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On the explanatory power of firm-specific variables in cross-sections of expected returns

  • Zhang, Chu
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    This paper pertains to the controversy surrounding the explanatory power of certain firm-specific variables such as size and the book-to-market ratio in cross-sections of average stock returns. To investigate whether these firm-specific variables capture the sensitivity of returns to unobserved systematic risk, two sets of principal component factors are used. The first set is constructed from individual stock returns and the second set is from size- and book-to-market-sorted portfolio returns. The evidence from the first set of factors shows that size and the book-to-market ratio have little to do with factor betas. The evidence from the second set of factors shows that the forces underlying size and the book-to-market ratio are indeed systematic risks, although they explain very little return variation at the firm level, and that the betas of size- and book-to-market-sorted portfolio returns with respect to the corresponding systematic factors do explain the size and book-to-market effects.

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    File URL: http://www.sciencedirect.com/science/article/B6VFG-4TP49M2-1/2/9ddeedbbf61989e7d395e730befd3e08
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    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 16 (2009)
    Issue (Month): 2 (March)
    Pages: 306-317

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    Handle: RePEc:eee:empfin:v:16:y:2009:i:2:p:306-317
    Contact details of provider: Web page: http://www.elsevier.com/locate/jempfin

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    1. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
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    6. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    7. Lakonishok, Josef & Shleifer, Andrei & Vishny, Robert W, 1994. " Contrarian Investment, Extrapolation, and Risk," Journal of Finance, American Finance Association, vol. 49(5), pages 1541-78, December.
    8. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
    9. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
    10. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
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