Research Review | 10 June 2022 | Risk Premia Sources

Inflation as the Source of the Bond, Equity, and Value Premia
Martin Tarlie (GMO)
May 2022
A no-arbitrage pricing model with inflation as the only priced risk factor explains the bond, equity, and value premia observed in the United States over the past sixty years. Even though inflation is the only priced factor, in an economy with three state variables – inflation, the real rate, and corporate profitability – the real rate and profitability play a crucial role because of their sensitivity to inflation shocks. For bonds, the shape of excess returns with respect to maturity depends on the dynamic interactions between the three state variables. For stocks, the equity and value premia are largely explained by exposure of cash flows to profitability, whereas growth stocks’ excess returns are largely explained by cash flow exposure to the real rate. With respect to inflation risk, stocks writ large are a store of value, and value stocks are a strong hedge as their dividends move more than one for one with inflation.

Understanding Negative Risk-Return Trade-offs
Aoxiang Yang (University of Wisconsin)
May 2022
In the data, stock market volatility negatively predicts short-run equity and variance risk premia, at odds with leading asset pricing models. I show that a puzzling negative volatility-risk premia relationship concentrates in scattered high-volatility states (20% of the time). While at other times, the relationship is strongly positive. I develop a survey-founded learning model in which investors underreact to structural breaks in high-volatility times and overreact to transitory volatility shocks in normal times. The model can successfully match the novel time-varying volatility-risk premia relationship across various horizons. The model can further account for many other salient data features, such as a robust positive correlation between equity and variance risk premium, a robust leverage effect, and negative observations of equity and variance risk premia at the onsets of recessions (structural breaks).

The Impact of Interest Rates on Different Equity Market Segments
Raymond Lee and Adam Zhardanovsky (independent researchers)
April 2022
This paper aims to examine the impacts and sensitivities of various maturity segments of the U.S. treasury yield curve on the equity markets. We will examine the impacts looking first at the stock market as a whole and then looking further into each of the 11 GICS sectors which make up the S&P 500. The literature which inspired this study either looked solely at short-term interest rates or at foreign international markets, and so our paper will build upon this existing literature by investigating the relationship between interest rates and equity prices along various interest rate maturities while focusing on the U.S. market. Our findings support the literature of a statistically significant negative relationship between the rates and equities, and found that, of the 11 GICS sectors, 10 had a negative relationship with rates, with Energy being the sole outlier.

Fundamental Portfolio Outperforms the Market Portfolio
Hayden Brown (University of Nevada)
May 2022
There is substantial empirical evidence showing the fundamental portfolio outperforming the market portfolio. Here a theoretical foundation is laid that supports this empirical research. Assuming stock prices revert around fundamental prices with sufficient strength and symmetry, the fundamental portfolio outperforms the market portfolio in expectation. If reversion toward the fundamental price is not sufficiently strong, then the fundamental portfolio underperforms the market portfolio in expectation.

Government Debt and Risk Premia
Yang Liu (University of Hong Kong)
May 2022
This paper shows that risk premia increase with government debt. Debt-to-GDP ratios positively predict risk premia at short and long horizons, in the U.S. and other advanced economies. Higher debt is also associated with higher credit risk premia and lower risk-free rates. Major government debt theories (liquidity, safety, crowding out) do not address or are inconsistent with these findings. New evidence suggests that the increased risk premia provide compensation for higher fiscal risk: during periods of elevated debt, fiscal policy becomes less certain, less countercyclical, and less effective, and can even lead to debt crises. I quantify these mechanisms in an equilibrium model.

Expected Market Returns and Underreaction to Liquidity: A Market Liquidity (Sentiment) Based Explanation
Baris Ince (University of Essex)
May 2022
While investors demand a premium to hold stocks with high illiquidity level and risk, they underreact to stock-level liquidity shocks and idiosyncratic liquidity. Built on Baker and Stein (2004) model, this paper documents: (i) significant relationship between market liquidity and sentiment, (ii) market liquidity negatively predicts subsequent market returns, (iii) market liquidity based explanation to the underreaction to liquidity shocks and idiosyncratic liquidity. Markets dominated by irrational investors contribute significantly to the underreaction. Hence, a long-short liquidity shocks (idiosyncratic liquidity) strategy earns significantly higher (lower) returns during abnormally liquid (illiquid) market states.

Wisdom of Crowds and Commodity Pricing
John Hua Fan (Griffith University), et al.
May 2022
We extract commodity-level sentiment from the Twittersphere in 2009-2020. A long-short systematic strategy based on sentiment shifts more than doubles the Sharpe ratio of extant commodity factors. The sentiment premium is unrelated to fundamentals but is exposed negatively to basis risk and is more pronounced during periods of macro contraction and deteriorating funding liquidity. Sentiment-induced mispricing is asymmetric, i.e., commodities with low (high) sentiment shifts tend to be overvalued (undervalued) when the aggregate market is in backwardation (contangoed). Furthermore, the observed premium arises almost entirely from commodities with the most retweet activities, while retweets and likes themselves do not exhibit stronger predictive ability compared to non-influential tweets.

Monetary Policy and Stock Prices
Christopher Cotton (Federal Reserve Bank of Boston)
May 2022
Stock prices have recently fallen as inflation has risen and expectations of rate rises have grown. I assess how changes in monetary policy affect stock prices through a high-frequency approach across a panel of nine developed countries and the eurozone and accounting for changes in interest rates across the yield curve. I find that a 1 basis point increase in the five-year interest rate due to monetary policy changes lowers stock prices by 3.56 basis points. Movements in the short-term part of the yield curve drive the relationship. I estimate the degree to which increases in interest rates have lowered stock prices in recent months and how much further they could fall if rates continue to rise.

Global Credit Supplies and Financial Stress
Helmut Herwartz (University of Goettingen), et al.
May 2022
Pointing to the prominent role of global shocks in determining financial outcomes, global credit aggregates and indicators of country-specific credit market stress co-move to a significant extent. In this work, we examine the transmission of global credit supply shocks associated with governments, businesses and households to the country level. In a data-rich environment, we show that a substantial amount of variation in credit aggregates and interest rates is explained by common global credit supply components. In addition, we find that real risk and term premia and their associated uncertainties (i.e. realized volatilities) transmit global shocks to country-level debt and equity markets. However, effect magnitudes and signs are heterogeneous across sectors, and highlight the relevance of sector-specific credit market monitoring. For instance, whereas global government credit supply eases financial pressures, acting as safe-haven lending, global household credit supply shocks significantly increase risk and liquidity premia across the globe.

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