This week, I had the pleasure to attend a seminar at Rutgers University in which Tobias Adrian (Federal Reserve Bank of New York) presented his work on “Funding Liquidity and the Cross-Section of Stock Returns” (written with Erkko Etula).
In this paper, the authors created a a funding liquidity model, because they believe that funding liquidity risk is important to explain returns in equity cross-sections. This model is a three-factor model, with the variables capital ratio of broker-dealers (inverse of the financial leverage), scaled capital ratio (ratio of broker-dealer equity to non-broker-dealer equity, multiplied by the broker-dealer capital ratio) and wealth ratio (ratio of broker-dealer equity to non-broker-dealer equity).
Adrian and Etula tested their model using the data available on Kenneth French’s data library. In the 30 industry portfolio, the model showed a very good explanatory power, since it has a adjusted R-squared of 49%. Not surprising, it performed far better than the Fama-French three factor model (it is not hard to beat a model that only explains 9% of the cross-sectional variation). The surprising part of the results is that their funding liquidity model is only slightly worst than the Fama-French three factor model in the cross-sections of 25 size and book-to-market portfolios, 25 size and momentum portfolios and 25 size and long-term reversal portfolios that have been tailored to fit the Fama-French model.
It might be a whole new beginning for asset pricing theory!
No comments:
Post a Comment