A Cross-sectional Theory of Price of Risk Proxies

Souza, Thiago de Oliveira

doi:10.2139/ssrn.3363939

Cited by 1 publication

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“…I explain in Section 2.1.1 that size-related variables, such as the BM spread, are theoretically related to the price of risk, based on the framework in de Oliveira Souza (2019a). This happens under the hypothesis that the book value of equity (BE) is a proxy for expected cash flows (Berk, 1995).…”

Section: Introductionmentioning

confidence: 99%

Macro-Finance and Factor Timing: Time-Varying Factor Risk and Price of Risk Premiums

Souza

2019

SSRN Journal

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This paper documents empirically that increases in the book-to-market spread predict larger market premiums in sample and larger size, value, and investment premiums (also) out of sample. In addition, increases in the investment (or profitability) spread exclusively predict larger investment (or profitability) premiums. This predictability generates "factor timing" strategies that deliver substantial economic gains out of sample. I argue theoretically that the book-to-market spread is a price of risk proxy, while the investment and profitability spreads are factor risk proxies. The evidence confirms standard theoretical predictions in the macro-finance literature and contradicts the hypothesis of constant factor risks.JEL Codes: G11, G12, G14. These strategies are a type of "managed portfolio", described in Cochrane (2005), in which the wealth allocated to portfolio factors, such as the ones in Fama and French (2015), changes over time according to a given signal that forecasts the factor premiums. 3 The evidence in Section 3.2 is consistent with the hypothesis that, from a portfolio perspective, the profitability factor becomes safer as the BM spread increases, which could explain the lack of predictability.

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Section: Introductionmentioning

confidence: 99%