Asset Pricing I
Session Chair: Patrick Kelly, The University of Melbourne
Yang Song, University of Washington
Mikhail Chernov, University of California, Los Angeles
Factor Demand and Factor Returns
Cameron Peng, London School of Economics and Political Science
Chen Wang, University of Notre Dame
We show that mutual funds’ factor demand drives cross-sectional stock return predictability; it explains why value and momentum prevail among certain stocks and fail among others. A fund’s factor demand, measured by the loadings of fund returns on factor returns, is highly persistent over time. Persistence in factor demand combined with time-varying stock characteristics generates a strong rebalancing motive—a phenomenon we term “factor rebalancing”—that leads to predictable trading. The associated price pressure results in stronger value and momentum returns for stocks with characteristics well-matched with the underlying funds’ factor demand. Mismatched stocks, in contrast, face more selling pressure in the short run and experience lower factor returns. By quantifying the scale of factor rebalancing and its price impact, we estimate an average factor demand elasticity of -0.23.
Exploring Risk Premia, Pricing Kernels, and No-Arbitrage Restrictions in Option Pricing Models
Steven Heston, University of Maryland
Kris Jacobs, University of Houston
Hyung Joo Kim, University of Houston
The literature on dynamic option valuation typically does not explicitly specify a pricing kernel. Instead it characterizes the kernel indirectly by specifying prices of risk, or defines it implicitly as the ratio of the risk-neutral and physical probabilities. We propose explicit pricing kernels for stochastic volatility option pricing models that satisfy absence of arbitrage. Different affine price-of-risk specifications correspond to pricing kernels with radically different, and sometimes implausible, economic implications. It can be difficult to statistically distinguish between pricing kernels with widely different economic implications and risk premia. We attribute this to the inherent statistical problem with the estimation of the equity and variance risk premia. This finding extends Merton's (1980) observations on the estimation of the market equity premium to joint estimation of the equity and variance risk premia using the cross-section of options and the underlying returns.