Working Paper: NBER ID: w21016
Authors: Hang Bai; Kewei Hou; Howard Kung; Lu Zhang
Abstract: Value stocks are more exposed to disaster risk than growth stocks. Embedding disasters into an investment-based asset pricing model induces strong nonlinearity in the pricing kernel. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples in which disasters are not materialized, and its relative success in samples in which disasters are materialized. The relation between pre-ranking market betas and average returns is flat in simulations, despite a strong positive relation between true market betas and expected returns. Evidence in the long U.S. sample from 1926 to 2014 lends support to the model’s key predictions.
Keywords: CAPM; value premium; disaster risk; asset pricing
JEL Codes: E32; E44; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | value stocks exposure (G12) |
| value stocks exposure (G12) | nonlinearity in pricing kernel (G19) |
| nonlinearity in pricing kernel (G19) | CAPM failure in normal times (P11) |
| disasters occur (H84) | CAPM accounts for value premium (G19) |
| disaster risk (H84) | CAPM performance in finite samples without disasters (G17) |
| measurement errors in rolling betas (C46) | CAPM failure to explain value premium (G19) |