Measuring the relative return contribution of risk factors

This paper proposes a simple method to measure and compare the average relative return contribution of proposed risk factors. The method is applied to six common risk factors, including market, size, value, momentum, profitability, and investment, using 49 U.S. industry portfolios in the period 1969–2014. We find that the average relative return contributions of the market factor and mispricing alpha are highest in all models and sample periods. When multifactors are included, their main effect is to reduce the contribution of the average market factor return with some reduction in the contribution of mispricing alpha

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This thesis replicates the study by Vassalou and Xing (2004) which claims that higher level of financial distress risk is the explanation for higher stock returns in small and undervalued firms, a return anomaly identified in financial literature since 1992. They used a financial distress indicator in the US stock market during 1971-1999 to conclude that the higher returns are compensation for carrying financial distress risk that cannot be diversified away. I replicate their study using the same model, but with a smaller sample from US stock market from 2006-2020 and minor differences in data specifications. I find that small firms indeed have higher stock returns, but undervalued firms seem to have unexpectedly lower stock returns, but this latter effect is less precise. I also find no indication that these effects would happen only among high-risk firms or that high distress risk firms in general would have higher stock returns, which was a central result of Vassalou and Xing. After the publication of their study there has been identified both in the area of financial research and other scientific areas a possibility that several of their results might be a result of data snooping. As the authors use methods that have been later identified to inflate the results in this topic area and they also perform multiple tests without correcting acceptance margins, it is likely that their results are not as robust as they claim. Other possible explanations for the absence of the default effect in our sample is the exclusion of smallest firms also known as microcaps, as they also have been identified to inflate results in return anomaly analysis. Related literature has also given several alternative explanations for anomalies that are inconsistent with the classical risk-based explanation for excess returns, and these might affect both the original results and the results of this study. As a conclusion, either distress risk is not able to explain higher returns among larger firms or the model used in this study is able to quantify this risk only among smaller companies. In results of this study the only firm characteristic that indicates higher returns in almost every test even with a higher acceptance margin is small size

Fundamental indexation and mean reversion on the Taiwanese equity market

Magister Commercii - MComThe equity market has a long memory of indexing. The market portfolio is a capweighted index that weights stocks based on the market capitalisation of the stocks constituting the index and has been upheld by modern portfolio theory as the optimal portfolio, generating the highest return for given risk. Justification for the meanvariance efficiency of the market portfolio stems from the assumed efficiency of stock markets. However, Siegel (2006) states that, because of speculative trading in the market, which induces noise in stock prices, the prices of stocks deviate from their intrinsic value. The subsequent reversal of overweighting of overvalued stocks and underweighting of undervalued stocks to their intrinsic values by capitalisation weighting results in a return drag. Recent observations of portfolios constructed based on weighting methodologies other than capitalisation weighting have resulted in portfolios that generate excess riskadjusted returns over and above that of the market portfolio; casting doubt on the assumed efficiency of the market. One such weighting methodologies is fundamental indexation, under which stocks are weighted by their fundamental metrics of size. The concept was introduced by Arnott, Hsu and Moore (2005). Chen, Chen and Bassett (2007) also introduced the concept of smoothed cap weights (SCW) as a more reliable estimate of the intrinsic value of a stock. This research study applies the concept of fundamental indexation and SCW to investigate the relative performance of fundamental indices of different concentrations (top 50 and mid-100 stocks) against cap-weighted portfolios on the Taiwanese equity market. The research period runs from January 2001 to June 2014, using the TEJ database as the data source. The TAIEX is employed as the market proxy. The research also examines the performance attribution and robustness of fundamental indices against cap-weighted portfolios. The results indicate that most fundamental indices constructed from the top 50 stocks are less mean-variance efficient than the TAIEX but more mean-variance efficient than the cap-weighted reference portfolio. All fundamental indices of the mid-100 stocks are more mean-variance efficient than the TAIEX and the reference portfolio. The return drag observed in the cap-weighted TAIEX and reference portfolio evidences the presence of mean reversion of stocks. Moreover, the returns of fundamental indices of the top 50 stocks are partly influenced by size risk premium but the fundamental indices comprised of the mid-100 stocks display return variations with statistically significant factor loading on the small cap (size) risk premium and value risk premium. Fundamental indices, on average show a higher resilience against the cap-weighted portfolios in both bull and bear markets. The sales index and fundamental composite index are the most mean-variance efficient fundamental indices and generate statistically significant alphas post accounting for both size and value risk premia

Rational price bubbles in traditional and behavioral finance

U ovoj disertaciji analiziraju se različiti aspekti racionalnih cenovnih balona u tradicionalnim i bihevioralnim finansijama. Studije koje proučavaju cenovne balone u tradicionalnim finansijama su veoma retke, jer se smatra da je cena jednaka fundamentalnoj vrednosti. Kratkotrajna pogrešna određivanja cene sredstava se objašnjavaju konceptima tradicionalnih finansija, ostajući u domenu hipoteze o racionalnim očekivanjima i hipoteze o efikasnim tržištima. S druge strane, bihevioralne finansije uvode kognitivno-psihološke i sociološke koncepte kako bi objasnile uočene anomalije i tržišne zagonetke. Motivacija i inspiracija za istraživanja sprovedena u ovoj disertaciji је uočen obrazac koji je postojao kod većine cenovnih balona u istoriji: često im je prethodila ekspanzivna monetarna politika, kao i pojava novih tehnologija, koje su obećavale da će biti veoma profitabilne, ali su bile i veoma rizične. Da bi se proverile hipoteze postavljene u radu, sproveden je ekonomski eksperiment, sa dva tretmana: jedan simulira ekspanzivnu, a drugi restriktivnu monetarnu politiku. Eksperimentalna struktura je osmišljena tako da obezbeđuje visok nivo interne i eksterne validnosti eksperimenta. Pri analizi podataka su primenjene ekonometrijske procedure za proveru stacionarnosti vremenskih serija cena i dividendi po akciji, kao i procedure za proveru postojanja kointegracije između njih. Rezultati istraživanja pokazuju da su cenovni baloni najčešći u uslovima ekspanzivne monetarne politike, pri trgovanju akcijama koje potencijalno mogu doneti visok prinos. Na osnovu ovih rezultata može se zaključiti da je ekspanzivna monetarna politika jedan od uzroka nastanka racionalnih cenovnih balona. Pored toga, uočeno je i da su psihološke karakteristike učesnika u eksperimentu uticale na formiranje cenovnih balona. Migracija tražnje iz akcija koje donose stabilne prinose u akcije koje potencijalno mogu da donesu visoke prinose se nije pokazala kao značajan uzrok formiranja racionalnih cenovnih balona. Zaključeno je da se značajni viškovi prinosa ii javljaju nakon nastanka dividendnih šokova. Uočeno je statistički signifikantno smanjenje vrednosti transakcija u uslovima restriktivne monetarne politike, odakle sledi pouka kreatorima monetarne politike da monetarna politika ne sme biti previše restriktivna, da se ne bi gušio obim trgovanja na berzi i smanjivala njena likvidnost.Different aspects of rational price bubbles in traditional and behavioral finance are analysed in this dissertation. Studies about rational price bubbles in traditional finance are very rare, because it is assumed that price equals fundamental value. Short-term asset mispricing is explained by traditional finance concepts, thereby staying in the domain of rational expectation hypothesis and efficient market hypothesis. On the other side, behavioral finance introduces cognitive psychological and social concepts in order to explain observed anomalies and market puzzles. The researches carried out in this doctoral thesis are motivated and inspired by a conspicuous pattern that has emerged in most of the previous price bubbles during history: they were often preceded by the expansionary monetary policy, as well as the emergence of innovative technologies that promised to be very profitable, but were also very risky. In order to test the hypotheses stated in the thesis, the economic experiment is conducted. There are two treatments in the experiment: one simulates expansionary, and the second one contractionary monetary policy. The experiment is designed with the aim to ensure high level of its internal and external validity. Adequate econometric procedures are implemented during data analysis in order to test stationarity and cointegration between price and dividend per share time series. Research results point out that price bubbles are most often to form in the conditions of expansionary monetary policy in trading with stocks that potentially bear high return. On the basis of these results, it can be concluded that expansionary monetary policy is one of the causes of rational price bubbles. Additionally, it was noticed that psychological characteristics of experimental participants had an effect on price bubbles’ emergence. The migration of demand from stocks that bear stable returns to those that can potentially bear high returns was not identified as an important reason for rational price bubbles’ forming. It is concluded that there are significant excess returns after dividend shocks occurrence. Statistically significant iv decrease in the transaction value is noticed in the contractionary monetary policy treatments

Noise-augmented asset pricing models : evidence from the Greater China stock markets during two major financial crises

The main contribution of the thesis is the construction of noise-augmented asset pricing models. These models are the extension of Fama & French Three Factor Model (1992,1993) and subsequent improved version of Five Factor Model (2015), by adding a behavourial factor - investor sentiment (INVSENT). To the author’s knowledge, this is one of the first attempts to quantitatively reconcile risk based theory and behavioral finance by developing parsimonious asset pricing models for explaining value premium phenomenon, especially in the context of financial crises. Little research has been carried out on the value premium phenomenon over a short horizon during high volatility period. Previous empirical results show that over the long run, value stocks outperformed growth stocks, with considerable firm size effect. There are two competing schools of thoughts that explain the value premium phenomenon - risk based theories and behavior models. However, the occurrence of the Global Financial Crisis and Eurozone Crisis has opened a new and alternative window to study the value premium phenomenon and further examine the underlying reasoning. Firstly, in examining the risk and return relationship of value stocks and growth stocks of the Greater China stock markets during the two major financial crises, it show that growth stocks outperformed value stocks during both the Global Financial Crisis and Euro Zone Crisis in the China and Hong Kong stock markets. However, value stocks outperformed the growth stocks in the Taiwan stock market during the Global Financial Crisis and Euro Zone Crisis. The small size effect did not really diminish in the Greater China stock markets during two major financial crises. Also, standard risk measures – standard deviation and Sharpe ratio do not fully explain the risk and return relationship of these two stock selection strategies. Secondly, in explaining value premium under the Banko, Conover and Jensen Model (2006), mixed results are observed. During the Global Financial Crisis, industry book-to-market ratio is a strong signal in the China and Hong Kong stock markets, whereas the firm book-to-market ratio is a strong signal in the Hong Kong and Taiwan stock markets. Further analysis at the industrial level has revealed that industry book-to-market ratio is a more prominent factor than the firm book-to-market ratio. During the Euro Zone Crisis, the firm level book-to-market ratio is significant the Hong Kong stock markets, even after controlling for market capitalisation and beta.The study under the Fama and French Three Factor Model (1992, 1993) has shown that the three risk measures - market risk premium (MRP) factor, SMB factor and HML factor are semi-strong signals in explaining value premium in the Greater China stock markets during the two major financial crises. Furthermore, the investigation under the Fama and French Five Factor Model (2015) has shed light that the five risk measures - market risk premium (MRP) factor, SMB factor, HML factor, profitability factor (RMW) and investment factor (CMA) are semi-strong signals. Considering the values of adjusted R-squared and varying signals of the risk measures, it is argued that risk factors of the three asset pricing models do not fully explain value premium phenomenon in the Greater China stock markets during the two major financial crises.Thirdly, the study under the noise-augmented capital asset pricing models reveals that the investor sentiment (INVSENT) factor is a statistically significant determinant of the stock returns in the Hong Kong stock markets during the Euro Zone Crisis. The investor sentiment (INVSENT) factor is only weakly significant or insignificant statistically in the China and Taiwan stock markets during these two financial crises. For the risk measures in the Fama and French’s models, market risk premium (MRP) factor, SMB factor, HML factor, profitability factor (RMW) and investment factor (CMA) are semi-strong signals. The adjusted R-squared values of the noise-augmented asset pricing models are higher than the original Fama and French models. The findings of this research are expected to provide a fresh insight to the investment managers in the asset allocation and portfolio management decision. The practical implication is that when investing during the period of financial crises, one has to firstly, be selectively in stocks and hence businesses involved, relying on the principles embodied in the risk based model – Fama and French Five Factor Model. Then, be aware of the mispricing caused by the investor sentiment

Noise-augmented asset pricing models : evidence from the Greater China stock markets during two major financial crises

The main contribution of the thesis is the construction of noise-augmented asset pricing models. These models are the extension of Fama & French Three Factor Model (1992,1993) and subsequent improved version of Five Factor Model (2015), by adding a behavourial factor - investor sentiment (INVSENT). To the author’s knowledge, this is one of the first attempts to quantitatively reconcile risk based theory and behavioral finance by developing parsimonious asset pricing models for explaining value premium phenomenon, especially in the context of financial crises. Little research has been carried out on the value premium phenomenon over a short horizon during high volatility period. Previous empirical results show that over the long run, value stocks outperformed growth stocks, with considerable firm size effect. There are two competing schools of thoughts that explain the value premium phenomenon - risk based theories and behavior models. However, the occurrence of the Global Financial Crisis and Eurozone Crisis has opened a new and alternative window to study the value premium phenomenon and further examine the underlying reasoning. Firstly, in examining the risk and return relationship of value stocks and growth stocks of the Greater China stock markets during the two major financial crises, it show that growth stocks outperformed value stocks during both the Global Financial Crisis and Euro Zone Crisis in the China and Hong Kong stock markets. However, value stocks outperformed the growth stocks in the Taiwan stock market during the Global Financial Crisis and Euro Zone Crisis. The small size effect did not really diminish in the Greater China stock markets during two major financial crises. Also, standard risk measures – standard deviation and Sharpe ratio do not fully explain the risk and return relationship of these two stock selection strategies. Secondly, in explaining value premium under the Banko, Conover and Jensen Model (2006), mixed results are observed. During the Global Financial Crisis, industry book-to-market ratio is a strong signal in the China and Hong Kong stock markets, whereas the firm book-to-market ratio is a strong signal in the Hong Kong and Taiwan stock markets. Further analysis at the industrial level has revealed that industry book-to-market ratio is a more prominent factor than the firm book-to-market ratio. During the Euro Zone Crisis, the firm level book-to-market ratio is significant the Hong Kong stock markets, even after controlling for market capitalisation and beta.The study under the Fama and French Three Factor Model (1992, 1993) has shown that the three risk measures - market risk premium (MRP) factor, SMB factor and HML factor are semi-strong signals in explaining value premium in the Greater China stock markets during the two major financial crises. Furthermore, the investigation under the Fama and French Five Factor Model (2015) has shed light that the five risk measures - market risk premium (MRP) factor, SMB factor, HML factor, profitability factor (RMW) and investment factor (CMA) are semi-strong signals. Considering the values of adjusted R-squared and varying signals of the risk measures, it is argued that risk factors of the three asset pricing models do not fully explain value premium phenomenon in the Greater China stock markets during the two major financial crises.Thirdly, the study under the noise-augmented capital asset pricing models reveals that the investor sentiment (INVSENT) factor is a statistically significant determinant of the stock returns in the Hong Kong stock markets during the Euro Zone Crisis. The investor sentiment (INVSENT) factor is only weakly significant or insignificant statistically in the China and Taiwan stock markets during these two financial crises. For the risk measures in the Fama and French’s models, market risk premium (MRP) factor, SMB factor, HML factor, profitability factor (RMW) and investment factor (CMA) are semi-strong signals. The adjusted R-squared values of the noise-augmented asset pricing models are higher than the original Fama and French models. The findings of this research are expected to provide a fresh insight to the investment managers in the asset allocation and portfolio management decision. The practical implication is that when investing during the period of financial crises, one has to firstly, be selectively in stocks and hence businesses involved, relying on the principles embodied in the risk based model – Fama and French Five Factor Model. Then, be aware of the mispricing caused by the investor sentiment