Robert F. Dittmar

Nonlinear Pricing Kernels, Kurtosis Preference, and Evidence from the Cross Section of Equity Returns

This paper investigates nonlinear pricing kernels in which the risk factor is endogenously determined and preferences restrict the definition of the pricing kernel. These kernels potentially generate the empirical performance of nonlinear and multifactor models, while maintaining empirical power and avoiding ad hoc specifications of factors or functional form. Our test results indicate that preferencerestricted nonlinear pricing kernels are both admissible for the cross section of returns and are able to significantly improve upon linear single- and multifactor kernels. Further, the nonlinearities in the pricing kernel drive out the importance of the factors in the linear multi-factor model.

Consumption, Dividends, and the Cross-Section of Equity Returns

We show that aggregate consumption risks embodied in cash flows can account for the puzzling differences in risk premia across book-to-market, momentum, and size-sorted portfolios. The dynamics of aggregate consumption and cash flow growth rates, modeled as a vector autoregression, are used to measure the consumption beta of discounted cash flows. Differences in these cash flow betas account for more than 60% of the cross-sectional variation in risk premia. The market price for risk in cash flows is highly significant. We argue that cash flow risk is important for interpreting differences in risk compensation across assets. Copyright 2005 by The American Finance Association.

Purebred or hybrid?: Reproducing the volatility in term structure dynamics

This paper investigates the implications of mixtures of affine, quadratic, and nonlinear models for the term structure of volatility. The dynamics of the term structure of interest rates appear to exhibit pronounced time-varying or stochastic volatility. Ahn, Dittmar, and Gallant (2000) provide evidence suggesting that term structure models incorporating a set of quadratic state variables are better able to reproduce yield dynamics than affine models, though none of the models is able to fully capture the term structure of volatility. In this study, we combine affine, quadratic and nonlinear factors in order to maximize the strengths of a term structure model in generating heteroskedastic volatility. We show that this combination entails a tradeoff between specification of heteroskedastic volatility and correlations among the state variables. By combining these factors, we are able to gauge the cost of this tradeoff. Using the Efficient Method of Moments [Gallant and Tauchen (1996)], we find that augmenting a quadratic model with a nonlinear factor results in improvement in fit over a model characterized only by quadratic factors. Since the nonlinear factor is characterized by stronger dependence of volatility on the level of the factor, we conclude that flexibility in the specification of both level dependence and correlation structure are important for describing term structure dynamics.

Interpreting Risk Premia Across Size, Value, and Industry Portfolios

In this paper, we model cash flow and consumption growth rates as a vector-autoregression (VAR), from which we measure the response of cash flow growth to consumption shocks. As the appropriate cash flow proxy is not unambiguous, nor likely to be measured without error, we consider three alternatives for portfolio cash flows: cash dividends, dividends plus repurchases and corporate earnings. We find that the long-run exposure of cash flows to aggregate consumption risk can justify a significant degree of the observed variation in risk premia across size, book-to-market, and industry sorted portfolios. Also, our economic model highlights the reasons for the failure of the market beta to justify the cross-section of risk premia. Most importantly, our results indicate that measured diferences in the long-run exposures of cash flows to aggregate economic fluctuations as captured by aggregate consumption movements contain very valuable information regarding diferences in risk premia. In all, our results indicate that the size, book-to-market and industry spreads are not puzzling from the perspective of economic models.

Momentum is Not an Anomaly

In this paper, we develop a new approach to test whether momentum is indeed an anomaly in that it reflects delayed reactions, or continued overreactions, to firm specific news. Our methodology does not depend on a specific model of expected returns and, more importantly, does not require a decomposition of momentum profits. Yet we provide distinct testable predictions that can discriminate between the two diametrically opposed causes for the profitability of momentum strategies: time-series continuation in the firm-specific component of returns, and cross-sectional differences in expected returns and systematic risks of individual securities. Our results show that, contrary to the common belief in the profession, momentum is not an anomaly; we find no evidence of continuation in the idiosyncratic component of individual-security returns. The evidence is instead consistent with momentum being driven entirely by cross-sectional differences in expected returns and risks of individual securities.

Long Run Risks and Equity Returns

We argue that investor concerns about the exposure of asset returns to permanent movements in consumption levels are a key determinant of the risk and return relation in asset markets. We show that as the investment horizon increases, (i) the returns systematic risk exposure (consumption beta) almost converges to the long-run relation between dividends and consumption, (ii) return volatility is increasingly dominated by dividend shocks. We find that most of the differences in risk premia, at short and long horizons, is due to the heterogeneity in the exposure to permanent risks in consumption. The long-run cross-sectional relation between risk and return provides a measure of the compensation for permanent risks in consumption. We find that the market compensation for these risks is large relative to that for transitory movements in consumption.

Cross-Market and Cross-Firm Effects in Implied Default Probabilities and Recovery Values

We propose a novel method of estimating default probabilities using equity option data. The resulting default probabilities are highly correlated with estimates of default probabilities extracted from CDS spreads, which assume constant recovery rates. Additionally, the option implied default probabilities are higher in bad economic times and for �?rms with poorer credit ratings and �?nancial positions. An inferred recovery rate, after controlling for liquidity effects, is also related to underlying business and �?rm conditions, varies across sectors and predicts subsequent equity returns.

Firm Characteristics, Consumption Risk, and Firm-Level Risk Exposures

Firm-level risk exposures and costs of equity are notoriously dicult to estimate. Using a novel mapping between consumption risk exposures and rm characteristics, we combine the traditional portfolio-level approach to testing asset pricing models with rm-level information to measure rm-level risk exposures. First, at the portfolio level, we investigate the empirical performance of a simple two-factor consumptionbased asset pricing model for the cross-section of equity returns. The priced factors in the model are innovations in the growth and volatility of aggregate consumption. Our empirical results show that this model can explain 78% of the cross-sectional variation in returns on a menu of 55 portfolios spanning size, value, momentum, asset growth, stock issuance, and accruals. Second, we use the estimated model to map point-in-time rm characteristics to consumption risk exposures. Measured in this way, we uncover sizeable cross-sectional and time-series variation in rm consumption risk exposures and are able to predict future rm equity returns.We propose a novel approach to measuring firm-level risk exposures and costs of equity. Using a simple consumption-based asset pricing model that explains nearly two-thirds of the variation in average returns across 55 anomaly portfolios, we map the relation between exposures to consumption risk and portfolio-level characteristics. We use this relation to calculate exposures to consumption risk at the firm level and show that the calculated consumption risk exposures yield portfolios with large differences in average returns and ex post consumption risk exposures consistent with those predicted by our calculated betas. Further, industry betas and risk premia implied by our procedure display economically intuitive variation over time. Finally, Fama-MacBeth regressions suggest that risk exposures calculated using our procedure dominate those from alternative factor models at explaining cross-sectional variation in returns.

Do Dollar-Denominated Emerging Market Corporate Bonds Insure Foreign Exchange Risk?

Dollar-denominated emerging market debt is marketed to investors as a way of exposing investors emerging market fixed income securities without exposure to exchange rate risk. However, the development literature suggests that dollarization of debt leads to increased probability of financial distress, which would indirectly expose these securities to exchange rate risk. We empirically examine the exposure of dollar-denominated corporate bonds to exchange rate risk in 14 emerging markets. We find that nearly three-fourths of bonds have yield spreads with statistically significant exposure to innovations in exchange rates, exchange rate volatility, or both. In a reduced-form bond pricing model with default risk, we find economically significant exposures of credit spreads to exchange rates and exchange rate volatility.

Default Risk and the Pricing of U.S. Sovereign Bonds

United States Treasury securities are traditionally viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can always be repaid by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to embed lower rate of recovery in case of default. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation between nominal Treasury securities and TIPS is significantly related to the premium paid on U.S. credit default swaps (CDS), controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in a no-arbitrage setting. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. The estimated model provides evidence that most of the TIPS mispricing after the crisis can be attributed to the exposure to default risk.