Firm fundamentals, stochastic risk premiums, and the cross-section of expected returns

Abstract

This thesis aims to understand the role of firm fundamentals in measuring the firm-level risk and expected returns in the cross-section. It contains three chapters and proceeds as follows. Chapter 1 presents the core research questions, outlines the key motivations, and summarizes the main results. Chapter 2 develops a novel theoretically derived approach towards estimating firm level expected stock returns. I show that the firm-level one-period-ahead expected stock return is a linear combination of book-to-market ratio, forward earnings yield, and a variable summarizing one-period-ahead value-relevant ‘other information’. This ‘other information’ can be inferred from the firm’s one-period-ahead earnings expectation and the current stock price. The empirical evidence shows that the expected return estimates exhibit meaningful associations with a wide range of firm characteristics and are significantly positively associated with future realized returns. Chapter 3 tests the cross-sectional associations of a set of firm fundamentals and stock returns against ‘beta’-based and ‘alpha’-based explanations jointly in a novel two-step testing framework. The new testing methodology builds on the intuition that, if a variable predicts stock returns due to its ability to proxy for firm betas, then its return predictive coefficients must vary consistently with rational expectations of the future realizations of corresponding risk factors. My test results suggest that the return predictive ability of many firm fundamentals is mostly consistent with ‘alpha’-based explanations. Chapter 4 summarizes the key contributions and results of the thesis.