On the Dynamics of Changing Correlations: Identification and Stock Returns

Previously circulated as: "Correlation, causation, and stock returns" and "Size-Related Risk Premiums", Discussion Papers on Business and Economics, University of Southern Denmark, 3/2018

76 Pages Posted: 21 Nov 2017 Last revised: 5 Oct 2020

See all articles by Thiago de Oliveira Souza

Thiago de Oliveira Souza

University of Southern Denmark; Danish Finance Institute

Multiple version iconThere are 2 versions of this paper

Date Written: October 5, 2020

Abstract

Riskier firms have lower prices - and higher book-to-market - exclusively due to the present value identity. For a small subset of firms, book equity is a good proxy for expected cash flows. This is why (i) the difference between the value and size premiums significantly decreases and becomes negative with the price of risk; (ii) among portfolios formed in low price of risk states, SMB returns explain none of the variation in HML returns; (iii) for the remaining portfolios, a strong factor structure exists; and (iv) only among these portfolios, SMB returns span HML returns. The hypothesis of (even indirect) stable economic relations between risk and market capitalization ("size") or book-to-market is theoretically inconsistent with the present value identity and inconsistent with the empirical evidence under fairly general conditions. There are no "missing factors" which size or book-to-market proxy for: Regressions that rely on size-related portfolios do not produce valid unconditional models of returns.

Keywords: Size premium, value premium, correlation, causation, missing risk

JEL Classification: G11, G12, G14

Suggested Citation

de Oliveira Souza, Thiago, On the Dynamics of Changing Correlations: Identification and Stock Returns (October 5, 2020). Previously circulated as: "Correlation, causation, and stock returns" and "Size-Related Risk Premiums", Discussion Papers on Business and Economics, University of Southern Denmark, 3/2018 , Available at SSRN: https://ssrn.com/abstract=3073777 or http://dx.doi.org/10.2139/ssrn.3073777

Thiago De Oliveira Souza (Contact Author)

University of Southern Denmark ( email )

Campusvej 55
DK-5230 Odense, 5000
Denmark

Danish Finance Institute ( email )

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