The Role of Fundamentals in Asset Pricing

Abstract

This thesis seeks to contribute to the understanding and measurement of the aggregate macroeconomic risks that drive security prices, via three empirical studies. Following Abreu and Brunnermeier (2002), Chapter 2 examines a wide cross-section of global equity markets to test the hypothesis that not only do deviations from fundamentals occur, but it is optimal for an arbitrageur to delay trades that would correct the mispricing. The evidence supports the hypothesis that market prices can and do experience sustained deviations from fundamentals despite the presence of arbitrageurs. Chapter 3 examines the tangled evidence that relates firm-level financial distress to the market, size and value factors of Fama and French (1996). Using panel data it is then shown that exposure to the Fama-French factors can be linked to distress risk, which demonstrates a link between priced aggregate macroeconomic risks and the financial performance of individual firms. Frazzini & Pedersen (2013)'s Betting-Against-Beta (BAB) factor is theorized to occur due to the leverage constraints of a subset of the population of investors. Chapter 4 demonstrates that in the post-1990 subsample the premium on the BAB factor is significantly diminished. Furthermore a conditional model using Carhart (1997)'s 4-factors reduces the alpha further, suggesting that part of the anomaly is in fact attributable to conditional exposure to existing factors, rather than market frictions.