Abstract
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
About this Dissertation
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