REVISION: Time Variation of the Equity Term Structure
I document that the term structure of one-period expected returns on dividend-claims is counter-cyclical: it is downward sloping in good times, but upward sloping in bad times. The counter-cyclical variation is consistent with theories of long-run risk and habit, but these theories cannot explain the average downward slope. At the same time, the cyclical variation is inconsistent with recent models constructed to match the average downward slope. More generally, the average and cyclicality of the slope are together inconsistent with any model with a single price of risk. I introduce a new model with two priced risk factors to solve the puzzle.
REVISION: Coronavirus: Impact on Stock Prices and Growth Expectations
We use data from the aggregate stock and dividend futures markets to quantify how investors' expectations about economic growth evolve across horizons in response to the new coronavirus (COVID-19) outbreak and subsequent policy responses until July 2020. Dividend futures, which are claims to dividends on the aggregate stock market in a particular year, can be used to directly compute a lower bound on growth expectations across maturities or to estimate expected growth using a forecasting model. We show how the actual forecast and the bound evolve over time. As of July 20, our forecast of annual growth in dividends points to a decline of 8% in both the US and Japan and a 14% decline in the EU compared to January 1. Our forecast of GDP growth points to a decline of 2% in the US and Japan and 3% in the EU. The lower bound on the change in expected dividends is -17% in the US and Japan and -28% in the EU at the 2-year horizon. News about fiscal stimulus around March 24 boosts the stock ...
REVISION: Duration-Driven Returns
We propose a duration-based explanation for the major equity risk factors, including value, profitability, investment, low-risk, and payout factors. Both in the US and globally, these factors invest in firms that earn most of their cash flows in the near future. The factors could therefore be driven by a premium on near-future cash flows. We test this hypothesis using a new dataset of single-stock dividend futures, which are claims on annual dividends for individual firms. Consistent with our hypothesis, risk-adjusted returns are higher on near- than on distant-future cash flows. In addition, the returns on individual cash flows do not vary across firms once controlling for maturity.
REVISION: Higher-Moment Risk
We use a new method to estimate ex ante higher order moments of stock market returns from option prices. Even and odd number higher order moments are strongly negatively correlated, creating periods where the return distribution is riskier because it is more left-skewed and fat tailed. The higher-moment risk increases in good times when variance is lower and prices are higher. This time variation is inconsistent with disaster-based models where disaster risk, and thus higher-moment risk, peaks in bad times. The variation in higher-moment risk also has important implications for investors as it causes the probability of a three-sigma loss on the market portfolio to vary from 0.7% to 1.9% percent over the sample, peaking in calm periods such as just before the onset of the financial crisis.
REVISION: Conditional Risk in Global Stock Returns
We estimate the premium associated with time-varying market betas without using rolling betas or instruments. Instead, we use a new conditional-risk factor, which is a market timing strategy defined as the unexpected return on the market times the ex ante price of risk. The factor is a powerful tool for documenting a global effect of conditional risk on stock returns: across 23 developed countries, all major equity risk factors load on our conditional-risk factor with the right sign, meaning their alpha can partly be explained by the time variation in their market betas. The conditional-risk factor explains 50% more alpha than traditional methods that use rolling betas to capture conditional risk.
REVISION: Betting Against Correlation: Testing Theories of the Low-Risk Effect
We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment.