History Doesn't Repeat, But It Rhymes.- Cash Flow Risk and Expected Returns
35 Pages Posted: 18 Nov 2019
Date Written: February 28, 2019
Chava, Hsu, and Zeng (2019) find that investors don't fully incorporate business cycle variation in cash flow growth and thus conditional Sharpe ratio can be informative for future industry returns. It suggests that cash flow risk at the idiosyncratic level is not fully incorporated into the prices by investors. I develop a stochastic volatility framework to evaluate the unexpected cash flow news through the variance decomposition perspective and apply the method to U.S. industry data. I find that i) The common cash flow volatility estimated from unexpected industry-level cash flow news is highly correlated to Uncertainty index constructed by Jurado, Ludvigson, and Ng (2015); ii) the idiosyncratic cash flow risk is robustly priced and the explanation power cannot be consumed by current well-known risk factors and firm characteristics; iii) stocks with high conditional Sharpe ratios tend to have higher idiosyncratic cash flow volatility and higher compensated returns, which is consistent with Chava, Hsu, and Zeng (2019)'s finding. A strategy that goes long the decile portfolio with the largest idiosyncratic cash flow volatility and short the decile portfolio with the smallest idiosyncratic cash flow volatility yields a Fama-French-Five-Factor alpha of 37 bps per month (t-stat: 6.90) in long sample (1931-2018) and 64 bps per month (t-stat: 12.28) in the modern sample (1963-2018).
Keywords: Cash flow risk, Idiosyncratic volatility, Cross-section of stock returns, Factor models, ICAPM
JEL Classification: G10
Suggested Citation: Suggested Citation