Bryan T. Kelly

Market Expectations in the Cross Section of Present Values

Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. Using a single factor extracted from the cross section of book- to-market ratios, we find an out-of-sample return forecasting R-squared as high as 13% at the annual frequency (0.9% monthly). We document similar out-of-sample predictability for returns on value, size, momentum and industry-sorted portfolios. We present a model linking aggregate market expectations to disaggregated valuation ratios in a dynamic latent factor system. We find that spreads in growth and value portfolios’ exposures to economic shocks are key to identifying predictability and are consistent with duration-based theories of the value premium. Our findings suggest that discount rates are far less persistent, and their shocks far more volatile, than implied by leading asset pricing models.

The common factor in idiosyncratic volatility: Quantitative asset pricing implications

We show that firms’ idiosyncratic volatility obeys a strong factor structure and that shocks to the common factor in idiosyncratic volatility (CIV) are priced. Stocks in the lowest CIV-beta quintile earn average returns 5.4% per year higher than those in the highest quintile. The CIV factor helps to explain a number of asset pricing anomalies. We provide new evidence linking the CIV factor to income risk faced by households. These three facts are consistent with an incomplete markets heterogeneous-agent model. In the model, CIV is a priced state variable because an increase in idiosyncratic firm volatility raises the average household’s marginal utility. The calibrated model matches the high degree of comovement in idiosyncratic volatilities, the CIV-beta return spread, and several other asset price moments.

Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees

We examine the pricing of financial crash insurance during the 2007-2009 financial crisis in U.S. option markets. A large amount of aggregate tail risk is missing from the price of financial sector crash insurance during the financial crisis. The difference in costs of out-of-the-money put options for individual banks, and puts on the financial sector index, increases fourfold from its pre-crisis 2003-2007 level. We provide evidence that a collective government guarantee for the financial sector, which lowers index put prices far more than those of individual banks, explains the divergence in the basket-index put spread.

The Value of Research

We estimate the value added by sell-side equity research analysts and explore the links between analyst research, informational efficiency, and asset prices. We identify the value of research from exogenous changes in analyst coverage. On announcement that a stock has lost all coverage, share prices fall by around 110 basis points or

The Price of Political Uncertainty: Theory and Evidence from the Option Market: The Price of Political Uncertainty

8.4 million on average. The share price reaction is attenuated the more analysts continue to cover the stock, suggesting that there are diminishing returns to coverage at the margin. The adverse effect of coverage terminations is proportional to the analysts reputation and experience and to the size of the brokers retail sales force. Exogenous reductions in coverage are followed by: less efficient pricing and lower liquidity; greater earnings surprises and more volatile trading around subsequent earnings announcements; increases in required returns; and reduced return volatility. Simulations suggest investors can trade profitably on the volatility changes. Finally, retail investors sell and large institutional investors buy around coverage terminations, suggesting that different investor clienteles have different demands for analyst research.

Excess Volatility: Beyond Discount Rates

We empirically analyze the pricing of political uncertainty, guided by a theoretical model of government policy choice. To isolate political uncertainty, we exploit its variation around national elections and global summits. We find that political uncertainty is priced in the equity option market as predicted by theory. Options whose lives span political events tend to be more expensive. Such options provide valuable protection against the price, variance, and tail risks associated with political events. This protection is more valuable in a weaker economy and amid higher political uncertainty. The effects of political uncertainty spill over across countries.

Text As Data

We document a form of excess volatility that is irreconcilable with standard models of prices, even after accounting for variation in discount rates. We compare prices of claims on the same cash flow stream but with different maturities. Standard models impose precise internal consistency conditions on the joint behavior of long and short maturity claims and these are strongly rejected in the data. In particular, long maturity prices are significantly more variable than justified by the behavior at short maturities. Our findings are pervasive. We reject internal consistency conditions in all term structures that we study, including equity options, currency options, credit default swaps, commodity futures, variance swaps, and inflation swaps.

Instrumented Principal Component Analysis

An ever increasing share of human interaction, communication, and culture is recorded as digital text. We provide an introduction to the use of text as an input to economic research. We discuss the features that make text different from other forms of data, offer a practical overview of relevant statistical methods, and survey a variety of applications.

Sophisticated Investors and Market Efficiency: Evidence from a Natural Experiment

We propose a new approach of latent factor analysis that, in addition to the main panel of interest, introduces other relevant data that serve as instruments for dynamic factor loadings. The method, called IPCA, provides a parsimonious means of incorporating vast conditioning information into factor model estimates. This improves the efficiency of estimates for the latent factors and their loadings, and helps to ascertain the economic relationships among factors and individuals via the observable instruments. The estimation is fast to calculate and accommodates unbalanced panels. We show consistency and asymptotic normality under general panel data generating processes. We demonstrate the advantages of IPCA in simulated data and in applications to equity asset pricing and international macroeconomics.

Characteristics Are Covariances: A Unified Model of Risk and Return

We study how sophisticated investors, when faced with changes in information environment, adjust their information acquisition and trading behavior, and how these changes in turn affect market efficiency. We find that, after exogenous reductions of analyst coverage due to closures of brokerage firms, hedge funds scale up information acquisition. They trade more aggressively and earn higher abnormal returns on the affected stocks. Moreover, the participation of hedge fund significantly mitigates the impairment of market efficiency caused by coverage reductions. Our results show a substitution effect between sophisticated investors and public information providers in facilitating market efficiency in a causal framework.