Search

I document that government debt is related to risk premia in various asset markets: (i) the debt-to-GDP ratio positively predicts excess stock returns with out-of-sample R 2 up to 30% at a five-year horizon, outperforming many popular predictors; (ii) the debt-to-GDP ratio is positively correlated with credit risk premia in both corporate bond excess returns and yield spreads; (iii) higher debt-to-GDP ratio is associated with lower real risk-free rates, (iv) higher debt-to-GDP ratio corresponds to lower average expected returns on government debt; (v) debt-to-GDP ratio positively comoves with fiscal policy uncertainty. I rationalize these empirical findings in a general equilibrium model featuring recursive preferences, endogenous growth, distortionary taxation, and time-varying fiscal uncertainty. In the model, the tax risk premium is sizable and its time variation is driven by fiscal uncertainty. Furthermore, the model generates an endogenous relationship between the debt-to-GDP ratio and fiscal uncertainty. Fiscal uncertainty increases debt valuation through lower government discount rate. This mechanism is reinforced as higher debt conversely raises uncertainty because of future fiscal consolidations.

This paper investigates the effect of the “financialization” of commodity markets in terms of pricing. I explore whether the emergence of commodity index traders affects weekly returns and turnover during the roll periods. I split the sample (1994–2017) into the pre-financialization (1994–2003) and the post-financialization (2004–2017). I directly test whether the market share of index traders contributes to commodity returns and whether risk adjustments (based on momentum, basis, basis-momentum, open interest, crowding, and average factors) alter liquidity and insurance premiums documented in Kang, Rouwenhorst, and Tang (2020). I also examine how the financialization affects liquidity and insurance premiums. Finally, since previous results are obtained with Fama-MacBeth regressions, I use an alternative method totest how liquidity and insurance premiums determine commodity returns.

Studies seek to identify the determinants of the inflation risk premium. Nevertheless, the literature investigating the effects of fiscal variables on the inflation risk premium is scarce. This study is the first to investigate the effects of discretionary fiscal policy and fiscal credibility on the inflation risk premium. Using a modern Fisher equation, we calculate the inflation risk premia to four different maturities as well as to the first principal component of these maturities. In order to provide robust results, we use two different fiscal credibility indicators, and two different fiscal impulse indicators to capture the use of discretionary fiscal policies. The analysis considers the Brazilian case for the period between January 2005 and June 2018. The findings suggest the adoption of discretionary fiscal policies increases the inflation risk premium. The estimates also indicate that fiscal credibility improvements reduce the inflation risk premium and, these improvements are able to mitigate the adverse effect of discretionary fiscal policies on the inflation risk premium. In addition, a dynamic analysis through impulse-response functions obtained from VAR estimates reveal that the inflation risk premium is more sensitive to improvements in fiscal credibility than in monetary credibility. The dynamic analysis also reveals that responses of the inflation risk premium last longer for improvements in fiscal credibility than for improvements in monetary credibility.

We apply a new methodology for identifying pervasive and discrete changes (“breaks”) in cross-sectional risk premia. Size, value, and investment risk premia have fallen off to the point where they are insignificantly different from zero at the end of the sample period. The market risk premium has also declined systematically over time but remains significant and positive as do the momentum and profitability risk premium. We construct a new instability risk factor from cross-sectional differences in individual stocks’ exposure to time-varying risk premia and show that this factor earns a premium comparable to that of commonly used risk factors.

This paper investigates whether multivariate crash risk is priced in the cross-section of expected stock returns. Motivated by a theoretical asset pricing model, we capture the multivariate crash risk of a stock by a combined measure based on its expected shortfall and its multivariate lower tail dependence with the systematic factors of the Carhart (1997) model. We find that stocks with a high exposure to joint crashes of the market and the momentum factor bear a risk premium which is not explained by traditional linear factor models or by other downside risk measures. Our results indicate that accounting for the multivariate crash risk of established state variables helps to understand the cross-section of expected stock returns without further expanding the factor zoo.

USA market is the benchmark for empirical finance and considered the closest example of how an efficient market should behave. On the other hand, divergent results from the observed in the USA are often associated with unreliable and due deviations from efficient hypothesis. However, how would the US market results behave had the data the same constraints as an emerging market economy? To answer that question we analyze the risk premia market estimation under the typical constraints from emerging equity markets: the small number of assets and the short time-series sample available for estimation. We use parameters of time-series length, number of assets and accounting variables distribution from the Brazilian equity market. Surprisingly, we conclude that the US market risk premia convey the same data features as the Brazilian risk premia if under the same time constraints. Then, we evaluate two potential causes of problems in risk premia estimations with small T: i) small sample bias on betas, and ii) divergence between ex-post and ex-ante risk premia. Through Monte Carlo simulations, we conclude that for the T around 5 years the beta estimates are no longer a problem. However, it is necessary to analyze a time-series sample exceeding 40 years to obtain robust ex-ante risk premia.

This paper shows that firms with longer debt maturities earn risk premia not explained by unconditional standard factor models. We develop a dynamic capital structure model and find that firms with long-term debt exhibit more countercyclical leverage, making them more highly levered in downturns, when the market price of risk is high. The induced covariance between risk exposure and the market price of risk generates a maturity premium which we estimate at 0.21% per month. Empirical results from a conditional CAPM as well as observed beta dynamics are consistent with the model. We also exploit exogenous variation of debt maturities at the onset of the financial crisis and find that firms with shorter debt maturities experienced a smaller increase in leverage during the crisis. Also, after an initial spike, the betas of short-maturity firms reverted to levels below those of long-maturity firms by the end of 2008.

This paper shows the cross-sectional and time series momentum in currencies, which cannot be explained by carry and dollar factors, summarize the autocorrelation of these factors. These momentum strategies long currency factors following positive factor returns and short them following losses. Carry and dollar factors are strongly autocorrelated and only earn significantly positive excess returns following positive factor returns. By contrast, idiosyncratic currency returns contain little momentum. Consequently, factor momentum not only outperforms the cross-sectional and time series momentum but also explains them. Limits to arbitrage and time-varying risk premium help explain factor momentum.

PurposeThe paper proposes using modified duration in calculating the proper risk-adjusted discount rate (RADR) to account for downside risk scenarios in capital budgeting.Design/methodology/approachThe paper shows how to use modified duration to summarize in a single number the bidimensional information about the inflows and terms in which they are charged in the use of the RADR. If a short modified duration characterizes the project, that is, the most relevant inflows are charged in short times, then discounting at RADR has mild effects on net present value (NPV). Else, if a long modified duration characterizes the project, discounting at RADR may have severe effects on NPV. The study proves that RADR's effectiveness increases with the project's modified duration.FindingsThe study builds a bridge between the regular NPV method used in academia and the RADR method used in the managerial context by identifying the proper RADR that leads the same NPV risk-adjustments, whichever method is used by including modified duration into the analysis.Practical implicationsThe results show how to select the proper RADR by reducing the subjectivity and increasing financial precision based on modified duration, thus providing an alternative to the norm. Simulations are used to make sensitivity analysis more effective and spotlight the main drivers in the risk-adjustments providing robust results.Originality/valueThis paper fulfils the gap between the RADR method and the expected net present value method by providing simple relations between the characteristic parameters.

This paper analyses uncertainty as one of the factors that affect the public debt-growth nexus. We put forward a hypothesis that uncertainty mediates the effect of public debt on economic growth. The empirical examination of the mediating effect is based on the neoclassical growth equation and consistent with specifications previously used to analyse the sources of heterogeneity in the debt-growth relationship. Since one part of the uncertainty is financial risk, which is closely related to the financial sector stability, we use interest rate spread as a main variable, and the risk premium on lending as an alternative one to proxy financial risk and thus, to some extent, uncertainty. Our results show that lower uncertainty is related to a bigger positive effect of debt on growth and a higher turning point in the debt-growth nexus. On the contrary, higher uncertainty leads to a lower positive and more considerable negative effect of debt on growth in both linear and quadratic specifications..

We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.

Measures of U.S. government policy approval, such as U.S. Presidential or Congressional ratings, are strongly related to persistent fluctuations in the dollar exchange rates. Contemporaneous correlations between approval ratings and the dollar value reach 50% against the advanced economy currencies, in real and nominal terms, in levels and multi-year changes. High approval ratings further forecast a decline in the dollar risk premium, a persistent increase in economic growth, and a reduction in future economic volatility several years in the future. We provide an illustrative economic model to interpret our empirical evidence. In the model, policy valuations are forward-looking and reflect net contributions of policy to economic growth. Policy valuations (approvals) increase at times of high policy-related growth and low policy-related uncertainty, which are the times of a strong dollar and low dollar risk premium.

We find that an option-based equity tail risk factor is priced in the cross section of currency returns; more exposed currencies offer a low risk premium because they hedge against equity tail risk. A portfolio that buys currencies with high equity tail beta and shorts those with low beta extracts the global component in the tail factor. The estimated price of risk of this novel global factor is consistently negative in currency carry and momentum portfolios, and in portfolios of other asset classes, suggesting that excess returns of these strategies can be partially understood as compensations for global tail risk.

This paper explores the impact of product market competition on the positive relation between labor mobility (LM) and future returns. We develop a production-based model and formalize the intuition that low exposure to systematic risk in a concentrated industry limits LM’s amplifying effect on operating leverage. Therefore, the model predicts a stronger positive relation between LM and expected returns for firms in competitive industries. Consistent with the model’s prediction, we empirically find that LM predicts returns only among firms in competitive industries. This evidence suggests that the intensity of competition in firms’ product market potentially drives the positive LM-return relation. (JEL G12, G14, J69)Received March 15, 2022; editorial decision December 17, 2022 by Editor Hui Chen. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Factor analysis proposes an alternative approach to standard portfolio theory: the latter is optimisation based, while the former is estimation based. Also, in standard portfolio theory, returns are only explained by the portfolio volatility factor, while factor analysis proposes a multiplicity of factors, which the managers can choose from to tilt their portfolios. In attempting to reconcile these alternative worlds, we propose a penalised utility function, incorporating both the Markowitzian risk-return trade-off and the manager’s preferences towards factors, and discriminating among losses and gains relative to a reference asset. The penalisation affects the optimisation process, favouring the selection of portfolios with less variance and more tilted towards the chosen risk factors. Penalty levels set by the manager generalise the traditional notion of risk aversion. We test our model by building an investment portfolio based on a combination of asset classes and selected investing factors, focussed on the eurozone. To identify the optimal portfolio, we adopt a set of three metaheuristic optimisation algorithms: the fitness function stochastic maximization using genetic algorithms, differential evolution algorithm for global optimisation, and the particle swarm optimisation, and dynamically choose the best solution. In this way, we can improve the Markowitzian optimisation by tilting the asset allocation with managers’ expectations and desired exposures towards designated factors.

This study examines whether auditors incorporate their clients’ corporate culture into audit pricing. We construct a measure of corporate collaboration culture using textual analysis of public firms’ 10-K reports. We find that firms with more collaboration culture pay lower audit fees. We argue that firms with a culture of collaboration emphasize harmony among people, leading to lower litigation risk, which lowers auditor risk premiums. Collaboration culture also encourages employees’ reporting of errors and problems, leading to lower control risk, which lowers audit risk premiums. Using path analysis and a structural equation model, our findings support the argument. Moreover, we do not find evidence supporting alternative explanations of reduced audit quality and significant auditor changes. The negative relation between collaboration culture and audit fees is robust to multiple alternative measures of collaboration culture, but we caution about the interpretation of the economic significance of our finding.

The use of futures instead of forwards exchange contracts completes the ma-turity spectrum of the correlation between spot yields and the premium. Wefind that the forward premium puzzle appears to be a precrisis phenomenonand is only observed for maturities longer than about 1 month. Differencesin the exposure to risk help to explain cross-sectional spreads in currency ex-cess returns. However, this only applies for medium and longer maturities.Considering that most studies that test the validity of a risk-based approachto currency excess returns focus on short maturity securities, this explainswhy this approach is so often rejected. Open access funding enabled and organized by Projekt DEAL

We propose an investor attention index based on proxies in the literature and find that it predicts the stock market risk premium significantly, both in sample and out of sample, whereas every proxy individually has little predictive power. The index is extracted using partial least squares, but the results are similar by the scaled principal component analysis. Moreover, the index can deliver sizable economic gains for mean-variance investors in asset allocation. The predictive power of the investor attention index stems primarily from the reversal of temporary price pressure and from the stronger forecasting ability for high-variance stocks.

We find that Chinese EPU shocks can explain 40% of the cross-sectional variation in bond returns. We also find that Chinese EPU shocks command a significant negative risk premia. In contrast to a strong explanatory power for bond markets, we do not find meaningful pricing power of Chinese EPU for equity markets. We argue and provide supporting empirical evidence that this result is attributable to the fact that Chinese EPU has a strong influence on the U.S. economy mainly during recessions. Overall, our findings suggest that a foreign EPU shock could be a potentially important factor in explaining bond returns.

In a static Lucas tree economy, we propose a model that the representative agent is sensitive to regret, that is, the agent is affected by not only the actual outcome but also value-differences between actual and foregone consequences. Our model generalizes the classical simple regret model pioneered by Bell (1982) and Loomes and Sugden (1982), and makes it possible to derive the equilibrium asset price and to see when the regret effect decreases the price. To verify that our model predicts sufficient decreases of the equilibrium price to explain the empirically high risk premium, we analyze the data of U.S. stock market and GDP growth rates during 1871–2018. The numerical calculation indicates that the estimated equilibrium price is small enough to explain the equity premium puzzle.

We price the risky component of specialness spreads—identified by their deviations from the expected auction cycle—within a dynamic term structure model estimated using daily prices of all outstanding Treasury securities and corresponding special collateral (SC) repo rates. This allows us to derive a time-varying SC risk premium that we quantitatively link to various price anomalies, such as the on-the-run premium. The SC risk premium explains about 80% of the on-the-run premium and a substantial share of other Treasury price anomalies, suggesting that unexpected fluctuations in the specialness spreads of recently issued nominal Treasury securities are a common risk factor.

PurposeThe Arrow–Pratt approximation to the risk premium is only valid for small risks. In this paper we consider a second approximation, based on risk-neutral probabilities and which requires no greater information than the Arrow–Pratt approximation, that works well for both small and large risks.Design/methodology/approachThe paper is theoretical in nature, although it also provides illustrative numerical simulations.FindingsThe new approximation proposed here appears to be significantly superior to Arrow–Pratt for approximating the true value of the risk premium when the risk is large. It may also approximate better even for relatively small risks.Originality/valueAs far as we are aware, there are no other known approximations for the risk premium when the risk involved is large.

We propose a new model for the pricing of wind power futures written on the wind power production index. Our approach is based on an arithmetic multi-factor pure-jump Ornstein–Uhlenbeck setup with time-dependent coefficients. We express the wind power production index and the corresponding futures price in terms of Fourier integrals and derive the related time dynamics. We conclude the paper by an investigation of the risk premium associated with our wind power model.

We study the pricing of shocks to uncertainty and volatility using a wide-ranging set of options contracts covering a variety of different markets. If uncertainty shocks are viewed as bad by investors, they should carry negative risk premiums. Empirically, however, uncertainty risk premiums are positive in most markets. Instead, it is the realization of large shocks to fundamentals that has historically carried a negative premium. In other words, we find that the return premium for gamma is negative, while that for vega is positive. These results imply that it is jumps, for which exposure is measured by gamma, not forward-looking uncertainty shocks, measured by vega, that drive investors’ marginal utility. In further support of the jump interpretation, the return patterns are more extreme for deeper out-of-the-money options.

We examine how executives' ability to control their firms' exposure to risk affects the design of their incentive-compensation contracts. Our natural experimental evidence shows that exchange-traded weather derivatives allow executives to control their firms' exposure to weather risk. Once these derivatives became available, those executives who use them to hedge experience relative reductions in their total compensation and equity incentives. The decline in compensation is consistent with a reduction in the risk premium that executives receive for exposure to weather risk. The decline in equity incentives is consistent with the relation between risk and incentives shifting in a complementary direction when executives can better control their firms' exposure to risk. Collectively, our findings provide evidence that executives' ability to control their firms' exposure and, by extension, their own to an important source of risk influences the design of their incentive-compensation contracts. JEL Classifications: G32; J33; J41.

Alternative risk premia (ARP) are designed to provide low-cost exposures to long–short risk premia often embedded in hedge fund returns. This article describes the performance of the ARP market in ...

In this paper, we study a comprehensive set of risk premia of country equity returns for 45 countries over the sample period 2002 - 2018 in both a single and a multiple factor setting. Using a new three-pass estimation method for factor risk premia by Giglio and Xiu (2021), we find that several factors, including default risk, are also priced in country equity excess returns, controlled by the Fama-French 5-factor and Carhart models. Moreover, we apply a novel approach to investigate the multi-factor impact on country equity returns. We find that the multi-factor information, constructed from the first principal component of the statistically significant single factors, provides a consistent and stronger prediction of anomalies in country equity returns.

Stocks of firms with cash flows concentrated in the short term (i.e., short duration stocks) pay a large premium over long duration stocks. I empirically demonstrate that this premium (i) is long-lived and strong even among large firms, (ii) subsumes the value and profitability premia, and (iii) exposes investors to variation in expected returns, especially in times when the premium is high. These facts are consistent with an intertemporal model in which the marginal (long-term) investor dislikes expected return declines as they lead to lower expected wealth growth. The model also captures the positive relation between risk premia and bond duration.

open access article Systematic tail risk is considered an important determinant of expected returns on risky assets. We examine its impact from two perspectives in a unified framework which originates from a simple asset pricing model. From the first perspective, systematic tail risk is proxied by a generalized tail dependence coefficient and is compensated with an economically sizeable and statistically significant premium. From the second perspective, systematic tail risk is proxied by the product of the same coefficient with a normalised tail risk measure and does not appear to earn a premium. We examine these contradictory findings and attempt to reconcile them. Evidence suggests that the components of our second systematic tail risk measure may be subject to common features. This finding may help explain the contradictory evidence in the literature.

Value stocks have endured a period of severe underperformance until recently. This article shows that the value spreads between valuations of value stocks and their most expensive peers expanded in all regions and sectors during this period of underperformance, reaching the same extreme high levels last seen at the peak of the tech bubble in 2000. Investors have rerated expensive stocks relative to their value peers, thus reflecting an expanding difference in their respective earnings growth forecasts. There are signs this trend may now have changed. Value spreads may have started a new period of compression at the end of 2020, led by shrinking differences in earnings growth forecasts. A compression in value spreads would be favorable for value stocks, small-capitalization stocks, and multifactor strategies. TOPICS:Security analysis and valuation, analysis of individual factors/risk premia, financial crises and financial market history, performance measurement Key Findings ▪ The spread between valuations of value stocks relative to their expensive peers reached levels last seen in the 2000 tech bubble in every region and sector investigated. This expansion of value spreads explains the recent underperformance of value stocks. ▪ The expansion of value spreads reflected an increasing difference between earnings growth forecasts for expensive and value stocks. Value spreads and earnings growth forecast differences peaked in 2020, suggesting that a regime of value spread compression has begun. ▪ Value spread compression periods are characterized by strong outperformance of value stocks relative to expensive peers and by outperformance of smaller-cap stocks relative to larger-cap stocks. Other sector-neutral styles and their multifactor combinations also do well.

Theoretical work generally predicts a negative association between disclosure and risk premium, where additional disclosure reduces estimation risk or information asymmetry. However, empirical studies frequently report mixed results. Recent theoretical studies suggest that the association between disclosure and risk premium is not necessarily always negative, and could be positive (or less negative). For example, Dutta and Nezlobin (2017) show that disclosure can be associated with higher risk premium when conditioned on a firm's growth rates. Similarly, Johnstone (2016) shows that higher signal quality can lead to higher risk premium. Motivated by these studies, we re-examine the association between disclosure and risk premium, conditional on growth. Using various proxies for risk premium, disclosure, and growth, we provide robust evidence that while the unconditional association between disclosure and risk premium is ambiguous, the conditional association is negative for lower growth firms but is less negative (or positive) for higher growth firms. Data Availability: Additional analyses are available from the authors upon request. JEL Classifications: M41; G12.

Organization capital (OC) constitutes a firm’s unique, hard-to-mimic, hard-to-transfer culture, internal knowledge and language, policies and procedures, growth opportunities and information technology, brand name and any other aspects that are not directly related to the production process. In order to disentangle value enhancement from agency costs inherent in the OC, we calibrate systematic risk premiums from the loss of managerial OC rents by decomposing OC into: (1) portable economic rents in the form of disclosed executive compensation and (2) a strategic component comprised of undisclosed, non-portable OC rents mixed with agency costs. Shareholders in firms with high strategic component (not the portable component) earn an annual systematic risk premium of 4.6%. Disclosures revealing the breakdown between OC and agency costs in the strategic component (earnings surprises, managerial obfuscation and stock mispricing) as well as corporate governance eliminate this risk premium by revealing the OC rents in strategic component and increasing OC portability.

We examine the profitability of multifactor portfolios on the US stock market. Using passive sector investing as the benchmark, we assess the performances of factor‐based asset management strategies in good and bad times. When short selling is unrestricted, factor investing outperforms sector investing in all respects. For long‐only portfolios, our results reveal a trade‐off between the risk premia associated with factors and the diversification potential of sectors. Multifactor investing tends to be more profitable than the benchmark during good times but less attractive during bad times, when diversification is needed the most.

Important dimensions of dividend behavior are not well understood. How do dividends behave in extreme states of the world? Why is the risk premium on dividend claims so high? Would dividend bans in crisis states have plausible effects on firms' cost of capital? In this paper we use evidence from the ongoing Corona pandemic to shed light on these questions. We find that, contrary to the folklore that near-future dividends are smoother than earnings or share prices, the opposite is true in disaster states. It appears that firms do not fulfill their role as liquidity intermediaries for their shareholders in precisely those states, in which predictable cash payments would be valued most highly. This is consistent with the apparent puzzle that near-maturity dividend futures have provided investors with "anomalously" high returns in the past years. In light of the recent Corona disaster, these risk premia are consistent with compensation for negative co-skewness and exposure to disaster risk. Our findings imply that policy setters who consider banning dividends in a crisis should take into account the potential effect this is likely to have on firms' future cost of capital.

PurposeEstablishing the strength of a novel variable–mortgage debt as a fraction of US gross domestic product (GDP)–on forecasting capitalisation rates in both the US office and multifamily sectors.Design/methodology/approachThe authors specify a vector error correction model (VECM) to the data. VECM are used to address the nonstationarity issues of financial variables while maintaining the information embedded in the levels of the data, as opposed to their differences. The cap rate series used are from Green Street Advisors and represent transaction cap rates which avoids the problem of artificial smoothness found in appraisal-based cap rates.FindingsUsing a VECM specified with the novel variable, unemployment and past cap rates contains enough information to produce more robust forecasts than the traditional variables (return expectations and risk premiums). The method is robust both in and out of sample.Practical implicationsThis has direct implications for governmental policy, offering a path to real estate price stability and growth through mortgage access–functions largely influenced by the Fed and the quasi-federal agencies Fannie Mae and Freddie Mac. It also offers a timely alternative to interest rate-based forecasting models, which are likely to be less useful as interest rates are to be held low for the foreseeable future.Originality/valueThis study offers a new and highly explanatory variable to the literature while being among the only to model either (1) transactional cap rates (versus appraisal) (2) out-of-sample data (versus in-sample) (3) without the use of the traditional variables thought to be integral to cap rate modelling (return expectations and risk premiums).