Essays on Asset Pricing Open Access

Rachwalski, Mark (2014)

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This dissertation consists of three essays. The first essay, "Idiosyncratic Risk Innovations and the Idiosyncratic Risk-Return Relation" (with Quan Wen), examines the role of idiosyncratic risk in asset pricing. I find that stocks with increases in idiosyncratic risk tend to earn low subsequent returns for a few months. However, high idiosyncratic risk stocks eventually earn persistently high returns. These results are consistent with positively priced idiosyncratic risk and temporary underreaction to idiosyncratic risk innovations. Because risk levels and innovations are correlated, the relation between historical idiosyncratic risk and returns may reflect both risk premia and underreaction and yield misleading inference regarding the price of risk. The results reconcile previous work, which offers conflicting evidence on the price of idiosyncratic risk, and help to discriminate among explanations of the idiosyncratic risk-return relation. In the second essay, "Stock Wealth, Consumption, and Return Predictability", I construct a novel empirical model of expected stock returns. The stock wealth-consumption ratio reflects expected stock returns and consumption growth. Because consumption growth is mostly unpredictable, much of the variation of this ratio likely reflects changing expected stock returns. In contrast, isolating expected stock return information from other variables may be difficult (in addition to stock returns, the dividend yield may predict dividend growth, while the consumption-wealth ratio may predict non-stock wealth returns). Empirically, a detrended version of this ratio strongly predicts U.S. and international stock returns. In contrast to other predictive variables, predictability does not deteriorate after 1980 and out-of-sample performance is impressive. The third essay, "Bonds, Aggregate Wealth, and Stock Market Risk", examines the role of bond risk in determining stock prices. I find that bond returns predict consumption growth after controlling for equity returns, which suggests that bonds capture important information about aggregate wealth. Consistent with this, bond risk is priced in the cross section of stocks. Bond risk partially explains some well-known anomalies. The results suggest stock indices are an insufficient proxy for aggregate wealth and that bond risk is an important component of consumption risk.

Table of Contents

Essay One: Idiosyncratic Risk Innovations and the Idiosyncratic Risk-Return Relation 1

Essay Two: Stock Wealth, Consumption, and Return Predictability 53 Essay Three: Bonds, Aggregate Wealth, and Stock Market Risk 108

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