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Nonlinearities and Pricing Complexity in the Cross-Section of Stock Returns
Fabio Girardi1, Lukas Körber2, Christian Schlag3
1Vienna University of Economics and Business; 2Goethe-University Frankfurt; 3Goethe-University Frankfurt and Leibniz Institute SAFE
Discussant: Dennis Umlandt (University of Innsbruck)
We evaluate the pricing performance of a robust stochastic discount factor spanned by a large set of cross-sectional factor returns. Methodologically, we employ kernel principal component analysis to construct factors that are nonlinear functions of a high-dimensional set of firm characteristics. We show that combining nonlinearities with novel regularization techniques enhances model performance, increasing the out-of-sample Sharpe ratio of the efficient mean-variance portfolio by roughly 30\% to 2.25 and reducing pricing errors across a wide range of prominent cross-sectional stock return anomalies. Moreover, we find that the improved out-of-sample performance of the nonlinear model correlates with measures that capture the time-varying pricing complexity of equity returns.
12:00pm - 12:30pm
Roy sorting: climate and status quo strategies
Thomas Kolbe Cauthorn1, Samuel Drempetic2, Andreas G.F. Hoepner3, Christian Klein1, Adair Morse4
1University of Kassel; 2Steyler Ethik Bank; 3University College Dublin and the European Commission’s Platform for Sustainable Finance; 4University of California-Berkeley and NBER
Discussant: Lukas Körber (Goethe Universität Frankfurt)
Firms may enact competitive sorting to value-optimizing transition or status quo opportunities. If firms Roy (1951) sort, then the information arrival of a firm’s competitive strategy should result in a positive equity price reaction. We apply latent variable techniques from Heckman, Stixrud, Urzua (2006) using a novel dataset of active manager self-edits of ESG scores. We find positive 18-83 basis point stock reactions in industrial base firms when information arrives that firms competitively sort toward transition or status quo growth strategies. Our effects largely go away in countries with high environmental stringency (much of Europe and East Asia), suggestive of unobservability in our data or a pooling toward transition investment induced by policy.
12:30pm - 1:00pm
Common factors in currency characteristics
Moritz Dauber, Dennis Umlandt
University of Innsbruck, Austria
Discussant: Thomas Kolbe Cauthorn (University of Mannheim)
We study the factor structure of currency characteristics by employing a three-dimensional tensor factor model that simultaneously captures the variation in characteristics of the G10 currencies over time. We show that factor-mimicking portfolios derived from these common factors in currency characteristics are able to price individual currency returns better than standard factor models derived from univariate sorts on the same characteristics. The variation in currency characteristics can be well captured by a parsimonious two-factor model, where the first factor closely resembles the carry trade and the second factor acts as a hedge against carry crash risk, that is composed of signals from FX momentum, FX value and the term spread.
