Regulations introduce significant fixed costs and add to operating leverage. Fixed regulatory costs that contribute to operating leverage should generate a risk premium. To explore whether such a premium exists, we introduce a measure of “regulatory operating leverage” that reflects the importance of fixed regulatory costs in a firm’s cost structure. Regulatory operating leverage predicts stock returns in the cross-section, and a zero-cost high-low regulatory operating leverage strategy generates positive and significant risk-adjusted return. Finally, the impact of regulatory operating leverage on returns is due to the (systematic) risk contribution of fixed regulatory costs.

We show how the Joslin, Singleton, and Zhu (2011) factor extraction approach to estimating the Gaussian term structure model can be modified to handle the interest rate lower bound without the approximations used in other approaches. This drastically reduces the computation time and produces more robust estimates of the lower bound parameter and the shadow rate. It makes feasible the extensive specification search necessary to allow for unspanned factors as in Joslin, Priebsch, and Singleton (2014), allowing the term structure model to be used to better assess the effects of policy on the term premium and market expectations.

Using contingent-claims valuation, we introduce novel hedge ratios for credit exposures using put options. Option hedge ratios are generally in line with the empirical sensitivities of credit spread changes to put option returns and, relative to stock hedge ratios, produce further reductions in volatility for a portfolio of North American firms. We show that option hedge ratios capture option-specific credit exposure related to the VIX index and the default spread, which is unaccounted for by Merton’s (1974) equity hedge ratios alone. Combining stocks and put options for credit risk hedging can be done effectively using the volatility smirk.

We find a negative relation between firm-level political risk and future delta-hedged equity option returns. A quasi-natural experiment based on Brexit corroborates this finding since after the referendum there is a decrease in the option returns of the positive-Brexit exposure firms. The predictability is driven by the jump risk component of political uncertainty, is more pronounced in periods of high intermediary constraints, and is stronger among high-demand pressure options but weaker among politically active firms. Finally, consistent with a risk-based explanation, investors of options on politically risky firms are compensated with high returns when major unexpected political shocks happen.

In a factor timing context, academic research has focused on identifying a set of predictors that can explain the dynamics of factor portfolios. We propose an alternative approach for timing factor portfolio returns by exploiting the information from their portfolio characteristics. Different combinations of dimension reduction techniques are employed to independently reduce the number of both predictors and portfolios to predict. Characteristic-based models outperform existing methods in terms of exact predictability, as well as investment performance.

The value effect and the idiosyncratic volatility (IVol) discount arise because growth firms and high IVol firms beat the CAPM during periods of increasing aggregate volatility (market volatility and average IVol), that makes their risk low. All else equal, growth options’ value increases with volatility, an effect that is stronger for high IVol firms, for which growth options take a larger fraction of the firm value and firm volatility responds more to aggregate volatility changes. The factor model with the market factor, the market volatility risk factor, and the average IVol factor explains the value effect and the IVol discount.

This paper investigates the firm-level, asset pricing implications of government expenditures. Higher government sales dependency (GD), unconditional on political partisanship cycles, significantly predicts positive future returns, and a GD-weighted portfolio substantially improves the tangency portfolio’s ex post Sharpe ratio. Conditionally, the results are stronger during Republican presidencies. Higher returns do not stem from political connections or political and regulatory risks. The underlying economic channel is higher expected cash flow from increased profitability. Atypical provisions of government contracts and information asymmetry likely drive higher profit margins. A risk versus a mispricing analysis elicits more convincing evidence for mispricing as an explanation for abnormal returns

Classic option pricing theory values a derivative contract via dynamic delta hedging and treating the contract as redundant relative to the underlying security. Dynamic delta hedging proves highly effective in practice, but the remaining risk is still large because of the practical limits of arbitrage. Derivatives can play primary roles in risk allocation. This paper quantifies the percentage variance reduction of delta hedging on U.S. stock options, proposes a top-down return attribution framework to identify the remaining risk sources of the delta-hedged option investment, and constructs a statistical return factor model to explain the variations of the delta-hedged option returns

This paper explores the impact of product market competition on the positive relation between labor mobility (LM) and future returns. We develop a production-based model and formalize the intuition that low exposure to systematic risk in a concentrated industry limits LM’s amplifying effect on operating leverage. Therefore, the model predicts a stronger positive relation between LM and expected returns for firms in competitive industries. Consistent with the model’s prediction, we empirically find that LM predicts returns only among firms in competitive industries. This evidence suggests that the intensity of competition in firms’ product market potentially drives the positive LM-return relation

The distribution of long-run compound returns to portfolio strategies is greatly affected by periodic rebalancing. Over time, buy-and-hold portfolios gradually lose diversification as extreme long-run skewness in individual stock returns leads to increasingly concentrated holdings. For long investment horizons, small rebalanced portfolios holding only a fraction of all stocks therefore achieve better diversification than much larger marketwide buy-and-hold portfolios. Consequently, over long horizons, rebalanced portfolios tend to outperform buy-and-hold portfolios, and risk-averse investors prefer the former. Empirical results strongly support the theoretical predictions and add further evidence to the strong empirical performance of (small) equal-weighted portfolios.