Academic journal article Business Economics

Disentangling Beta and Value Premium Using Macroeconomic Risk Factors

Academic journal article Business Economics

Disentangling Beta and Value Premium Using Macroeconomic Risk Factors

Article excerpt

In this paper, ire study the time-varying total risk of value and growth clocks. The objective is 10 investigate the contention that the market factor's ability to explain the value premium is limited. Inspired by Person and Harvey [1999], ire revisit the role of the market beta in the presence of aggregate economic factors. We discuss the incorporation of aggregate economic conditions in the context of multifactor risk models and provide cross-sectional evidence on the relationship between average returns and postranking betas for book-lo-market BE/ME) sorted portfolios. We show that the ineffective role of the market beta can be altered by incorporating aggregate economic risk factors in the cross-sectional asset pricing tests of size and BE/ME sorted portfolios. No previous study provides such a decomposition of. the cross-sectional role of the market beta in the presence of macroeconomic risk factors.

Business Economics (2012) 47, 104-118.

doi:10.1057/be.2012.6

Keywords: firm sire, book-to-market equity, macroeconomic risk factors, stock returns, value premium

The most basic prediction of the capital asset pricing model of Sharpe [1964], Lintner [1965], and Black [1972] (the SLB model) is that average stock returns are positively i elated to market betas. The finance community has conducted a large number of studies that do not support this central prediction of the SLB model and refer to them as asset pricing anomalies. (1) In the wake of the seminal work of Fama and French [1992] and Lakonishok and others [1994]. researchers have extensively used firm size (that is, market capitalization), book-to-market ratio (that is, the ratio of book equity (BE) to market equity (ME)), and other firm-level characteristics, in order to explain various anomalous cross-sectional patterns.

For example, it is widely recognized that portfolios of stocks with high BE/ME ratios--so-called value stockstend to have higher average returns than portfolios of stocks with low BE/ME ratios. or "growth" stocks [Chan and Lakonishok 2004]. The general consensus among financial economists is that a traditional market beta fails to explain any such existing anomalous patterns in average stock returns, and therefore some measure of risk related to financial performance of the firms that constitute the portfolio may complement the explanation.

Even though there is consensus on the existence of superior returns of value stocks, there is much less agreement on its possible explanations. The behavioral arguments, including the work of De Bondt and Thaler [1985, 1987], Lakonishok and others [1994], and Haugen [1995], suggest cognitive biases and investors' over-reaction as the main sources of the higher returns of value strategies. The risk-based explanations [Chan and Chen 1991; Fama and French 1995, 1996; and Chen and Zhang 1998] argue that the value premium is nothing but a proxy for a distress effect. (2) In contrast, some researchers--such as Liew and Vassalou [2000], Vassalou [2003], Hahn and Lee [2006], Petkova [2006], and Nguyen and others [2009]--have tried to relate value premium with macroeconomic factors such as future GDP growth. Recently, Petkova and Zhang [2005] studied the relative risk of value stocks and identified one potential risk as time-varying risk. (3) Irrespective of the type and source of the explanations, one thing stands out from the accumulated evidence of the academic work on the value and growth effect: the limited role of the market beta.

In this paper, we investigate the contention that the market factor's ability to explain the value premium is limited. Inspired by Ferson and Harvey [1999], we revisit the role of the market beta in the presence of aggregate economic factors. We examine the predictive power of an alternative market beta, which incorporates information from a set of macroeconomic variables, and show the time and cross-sectional variations in value premium based on the suggested variables. …

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