(Job market paper)
The correlation between the returns to value and momentum strategies varies over time. This paper shows that the time-variation of the correlation is related to the business cycle, aggregate investment and aggregate external financing. I provide an explanation for this evidence based on a theory of investment that incorporates uncertain financing conditions. In the model, the behaviour of the return premia is a response to a fundamental mechanism: the interaction between uncertain financing costs and earnings. The risk of higher financing costs in the future motivates the most financially constrained firms to time equity issuances. Following negative earnings shocks, the timing option becomes more into the money, inducing these firms to increase investment. As a result, the systematic risk of the equity decreases. This implies a positive correlation between past and expected returns for the most constrained firms, leading to a positive momentum premium. A positive value premium also emerges in the model because the book-to-market ratio increases with financing constraints. Changes in the cost of issuance over the business cycle lead to a procyclical momentum premium and a countercyclical value premium, consistent with the data. The model can also explain the performance of the two strategies during market rebounds as well as the time-series behaviour of their correlation. Several new testable predictions arise in this set up regarding the dynamics of the investment and external financing of firms included in value and momentum strategies. The empirical evidence is largely supportive. Value and momentum premia and their combination no longer seem anomalous when considering a parsimonious empirical asset pricing model that includes investment and financing factors.
Transitory Earnings Shocks, Financial Constraints and Price Momentum.
2017 Cass Finance Research Day Best Paper Award
I examine the separate roles of persistent and transitory earnings shocks in explaining the performance of price momentum strategies. I find that transitory shocks have significant explanatory power, a result that indicates financial constraints may be important for momentum firms. Intuitively, transitory shocks do not affect future cash flows but increase the risk of liquidation if the firm is constrained. Empirical measures of financial constraints, that rely on accounting data or textual analysis of 10-K reports, all indicate that momentum winners and losers are the most constrained firms in the cross-section. Constraints pertain specifically to the issuance of new equity.
Market-implied equity issuance costs, with Enrique Schroth and Mamdouh Medhat.
(Work in progress)
Existing literature measures the cost of issuing equity using low frequency accounting data from Compustat or specific databases with limited coverage. This paper proposes an alternative measure, motivated by Fama and French (2005), but based on the daily variation in outstanding equity from CRSP. The usefulness of this measure lies in its ability to capture each issuance and relate it to its associated price reaction. The Bolton, Chen and Wang (2013) model serves as the basic set up for the structural estimation. The project is currently at the final estimation stage.