into systematic and idiosyncratic components, and find that stocks with higher PDs underperform because they have, on average, higher idiosyncratic risk.
Abstract: While empirical literature has documented a negative relation between default risk and stock returns, theory suggests that default risk should be positively priced. In this paper, we calculate monthly probabilities of default (PDs) for a large sample of European firms and break them down into systematic and idiosyncratic components. The approach that we follow does not require data on credit spreads, thus it can also be applied to small firms that do not have such data available. In accordance with theory, we find that the systematic part, measured as the PD sensitivity to aggregate default risk, is positively related to stock returns. We show that stocks with higher PDs underperform because they have, on average, higher idiosyncratic risk. Finally, small and value stocks are quite heterogeneous with respect to their exposure to aggregate default risk.
10 citations
TL;DR: In this article, the authors show that high-fee funds exhibit a strong preference for stocks with low operating profitability and high investment rates, characteristics recently found to associate with low expected returns.
Abstract: The well-established negative relation between expense ratios and future net-of-fees performance of actively managed equity mutual funds guides portfolio decisions of institutional and retail investors. We show that this relation is an artifact of the failure to adjust performance for exposure to the profitability and investment factors. High-fee funds exhibit a strong preference for stocks with low operating profitability and high investment rates, characteristics recently found to associate with low expected returns. We show that after controlling for exposures to profitability and investment factors, high-fee funds significantly outperform low-fee funds before expenses, and perform equally well net of fees. Our results have important implications for asset allocation decisions and support the theoretical prediction that skilled managers extract rents by charging high fees.
9 citations
TL;DR: The authors investigated the pricing of systematic variance risk in the equity options market and found that options on small and value stocks are more expensive than options on large and growth stocks, respectively, and that these results are not explained by dierential exposure to risk factors, nor by market microstructure considerations.
Abstract: We construct synthetic variance swap returns from prices of traded options to investigate the pricing of systematic variance risk in the equity options market. Cross sectional tests reveal no evidence of a negative market variance risk premium. Furthermore, we show that a class of linear factor models cannot simultaneously explain index and equity option prices. In particular, equity options appear to be underpriced relative to index options. To exploit the mispricing, we analyze an investment strategy known as dispersion trading, which is implemented by going long a portfolio of equity options, and short a portfolio of index options. After transaction costs, the strategy generates a Sharpe ratio which is more than four times greater than that of the market. We also find that equity option prices are related to underlying firm characteristics: Options on small and value stocks are more expensive than options on large and growth stocks, respectively. We find that these results are not explained by di.erential exposure to risk factors, nor by market microstructure considerations. One interpretation is that investors overestimate risk on small and value stocks. This finding provides a new context for understanding the size and value anomalies in stock returns: It suggests that investors expect higher rates of return on small and value stocks because they perceive them to be riskier than they truly are.
9 citations
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TL;DR: In this paper, the authors present some additional tests of the mean-variance formulation of the asset pricing model, which avoid some of the problems of earlier studies and provide additional insights into the nature of the structure of security returns.
Abstract: Considerable attention has recently been given to general equilibrium models of the pricing of capital assets Of these, perhaps the best known is the mean-variance formulation originally developed by Sharpe (1964) and Treynor (1961), and extended and clarified by Lintner (1965a; 1965b), Mossin (1966), Fama (1968a; 1968b), and Long (1972) In addition Treynor (1965), Sharpe (1966), and Jensen (1968; 1969) have developed portfolio evaluation models which are either based on this asset pricing model or bear a close relation to it In the development of the asset pricing model it is assumed that (1) all investors are single period risk-averse utility of terminal wealth maximizers and can choose among portfolios solely on the basis of mean and variance, (2) there are no taxes or transactions costs, (3) all investors have homogeneous views regarding the parameters of the joint probability distribution of all security returns, and (4) all investors can borrow and lend at a given riskless rate of interest The main result of the model is a statement of the relation between the expected risk premiums on individual assets and their "systematic risk" Our main purpose is to present some additional tests of this asset pricing model which avoid some of the problems of earlier studies and which, we believe, provide additional insights into the nature of the structure of security returns The evidence presented in Section II indicates the expected excess return on an asset is not strictly proportional to its B, and we believe that this evidence, coupled with that given in Section IV, is sufficiently strong to warrant rejection of the traditional form of the model given by (1) We then show in Section III how the cross-sectional tests are subject to measurement error bias, provide a solution to this problem through grouping procedures, and show how cross-sectional methods are relevant to testing the expanded two-factor form of the model We show in Section IV that the mean of the beta factor has had a positive trend over the period 1931-65 and was on the order of 10 to 13% per month in the two sample intervals we examined in the period 1948-65 This seems to have been significantly different from the average risk-free rate and indeed is roughly the same size as the average market return of 13 and 12% per month over the two sample intervals in this period This evidence seems to be sufficiently strong enough to warrant rejection of the traditional form of the model given by (1) In addition, the standard deviation of the beta factor over these two sample intervals was 20 and 22% per month, as compared with the standard deviation of the market factor of 36 and 38% per month Thus the beta factor seems to be an important determinant of security returns
2,899 citations
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TL;DR: In this paper, the generalized autoregressive conditionally heteroskedastic (GARCH) model of returns is modified to allow for volatility feedback effect, which amplifies large negative stock returns and dampens large positive returns, making stock returns negatively skewed and increasing the potential for large crashes.
Abstract: It is sometimes argued that an increase in stock market volatility raises required stock returns, and thus lowers stock prices. This paper modifies the generalized autoregressive conditionally heteroskedastic (GARCH) model of returns to allow for this volatility feedback effect. The resulting model is asymmetric, because volatility feedback amplifies large negative stock returns and dampens large positive returns, making stock returns negatively skewed and increasing the potential for large crashes. The model also implies that volatility feedback is more important when volatility is high. In U.S. monthly and daily data in the period 1926-88, the asymmetric model fits the data better than the standard GARCH model, accounting for almost half the skewness and excess kurtosis of standard monthly GARCH residuals. Estimated volatility discounts on the stock market range from 1% in normal times to 13% after the stock market crash of October 1987 and 25% in the early 1930's. However volatility feedback has little effect on the unconditional variance of stock returns.
1,793 citations
TL;DR: In this article, the authors examined a class of continuous-time models that incorporate jumps in returns and volatility, in addition to diffusive stochastic volatility, and developed a likelihood-based estimation strategy and provided estimates of model parameters, spot volatility, jump times and jump sizes using both S&P 500 and Nasdaq 100 index returns.
Abstract: This paper examines a class of continuous-time models that incorporate jumps in returns and volatility, in addition to diffusive stochastic volatility. We develop a likelihood-based estimation strategy and provide estimates of model parameters, spot volatility, jump times and jump sizes using both S&P 500 and Nasdaq 100 index returns. Estimates of jumps times, jump sizes and volatility are particularly useful for disentangling the dynamic effects of these factors during periods of market stress, such as those in 1987, 1997 and 1998. Using both formal and informal diagnostics, we find strong evidence for jumps in volatility, even after accounting for jumps in returns. We use implied volatility curves computed from option prices to judge the economic differences between the models. Finally, we evaluate the impact of estimation risk on option prices and find that the uncertainty in estimating the parameters and the spot volatility has important, though very different, effects on option prices.
1,040 citations
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TL;DR: In this article, a new way to generalize the insights of static asset pricing theory to a multi-period setting is proposed, which uses a loglinear approximation to the budget constraint to substitute out consumption from a standard intertemporal asset pricing model.
Abstract: This paper proposes a new way to generalize the insights of static asset pricing theory to a multi-period setting. The paper uses a loglinear approximation to the budget constraint to substitute out consumption from a standard intertemporal asset pricing model. In a homoskedastic lognormal selling, the consumption-wealth ratio is shown to depend on the elasticity of intertemporal substitution in consumption, while asset risk premia are determined by the coefficient of relative risk aversion. Risk premia are related to the covariances of asset returns with the market return and with news about the discounted value of all future market returns.
805 citations
TL;DR: This article investigated whether market-wide liquidity is a state variable important for asset pricing and found that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity.
Abstract: This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5% annually, adjusted for exposures to the market return as well as size, value, and momentum factors.
789 citations