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Contingent Claim-Based Expected Stock Returns

Author

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  • Nicholas Zhiyao Chen

    (ICMA Centre, Henley Business School, University of Reading)

  • Ilya A. Strebulaev

    (Stanford University - Graduate School of Business; National Bureau of Economic Research)

Abstract

We develop and test a parsimonious contingent claims model for cross-sectional returns of stock portfolios formed on market leverage, book-to-market equity, asset growth rate, and equity size. Since stocks are residual claims on firms' assets that generate operating cash flows, stock returns are cash flow rates scaled by the sensitivities of stocks to cash flows. Our model performs well because the stock-cash flow sensitivities contain economic information. Value stocks, high-leverage stocks and low-asset-growth stocks are more sensitive to cash flows than growth stocks, low-leverage stocks and high-asset-growth stocks, particularly in recessions when default probabilities are high.

Suggested Citation

  • Nicholas Zhiyao Chen & Ilya A. Strebulaev, 2013. "Contingent Claim-Based Expected Stock Returns," ICMA Centre Discussion Papers in Finance icma-dp2013-08, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2013-08
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