EMPIRICAL ASSET PRICING EMPIRICAL ASSET PRICING The Cross Section of Stock Returns TURAN G BALI ROBERT F ENGLE SCOTT MURRAY Copyright © 2016 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permission Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic formats For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data Names: Bali, Turan G., author | Engle, R F (Robert F.) author | Murray, Scott, 1979- author Title: Empirical asset pricing : the cross section of stock returns / Turan G Bali, Robert F Engle, Scott Murray Description: Hoboken : Wiley, 2016 | Includes bibliographical references and index Identifiers: LCCN 2015036767 (print) | LCCN 2016003455 (ebook) | ISBN 9781118095041 (hardback) | ISBN 9781118589663 (ePub) | ISBN 9781118589472 (Adobe PDF) Subjects: LCSH: Stocks–Prices | Rate of return | Stock exchanges | BISAC: BUSINESS & ECONOMICS / Finance Classification: LCC HG4636 B35 2016 (print) | LCC HG4636 (ebook) | DDC 332.63/221–dc23 LC record available at http://lccn.loc.gov/2015036767 Typeset in 10/12pt TimesLTStd by SPi Global, Chennai, India Printed in the United States of America 10 “The empirical analysis of the cross section of stock returns is a monumental achievement of half a century of finance research Both the established facts and the methods used to discover them have subtle complexities that can mislead casual observers and novice researchers Bali, Engle, and Murray’s clear and careful guide to these issues provides a firm foundation for future discoveries.” John Campbell, Morton L and Carole S Olshan Professor of Economics, Harvard University “Bali, Engle, and Murray have produced a highly accessible introduction to the techniques and evidence of modern empirical asset pricing This book should be read and absorbed by every serious student of the field, academic and professional.” Eugene Fama, Robert R McCormick Distinguished Service Professor of Finance, University of Chicago “Bali, Engle, and Murray provide clear and accessible descriptions of many of the most important empirical techniques and results in asset pricing.” Kenneth R French, Roth Family Distinguished Professor of Finance, Tuck School of Business, Dartmouth College “This exciting new book presents a thorough review of what we know about the cross section of stock returns Given its comprehensive nature, systematic approach, and easy-to-understand language, the book is a valuable resource for any introductory PhD class in empirical asset pricing.” Lubos Pastor, Charles P McQuaid Professor of Finance, University of Chicago CONTENTS PREFACE PART I xv STATISTICAL METHODOLOGIES Preliminaries 1.1 1.2 1.3 1.4 2.2 2.3 Implementation, 10 2.1.1 Periodic Cross-Sectional Summary Statistics, 10 2.1.2 Average Cross-Sectional Summary Statistics, 12 Presentation and Interpretation, 12 Summary, 16 Correlation 3.1 Sample, Winsorization and Truncation, Newey and West (1987) Adjustment, Summary, References, Summary Statistics 2.1 Implementation, 18 3.1.1 Periodic Cross-Sectional Correlations, 18 3.1.2 Average Cross-Sectional Correlations, 19 17 viii CONTENTS 3.2 3.3 3.4 Interpreting Correlations, 20 Presenting Correlations, 23 Summary, 24 References, 24 Persistence Analysis 4.1 4.2 4.3 4.4 Implementation, 26 4.1.1 Periodic Cross-Sectional Persistence, 26 4.1.2 Average Cross-Sectional Persistence, 28 Interpreting Persistence, 28 Presenting Persistence, 31 Summary, 32 References, 32 Portfolio Analysis 5.1 5.2 5.3 5.4 5.5 5.6 25 Univariate Portfolio Analysis, 34 5.1.1 Breakpoints, 34 5.1.2 Portfolio Formation, 37 5.1.3 Average Portfolio Values, 39 5.1.4 Summarizing the Results, 41 5.1.5 Interpreting the Results, 43 5.1.6 Presenting the Results, 45 5.1.7 Analyzing Returns, 47 Bivariate Independent-Sort Analysis, 52 5.2.1 Breakpoints, 52 5.2.2 Portfolio Formation, 54 5.2.3 Average Portfolio Values, 57 5.2.4 Summarizing the Results, 60 5.2.5 Interpreting the Results, 64 5.2.6 Presenting the Results, 66 Bivariate Dependent-Sort Analysis, 71 5.3.1 Breakpoints, 71 5.3.2 Portfolio Formation, 74 5.3.3 Average Portfolio Values, 76 5.3.4 Summarizing the Results, 80 5.3.5 Interpreting the Results, 80 5.3.6 Presenting the Results, 81 Independent Versus Dependent Sort, 85 Trivariate-Sort Analysis, 87 Summary, 87 References, 88 33 ... understanding of the most prevalent patterns of risk and returns in the cross- section of stocks It is assumed that the reader of this book has at least an MBA level understanding of theoretical asset pricing. .. India Printed in the United States of America 10 The empirical analysis of the cross section of stock returns is a monumental achievement of half a century of finance research Both the established... referred to using i and the time periods are referenced using t In most asset pricing studies, the entities correspond to stocks, Empirical Asset Pricing: The Cross Section of Stock Returns, First Edition