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Understanding equity returns

Jing Chen, 2007
Faculty Advisor: Robert Hodrick
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This dissertation is trying to empirically investigate the determinants of equity returns. The first chapter of this dissertation constructs a measure of pervasive liquidity risk and its associated risk premium. I examine seven market-wide liquidity proxies and use Principal Component analysis to extract the first principal component, which captures 62% of the standardized liquidity variance. The first common factor is rewarded with a significant premium in cross-sectional asset pricing tests. Liquidity risk is different from volatility effects, and provides a partial explanation for momentum. Stock market liquidity risk is priced in the bond markets as well. Finally, there is a significant negative relation between liquidity and the conditional variance of monthly stock returns, and the liquidity measure subsumes traditional GARCH coefficients in the conditional variance.

The second chapter examines the interrelation of the stock liquidity and default risk, as well as their relative importance in equity returns. We consider the common market liquidity measure constructed in Chapter 1 and a default measure based on Merton's (1974) contingent claims approach. There exist significant contemporaneous relation between market-wide stock liquidity and default risk. Vector Autoregressive tests reveal the existence of intertemporal relations between stock market liquidity, default risk and stock market return. Market liquidity Granger-causes market survival rate, and shocks to the liquidity measures have the ability to partly influence the future path of the market survival rate. High market return Granger-causes both high market liquidity and high market survival rate. Cross-sectionally low liquidity stocks earn higher returns than high liquidity stocks only if these stocks also have high default risk, but in no other case. In contrast, high default risk stocks always earn higher returns than low default risk stocks, independently of their liquidity level. Both liquidity and default play the role of state variables that investors would want to hedge against in the context of the ICAPM.

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