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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: It is found that EPU positively forecasts log excess market returns and innovations in EPU earn a significant negative risk premium in the Fama-French 25 size-momentum portfolios.
Abstract: Using the Baker, Bloom, and Davis (2013) news-based measure to capture economic policy uncertainty (EPU) in the United States, we find that EPU positively forecasts log excess market returns. A one-standard deviation increase in EPU is associated with a 1.5% increase in forecasted 3-month abnormal returns (6.1% annualized). Furthermore, innovations in EPU earn a significant negative risk premium in the Fama French 25 size-momentum portfolios. Among the Fama French 25 portfolios formed on size and momentum returns, the portfolio with the greatest EPU beta underperforms the portfolio with the lowest EPU beta by 5.53% per annum, controlling for exposure to the Carhart four factors as well as implied and realized volatility. These findings suggest that EPU is an economically important risk factor for equities.
800 citations
TL;DR: In this paper, a five-factor model that adds profitability (RMW) and investment (CMA) factors to the three factor model of Fama and French (1993) suggests a shared story for several average-return anomalies.
Abstract: A five-factor model that adds profitability (RMW) and investment (CMA) factors to the three-factor model of Fama and French (1993) suggests a shared story for several average-return anomalies. Specifically, positive exposures to RMW and CMA (returns that behave like those of the stocks of profitable firms that invest conservatively) capture the high average returns associated with low market β, share repurchases, and low stock return volatility. Conversely, negative RMW and CMA slopes (like those of relatively unprofitable firms that invest aggressively) help explain the low average stock returns associated with high β, large share issues, and highly volatile returns.
605 citations
TL;DR: This paper used a sample of option prices and the method of Bakshi, Kapadia and Madan (2003) to estimate the ex ante higher moments of the underlying individual securities' risk-neutral returns distribution.
Abstract: We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities’ risk-neutral returns distribution. We find that individual securities’ volatility, skewness, and kurtosis are strongly related to subsequent returns. Specifically, we find a negative relation between volatility and returns in thecross-section. We also find a significant relation between skewness and returns, with more negatively (positively) skewed returns associated with subsequent higher (lower) returns, while kurtosis is positively related to subsequent returns. We analyze the extent to which these returns relations represent compensation for risk. We find evidence that, even after controlling for differences in comoments, individual securities’ skewness matters. As an application, we examine whether idiosyncratic skewness in technology stocks might explain bubble pricing in Internet stocks. However, when we combine information in the risk-neutral distribution and a stochastic discount factor to estimate the implied physical distribution of industry returns, we find little evidence that the distribution of technology stocks was positively skewed during the bubble period – in fact, these stocks have the lowest skew, and the highest estimated Sharpe ratio, of all stocks in our sample.
594 citations
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TL;DR: The authors investigated the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low-interest rate currencies and invest in high interest rate currencies, so-called carry trades.
Abstract: We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low-interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.
580 citations
TL;DR: In this paper, the predictive relationship between social media and firm equity value, the relative effects of social media metrics compared with conventional online behavioral metrics, and the dynamics of these relationships were examined.
Abstract: Companies have increasingly advocated social media technologies to transform businesses and improve organizational performance. This study scrutinizes the predictive relationships between social media and firm equity value, the relative effects of social media metrics compared with conventional online behavioral metrics, and the dynamics of these relationships. The results derived from vector autoregressive models suggest that social media-based metrics (web blogs and consumer ratings) are significant leading indicators of firm equity value. Interestingly, conventional online behavioral metrics (Google searches and web traffic) are found to have a significant yet substantially weaker predictive relationship with firm equity value than social media metrics. We also find that social media has a faster predictive value, i.e., shorter “wear-in” time, than conventional online media. These findings are robust to a consistent set of volume-based measures (total blog posts, rating volume, total page views, and search intensity). Collectively, this study proffers new insights for senior executives with respect to firm equity valuations and the transformative power of social media.
475 citations
References
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TL;DR: In this paper, the authors derived underlying asset risk-neutral probability distributions of European options on the S&P 500 index and used nonparametric methods to choose probabilities which minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices.
Abstract: This paper derives underlying asset risk-neutral probability distributions of European options on the S&P 500 index. Nonparametric methods are used to choose probabilities which minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices. Alternative optimization specifications produce approximately the same implied distributions. A new and fast optimization technique for estimating probability distributions based on maximizing the smoothness of the resulting distribution is proposed. Since the crash, the risk-neutral probability of a three (four) standard deviation decline in the index (about-36% (-46%) over a year) is about 10 (100) times more likely than under the assumption of lognormality.
159 citations
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TL;DR: In this article, the authors investigated the effect of trading volume on the future evolution of stock prices and found that stocks experiencing unusually high (low) volume over a period of one day to a week tend to appreciate (depreciate) over the course of the following month.
Abstract: The idea that extreme trading activity (as measured by trading volume) contains information about the future evolution of stock prices is investigated. We find that stocks experiencing unusually high (low) volume over a period of one day to a week tend to appreciate (depreciate) over the course of the following month. This effect is consistent across firm sizes, portfolio formation strategies, and volume measures. Surprisingly, the effect is even stronger when the unusually high or low trading activity is not accompanied by extreme returns, and appears to be permanent. The significantly positive returns of our volume-based strategies are not due to compensation for excessive risk taking, nor are they due to firm announcement events. Previous studies have documented the positive contemporaneous correlation between a stock's trading volume and its return, and the autocorrelation in returns. The high volume return premium that we document in this paper is not an artifact of these results. Finally, we also show that profitable trading strategies can be implemented to take advantage of the information contained in the trading volume.
117 citations
TL;DR: An economic tracking portfolio is a portfolio of assets with returns that track an economic variable as mentioned in this paper, which is useful in forecasting post-war US output, consumption, labor income, inflation, stock returns, bond returns, and Treasury bill returns.
Abstract: An economic tracking portfolio is a portfolio of assets with returns that track an economic variable. Monthly returns on stocks and bonds are useful in forecasting post-war US output, consumption, labor income, inflation, stock returns, bond returns, and Treasury bill returns. These forecasting relationships define portfolios that track market expectations about future economic variables. Using tracking portfolio returns as instruments for future economic variables substantially raises the estimated sensitivity of asset prices to news about future economic variables. Out-of-sample results show that tracking portfolios are useful in forecasting macroeconomic variables and hedging economic risk.
117 citations
Posted Content•
TL;DR: In this article, the authors study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss-averse over fluctuations of individual stocks that they own.
Abstract: We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss averse over the fluctuations of individual stocks that they own. Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: in that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross-section which can, to some extent, be captured by a commonly used multifactor model.
89 citations
Posted Content•
TL;DR: The authors empirically analyzes some properties shared by all one-dimensional diffusion option models and concludes that using SP options are not redundant securities, nor ideal hedging instruments, and puts and the underlying asset prices may go down together.
Abstract: This article empirically analyzes some properties shared by all one-dimensional diffusion option models. Using SP options are not redundant securities, nor ideal hedging instruments---puts and the underlying asset prices may go down together.
45 citations