The Role of Preferences in Corporate Asset Pricing

Transcription

1 The Role of Preferences in Corporate Asset Pricing Adelphe Ekponon May 4, 2017 Introduction HEC Montréal, Department of Finance, 3000 Côte-Sainte-Catherine, Montréal, Canada H3T 2A7. Phone: (514) Website: 1

2 Understanding the impact of investors preferences in the asset pricing has long represented a real challenge. That is because it is difficult to disentangle empirically the quantity from the price of risk. This paper proposes a theoretical approach for resolving this issue. First, in bad economic times, assets prices are lower and so the equity risk premium and the credit spread are higher. This could be due to the fact that fundamentals deteriorate and are more volatile, increasing the quantity of risk. Another reason could be that a risk-averse investor would ask a higher additional compensation for the higher level of systematic risk. Hence, the concern is to determine which type of compensation matters more: the compensation for the level of risk itself or the additional compensation asked by a risk-averse investor. Second, there are several types of systematic risks and it is crucial to evaluate their relative importance. This paper contributes to the literature in various dimensions by i) disentangling the quantity and the price of risk; ii) comparing the effects of the price of risk across assets classes, equity versus debt; iii) disentangling the price of risk due to the various type of systematic risks and analyzing their relative weights; iv) showing that in the cross-section, prices of risk may vary according to firms characteristics. To achieve these results, I consider a consumption-based asset pricing model with two sources of systematic risks and with the existence of business cycles. The first source of systematic risk stems from the fact that the firm s fundamentals and the consumption growth follow the same business cycles. This is labeled herein as the lowfrequency systematic risk (SR). The second source originates, as in the classical consumption-based asset pricing models, from the fact that the firm s fundamentals and consumption correlate, which yields the consumption beta or the high-frequency systematic risk. The representative agent is not only risk-averse (to the high-frequency SR) but also pays 2

3 attention to the resolution of the uncertainty regarding the future states of the economy (lowfrequency SR). For indebted firms, the price of risk affects both equity and debt because both are priced by the same risk-averse agent. This framework built on Chen (2010) and Bhamra, Kuehn, and Strebulaev (2010a, b). We obtain the risk premium due to one category of systematic risk by comparing the full model with a special case model in which the agent is neutral to this risk. Thus, one could directly infer the prices of low-frequency SR and high-frequency SR incorporated into both the equity risk premium and the credit spread. The model is constructed in time-varying macroeconomic conditions, modeled by a twostates Markov-regime switching setting. Consequently, the two states, i.e. expansion and recession, are calibrated using the NBER dates. The moments of the firm s fundamental (respectively the consumption growth) is calibrated using U.S. corporate profits before tax (respectively U.S. real non-durables goods plus service consumption expenditures), which data are taken from the Bureau of Economic Analysis. The data span the period from 1952Q1-2015Q4. The baseline case results are computed for the situation when the firm s optimal decisions are endogenous. The main findings are as follow: First, the asset classes (equity versus bond) react differently to the different types of systematic risks. For the equity risk premium, there is no quantity of risk while the price represents 100% of the total equity risk premium. For the credit spread, the quantity of risk represents 86.5% while the price represents 13.5% of the total credit spread. 1 Second, the macroeconomic risk s impact, when the agent is Epstein-Zin-Weil with preference for earlier resolution of the uncertainty, is preponderant within risk premiums. The 1 Using the Fama-French three factors model, Elton, Gruber, Agrawal, and Mann (2001) find a direct evidence of the existence of a risk premium and demonstrates that this risk premium is compensation for the systematic nature of risk in bond returns. Longstaff, Mithal, and Neis (2005) show that the default component represents 56% for A-rated bonds, 71% for BBB-rated bonds, and 83% for BB-rated bonds. For an exogenous policy, the model predicts a quantity of risk of 62% of the total price of risk (see the finding 4) below). 3

4 unconditional price of risk due to the earlier resolution of uncertainty represents 64.4% of the total risk premium embedded into equity prices while the remaining 35.6% represents the investor s risk aversion. The proportion of the price of low-frequency SR and high-frequency SR into the credit spread represents respectively 73.5% and 26.5% of the total risk premium. Overall, around 64 to 75% of the price of risk arises from the aversion to the macroeconomic risk through time and across asset classes. These results show that the impact of the aversion to the low-frequency SR is significantly higher than the one due to the high-frequency SR. The implication is that investors pay more attention the news concerning the future states of the economy than to the shocks that can affect they consumption. Third, the risk premiums vary over the business cycle. The conditional total price of risk in equity risk premium is 4.44% in recession and 0.80% in expansions. The conditional total price of risk in the credit spread is 20.0 bps in recession and 17.0 bps in expansion. Moreover, in recessions, low-frequency SR and high-frequency SR represent respectively 72% and 28%; while in expansions, the they represent respectively 63% and 37% of the equity risk premium. The proportion of the price of low-frequency SR and high-frequency SR in credit spread is stable over time, respectively 73.5% and 26.5% of the total price of risk in any state of the economy. Hence, bondholders are indifferent to the current state of economy while stockholders price more their aversion to quicker resolution of the uncertainty in recession. Fourth, risk premiums differ on the cross-section with regard to firms characteristics. The aversion to the systematic risks, in particular, the preference for earlier resolution of the uncertainty, is more pronounced (affect more negatively) for the firms with following characteristics: high leverage, high idiosyncratic volatility, and small size. Firms with these characteristics are riskier due to a higher level of default risk. Hence, this would increase investors reluctance for buying these firms claims. So, they will then ask to be compensated more, leading to a higher risk premium. 4

5 Finally, preferences affect optimal debt and default decisions. Two situations are compared: i) the case of an exogenous policy, i.e. when managers cannot adjust the firm s debt level and default barriers; ii) the case of an endogenous policy. Thus, in presence of endogenous policy, the total price of risk in the credit spread (14% against 38% for an exogenous policy) has less influence. The reason, in the case of an endogenous policy, is that when we assume risk neutrality both optimal debt level and default barrier increase, leading to a higher default risk. This automatically reduces the impact of risk premium part in the credit spread. Overall, this paper contributes the literature by offering, in a unified approach, crucial predictions regarding the impact of preferences on equity and stock valuations. 5