Risk Factors That Explain Stock Returns: A Non-Linear Factor Pricing Model

35 Pages Posted: 31 Oct 2017 Last revised: 5 Sep 2018

See all articles by John R. Birge

John R. Birge

University of Chicago - Booth School of Business

Yi Zhang

Illinois Institute of Technology

Date Written: August 9, 2018

Abstract

The value of an equity investment can be framed as an embedded call option on a firm’s assets. The embedded call option creates a non-linear relationship between stock returns and underlying risk factors; however, such option value and the impact of this non-linearity are often underestimated or overlooked in most asset pricing studies. In this paper, we use the forward-looking measure of default risk in CDS spreads and an associated quadratic term as a non-linear asset pricing model to explain and predict individual stock returns. Notably, in this model, the intercept α disappears in predictions of future risk-adjusted stock returns. The model also provides an alternative to Fama and French (1993)’s three-factor model in substituting functions of our factors for size and value.

Keywords: Non-Linear Asset Pricing Model, Fama and Frech, Default Risk, Option, Daily stock returns

JEL Classification: G12, G13, G11

Suggested Citation

Birge, John R. and Zhang, Yi, Risk Factors That Explain Stock Returns: A Non-Linear Factor Pricing Model (August 9, 2018). Available at SSRN: https://ssrn.com/abstract=3061712 or http://dx.doi.org/10.2139/ssrn.3061712

John R. Birge (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Yi Zhang

Illinois Institute of Technology ( email )

Stuart Graduate School of Business
565 W. Adams St.
Chicago, IL 60661
United States

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