Linking Cross-Sectional and Aggregate Expected Returns

51 Pages Posted: 3 Nov 2014 Last revised: 22 Feb 2015

See all articles by Serhiy Kozak

Serhiy Kozak

University of Maryland - Robert H. Smith School of Business

Shrihari Santosh

University of Colorado at Boulder - Department of Finance

Date Written: February 8, 2015

Abstract

We propose a one-state-variable ICAPM which rationalizes a large set of stock return anomalies, including size, value, and momentum. Differential covariance with news about future market discount rates drives observed cross-sectional patterns in expected returns. In response to discount-rate shocks, large, growth, and recent loser stocks outperform small, value, and winner stocks, respectively. Our interpretation is that increases in discount rates represent “bad” news, increasing investors’ marginal utility of wealth. Ignoring this state variable causes drastic underestimation of the equilibrium price of “level risk” in bond returns. The model augmented with a “level” factor jointly prices stocks and bonds.

Keywords: risk premium, CAPM, ICAPM, discount rates, hedging demand

JEL Classification: G12, G14

Suggested Citation

Kozak, Serhiy and Santosh, Shrihari, Linking Cross-Sectional and Aggregate Expected Returns (February 8, 2015). Ross School of Business Paper No. 1257, Finance Down Under 2015 Building on the Best from the Cellars of Finance Paper, Available at SSRN: https://ssrn.com/abstract=2518256 or http://dx.doi.org/10.2139/ssrn.2518256

Serhiy Kozak (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

7621 Mowatt Ln
College Park, MD 20742
United States

HOME PAGE: http://https://serhiykozak.com

Shrihari Santosh

University of Colorado at Boulder - Department of Finance ( email )

Campus Box 419
Boulder, CO 80309
United States

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