Monotonic Effects of Characteristics on Returns

38 Pages Posted: 1 Aug 2018

See all articles by Jared Fisher

Jared Fisher

University of Texas at Austin - Red McCombs School of Business

David Puelz

University of Chicago - Booth School of Business - Econometrics and Statistics

Carlos M. Carvalho

University of Texas at Austin - Red McCombs School of Business

Date Written: July 12, 2018

Abstract

Using standard linear regression to describe the cross-section of expected returns implies that the relationships between firm characteristics and returns are both linear and stationary. While this is historically a common practice, finance literature now suggests that these relationships are nonlinear and/or nonstationary. We submit that many of these effects should also be monotonic. To this end, we present a time-dynamic, additive quadratic spline model that can constrain individual splines to be monotonic. The model shrinks irrelevant spline coefficients toward zero and selects the appropriate number of knots through carefully designed shrinkage priors. The additive nature of the model allows it to handle many characteristics from many firms. Selection among characteristics and model complexity are established through utility-based posterior summarization. This model design admits parsimony and economically meaningful interpretation. As the model maintains interpretability, these relationships can be evaluated for linearity, stationarity, and monotonicity.

Keywords: Bayesian Econometrics, Monotonic Splines, Cross Section of Returns

Suggested Citation

Fisher, Jared and Puelz, David and Carvalho, Carlos M., Monotonic Effects of Characteristics on Returns (July 12, 2018). Available at SSRN: https://ssrn.com/abstract=3212934 or http://dx.doi.org/10.2139/ssrn.3212934

Jared Fisher (Contact Author)

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

HOME PAGE: http://jareddf.github.io/

David Puelz

University of Chicago - Booth School of Business - Econometrics and Statistics ( email )

Chicago, IL 60637
United States

Carlos M. Carvalho

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

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