A Macroeconomic Hedge Portfolios and the Cross-Section of Stock Returns

Abstract

This paper proposes a zero-investment portfolio that can be used to hedge against unexpected changes in the state of the economy. The so-called “macroeconomic hedge portfolio” (MHP) is formed based on a stock's hedging ability, which we derive from a stock's price reaction to important scheduled macroeconomic news. This portfolio earns a positive risk premium over time and a similar premium when used as a risk factor in an asset pricing model. A model that includes the MHP along with the market factor can explain the cross-section of stock returns about as well as the factor models of Fama and French (1993, 2014). Furthermore, our results provide a possible risk-based explanation for the roles of the characteristic-sorted Fama-French factors: they are, to some extent, compensation for higher exposure to the risk related to unexpected changes in the state of the economy. When the MHP is present in a model, the Fama-French factors lose much of their ability to explain the cross-section of stock returns.

Keywords: Asset Pricing, Expected Returns, Scheduled Macroeconomic Announcements, Macroeconomic Hedge Portfolio, Characteristic-sorted Risk Factors

JEL Classification: G11, G12