Monotonic Effects of Characteristics on Returns
33 Pages Posted: 1 Aug 2018 Last revised: 17 Jan 2019
Date Written: December 14, 2018
This paper considers the problem of modeling a firm's expected return as a nonlinear function of its observable characteristics. We investigate whether theoretically-motivated monotonicity constraints on characteristics and nonstationarity of the conditional expectation function provide statistical and economic benefit. Additionally, we provide an approach for characteristic selection using utility functions to summarize the posterior distribution. Standard unexplained volume, short-term reversal, size, and variants of momentum are found to be significant characteristics, and there is evidence this set changes in time. The data also provide strong support for monotonicity and time variability of the expected return function.
Keywords: Cross Section of Returns, posterior summarization, Bayesian modeling, Bayesian econometrics
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