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On the systematic volatility of unpriced earnings

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  • Johnson, Timothy C.
  • Lee, Jaehoon

Abstract

Some important puzzles in macro finance can be resolved in a model featuring systematically varying volatility of unpriced shocks to firms׳ earnings. In the data, the correlation between corporate debt and stock market valuations is low. The model accounts for this via the opposing effect of unpriced earnings risk on levered debt and equity prices. The model also explains the low (or nonexistent) risk-reward relation for the market portfolio of levered equity via the opposing effects of unpriced and priced uncertainty (both components of stock volatility) on the levered equity risk premium. Versions of the model calibrated to empirical measures of both types of fundamental risk can quantitatively substantiate these explanations. Variation in residual earning dispersion accounts for a significant fraction of observed disagreement between debt and equity valuations and of realized stock volatility. The implication that the two components of risk should forecast the levered equity risk premium with opposite signs is also supported in the data. The results are a notable advance for risk-based asset pricing.

Suggested Citation

  • Johnson, Timothy C. & Lee, Jaehoon, 2014. "On the systematic volatility of unpriced earnings," Journal of Financial Economics, Elsevier, vol. 114(1), pages 84-104.
    • Handle: RePEc:eee:jfinec:v:114:y:2014:i:1:p:84-104
    DOI: 10.1016/j.jfineco.2014.05.012
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    7. Liu, Li & Zhang, Tao, 2015. "Economic policy uncertainty and stock market volatility," Finance Research Letters, Elsevier, vol. 15(C), pages 99-105.
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    9. Wang, Yuchen & Wang, Xiaoming, 2023. "Economic policy uncertainty and information intermediary: The case of short seller," Economic Modelling, Elsevier, vol. 120(C).
    10. Kuk Mo Jung, 2017. "Liquidity Risk And Time-Varying Correlation Between Equity And Currency Returns," Economic Inquiry, Western Economic Association International, vol. 55(2), pages 898-919, April.
    11. Gaoke Liao & Peng Hou & Xiaoyan Shen & Khaldoon Albitar, 2021. "The impact of economic policy uncertainty on stock returns: The role of corporate environmental responsibility engagement," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(3), pages 4386-4392, July.
    12. Ball, Ray & Sadka, Gil, 2015. "Aggregate earnings and why they matter," Journal of Accounting Literature, Elsevier, vol. 34(C), pages 39-57.
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    More about this item

    Keywords

    Credit spreads; Equity premium; Volatility components;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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