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In this paper, ire study the time-varying total risk of value and growth clocks. The objective is 10 investigate the contention that the market factor's ability to explain the value premium is limited. Inspired by Person and Harvey [1999], ire revisit the role of the market beta in the presence of aggregate economic factors. We discuss the incorporation of aggregate economic conditions in the context of multifactor risk models and provide cross-sectional evidence on the relationship between average returns and postranking betas for book-lo-market BE/ME) sorted portfolios. We show that the ineffective role of the market beta can be altered by incorporating aggregate economic risk factors in the cross-sectional asset pricing tests of size and BE/ME sorted portfolios. No previous study provides such a decomposition of. the cross-sectional role of the market beta in the presence of macroeconomic risk factors.
Business Economics (2012) 47, 104-118.
doi:10.1057/be.2012.6
Keywords: firm sire, book-to-market equity, macroeconomic risk factors, stock returns, value premium
The most basic prediction of the capital asset pricing model of Sharpe [1964], Lintner [1965], and Black [1972] (the SLB model) is that average stock returns are positively i elated to market betas. The finance community has conducted a large number of studies that do not support this central prediction of the SLB model and refer to them as asset pricing anomalies. (1) In the wake of the seminal work of Fama and French [1992] and Lakonishok and others [1994]. researchers have extensively used firm size (that is, market capitalization), book-to-market ratio (that is, the ratio of book equity (BE) to market equity (ME)), and other firm-level characteristics, in order to explain various anomalous cross-sectional patterns.
For example, it is widely recognized that portfolios of stocks with high BE/ME ratios--so-called value stockstend to have higher average returns than portfolios of stocks with low BE/ME ratios. or "growth" stocks [Chan and Lakonishok 2004]. The general consensus among financial economists is that a traditional market beta fails to explain any such existing anomalous patterns in average stock returns, and therefore some measure of risk related to financial performance of the firms that constitute the portfolio may complement the explanation.