The Fed and Stock Market Anomalies

Abstract:     
We present a simple three-factor asset pricing model that helps explain several CAPM anomalies --- value premium, long-term reversal in returns, investment anomaly, and momentum. Two of the risk factors are related with the same variable --- the Fed funds rate. We test our model with portfolios sorted on book-to-market ratio, long-term prior returns, firms’ asset growth, investment-to-assets ratio, and momentum. The model explains a large percentage of the dispersion in average returns associated with each anomaly, with cross-sectional R^2 between 66% and 95%. Moreover, the model clearly outperforms the Fama-French three-factor model in pricing the joint four CAPM anomalies.

Number of Pages in PDF File: 66

Keywords: Cross-section of stock returns, Asset pricing, Intertemporal CAPM, Conditional CAPM, Conditioning information, State variables, Linear multifactor models, Predictability of returns, Fama-French factors, Value premium, Momentum, Long-term reversal in returns, Investment anomaly

JEL Classification: E44, G12, G14

working papers series