Risk Factors That Explain Stock Returns: A Non-Linear Factor Pricing Model
35 Pages Posted: 31 Oct 2017 Last revised: 5 Sep 2018
Date Written: August 9, 2018
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: Suggested Citation