On Duration-Based Explanation of the Profitability and Investment Anomalies: An Empirical Investigation

Description

Profitability and investment have recently emerged as two very prominent anomalies. Factors based on profitability and investment are the two vital new factors in newly developed factor models, such as Hou, Xue and Zhang (2015), Fama and French (2015), and Barillas and Shanken (2016). These studies highlight the importance of value, profitability and investment factors in explaining average stock returns. Even though the literature offers motivations and intuitions on why these factors are essential, there is still a lack of a coherent risk-based explanation on how and why these factors drive cross-sectional stock returns. This project intends to investigate whether equity duration can unify these three prominent pricing factors under a risk-based framework. Dechow, Sloan and Soliman (2004) show a duration-based explanation of the value premium: a short duration stock (value) tends to have a higher average return than a long duration stock (growth). Lettau and Wachter (2007, 2011) propose a no-arbitrage model that can generate a downward sloping term structure of equity risk premia, and hence the value premium. Growth stocks tend to have longer horizons of future cash flows than that of value stocks and thus have lower book-to-market ratios by having lower required discount rates. Intuitively, this framework can be extended to include profitability and investment: high profitability may shorten a firm's duration by shifting cash flows relatively close to present, whereas high investment may lengthen a firm's duration by distributing cash flows relatively more in the far future. This project will examine empirically whether equity duration can be the underlying economic force behind the profitability, investment, and other related anomalies.