FRB,FEDS Paper: A Stock Return Decomposition Using Observables(Revised)

FEDS Paper: A Stock Return Decomposition Using Observables (Revised)

Publication Date: January 31, 2025

Authors: Jinqing Cao, Matthew Richardson, Bo Sun

Institution: Federal Reserve Bank of San Francisco

Abstract

This paper uses a large set of firm-level characteristics to decompose stock return variation into components associated with a variety of factors, including fundamental variables, idiosyncratic risk, liquidity, and market microstructure. The authors find that firm characteristics explain a significant portion of stock return variation, both in-sample and out-of-sample.

Key Findings

• Fundamental Variables: Fundamental variables, such as book-to-market ratio, return on assets, and sales growth, explain a substantial portion of stock return variation. This suggests that investors reward firms with strong fundamentals by demanding a lower expected return.
• Idiosyncratic Risk: Idiosyncratic risk, or the risk that is specific to a particular firm, also explains a significant portion of stock return variation. This suggests that investors demand a premium for holding stocks that are more volatile than the market.
• Liquidity: Liquidity, or the ease with which stocks can be traded, also explains some variation in stock returns. This suggests that investors demand a premium for holding stocks that are more difficult to trade.
• Market Microstructure: Market microstructure, or the institutional and technological features of the stock market, also explains some variation in stock returns. This suggests that investors demand a premium for holding stocks that are traded in less efficient markets.

Implications

The findings of this paper have several implications for investors and policymakers.

• For Investors: The findings suggest that investors should consider fundamental variables, idiosyncratic risk, liquidity, and market microstructure when making investment decisions. By understanding the components of stock return variation, investors can potentially make more informed investment decisions.
• For Policymakers: The findings suggest that policymakers should focus on policies that promote market efficiency and stability. By reducing idiosyncratic risk and improving liquidity, policymakers can potentially make it easier for investors to diversify their portfolios and reduce their overall level of risk.

Methodology

The authors use a large dataset of firm-level characteristics and stock returns to estimate a model that decomposes stock return variation into its various components. The model is estimated using a Bayesian approach that allows the authors to incorporate a wide range of prior information.

Conclusion

The findings of this paper provide new insights into the sources of stock return variation. The authors find that fundamental variables, idiosyncratic risk, liquidity, and market microstructure all play a role in determining stock returns. These findings have implications for investors and policymakers alike.

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