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A new risk factor based on equity duration

Hannes Mohrschladt and Sven Nolte

Journal of Banking & Finance, 2018, vol. 96, issue C, 126-135

Abstract: We introduce a new risk factor linking a firms equity duration to investment opportunity risk. Low-duration firms generate short-run cash flows and face strong reinvestment risk. High-duration firms have long-run cash flows and their present value increases when discount rates decrease as a result of a deteriorating investment environment. Our empirical analysis reveals a significant return premium of low-duration stocks, confirming that investors charge a risk premium for stocks with returns that are positively related to the investment environment. Our newly introduced risk factor carries significant risk premiums in cross-sectional asset pricing tests. These premiums are robust to including further risk factors and a variety of different test specifications. Notably, our duration risk factor retains high explanatory power on the cross-section of stock returns in a model including direct measurement of the investment environment via state variable innovations.

Keywords: Duration; Multifactor models; Asset pricing; State variable innovations (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:jbfina:v:96:y:2018:i:c:p:126-135