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APE-5: Economic Risk Factors
Hedging Risk Factors
1UCLA; 2University of Rochester
Standard risk factors can be hedged with minimal reduction in average return. This is true for ``macro'' factors such as industrial production, unemployment, and credit spreads, as well as for ``reduced form'' asset pricing factors such as value, momentum, or profitability. Low beta versions of the factors perform close to as well as high beta versions, hence a long short portfolio can hedge factor exposure with little reduction in expected return. For the reduced form factors this mismatch between factor exposure and expected return generates large alphas. For the macroeconomic factors, hedging the factors also hedges business cycle risk by significantly lowering exposure to consumption, GDP, and NBER recessions. We study implications both for optimal portfolio formation and for understanding the economic mechanisms for generating equity risk premiums.
News Shocks and Asset Prices
1London Business School, United Kingdom; 2Federal Reserve Board; 3London School of Economics
We examine the role of expectation, or news, shocks for the measurement of macroeconomic risk and the natural rate of interest. To this end, we estimate a New-Keynesian dynamic stochastic general equilibrium model that allows us to infer agents’ expectations about future fundamentals at different horizons. Accounting for news shocks results in better-specified macroeconomic risk factors that have significant explanatory power for the cross-section of stock and long-term bond returns. Further, anticipated changes in future productivity growth induce sizeable fluctuations in the natural rate of interest, which we show to have important implications for the conduct of monetary policy.
Decomposing Firm Value
1INSEAD, France; 2PIMCO; 3University of Minnesota
What are the economic determinants of the firm’s market value? We answer this question through the lens of a generalized neoclassical model of investment with physical capital, quasi-fixed labor, and two types of intangible capital, knowledge capital and brand capital. We estimate the structural model using firm-level data on U.S. publicly traded firms and use the parameter values to infer the contribution of each input for explaining firm’s market value in the last four decades. The model performs well in explaining both cross-sectional and time-series variation in firms’ market values across all firms, with a time series R2 of 80% and a cross sectional R2 of 99%. We find that the relative importance of each input for firm value varies across industries. On average, physical capital accounts for 22.7% to 56.7% of firm’s market value, installed labor force accounts for 18.2% to 40.1%, knowledge capital accounts for 0.9% to 33%, and brand capital accounts for 3.5% to 24%. These values also vary over time: the importance of physical capital for firm value has decreased in the last decades, while the importance of knowledge capital has increased, especially in high tech industries. Overall, our value decomposition provides direct empirical evidence supporting models with multiple capital inputs as main sources of firm value.
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