Rational Explanations for Asset Pricing Anomalies


My paper Default Risk in Equity Returns,” (co-authored with Yuhang Xing) shows that the size effect is in fact a default effect. It is present only within the segment of the market with the highest default risk. Within that segment, small caps earn always significantly higher returns than big caps.


The paper Default Risk in Equity Returns,” (co-authored with Yuhang Xing) shows that the book-to-market effect is partly due to default risk. Unlike the case of the size effect, default risk does not constitute a complete explanation of the book-to-market anomaly.

SMB, HML, and the empirical success of the Fama-French (1993) model

Fama and French (1993) turned the size and book-to-market anomalies into factors that explain the cross-section of equity returns. Their three-factor model includes the return on the market portfolio, SMB, and HML. SMB is the size-related factor, whereas HML is the book-to-market-related factor. Arguably, HML has greater ability to explain the cross-section than SMB.

In my paper “Can book-to-market, size and momentum be risk factors that predict economic growth?,” (co-authored with Jimmy Liew) I provide the first evidence that SMB and HML can predict future GDP growth in the US and several other developed markets. This paper is the first to suggest that HML and SMB may contain business-cycle related information.

In my paper “News related to future GDP growth as a risk factor in equity returns,” I further explore the above idea. In particular, I show that one can replicate the performance of the Fama-French (1993) model by considering a model that includes the return on the market factor, in addition to a mimicking portfolio that captures news about future GDP growth. In the presence of this mimicking portfolio, SMB and HML lose their ability to explain the cross-section.

GDP is an aggregate variable. At a first-level, it can be decomposed into investment and consumption. In my paper “Sector Investment Growth Rates and the Cross Section of Equity Returns,” (co-authored with Qing Li, and Yuhang Xing), we show that it is the investment side of GDP that is most important for explaining equity returns. A sector-investment growth asset pricing specification greatly outperforms the Fama-French model in explaining the cross-section of equity returns. It also completely eliminates the ability of SMB and HML to explain the cross-section.

Price Momentum

My paper “Corporate Innovation, Price Momentum, and Equity Returns,” (co-authored with Kodjo Apedjinou) provides a rational explanation for price momentum. Corporate innovation is the change in a firm’s gross profit margin, which cannot be explained by its growth in capital and labor. “Winners” are firms with the highest level of corporate innovation among momentum portfolios. Similarly, “losers” are the firms with the lowest levels (negative) corporate innovation among momentum portfolios. Momentum strategies are profitable, only when the winners are chosen from a pool of high corporate innovation stocks. Click on the title to learn more about corporate innovation and what price momentum strategies proxy for.

Return Reversals

The explanation about price momentum provided in my paper “Corporate Innovation, Price Momentum, and Equity Returns,” (co-authored with Kodjo Apedjinou) is also consistent with the long-horizon return reversals. Check out the last table of the paper to see how corporate innovation of firms evolves over time. “Winners” underperform “losers” in 3-5 year horizons because they cannot keep up the high levels of corporate innovation in the long-run. Similarly, “losers” cannot waste scarce resources for too long, or they will go bankrupt. We show that although “losers” start out with much lower levels of corporate innovation than “winners”, by the end of the 3-5 year holding period, they exhibit higher levels of corporate innovation than the “winners”. This reversal in the relative levels of corporate innovation also explains the reversal in the returns.

Negative Abnormal Equity Returns Following Downgrades

A number of papers show that abnormal equity returns following downgrades are negative. This phenomenon is considered an anomaly, since downgrades are considered to imply an increase in a firm’s default risk. In my paper “Abnormal Equity Returns Following Downgrades,” (co-authored with Yuhang Xing), we show that this phenomenon is purely due to the way previous papers computed abnormal returns. We present interesting facts about the evolution of default probabilities around downgrades. We also show that when the variation in default risk around downgrades is taking into account when one computes abnormal returns, then those abnormal returns disappear in short and medium horizons. Furthermore, when we also take into account subsequent downgrades following the initial one, the abnormal negative returns disappear completely. In other words, there is no anomaly!