Dr. Prodosh Simlai, Professor in the Department of Economics & Finance, paper accepted in the Journal of Managerial Finance.

Please join us in congratulating Dr. Prodosh Simlai, Professor of Economics & Finance, for his recent paper accepted in the Journal of Managerial Finance.

Title: Structural innovation in state variables and expected stock returns

Journal: Managerial Finance (level 2)

Author: Prodosh Simlai

Abstract: We use innovations of systematic risk, which affect the cash flows and risk-adjusted discount rates of all firms in an economy and determine the expected returns of portfolios based on firm characteristics. We use independent sorts based on size, book-to-market, and total accruals—all of which are measured at the firm level—and construct three-dimensional test portfolios. For unobserved innovations, we estimate a triangular structural vector autoregressive system and obtain the exogenous innovations in state variables. We find that variations in expected returns of testing assets are determined by differences in the underlying assets’ exposure to systematic risk innovation. The empirical evidence also shows that exogenous innovation in Fama-French (FF) risk factors leaves out important cross-sectional information about expected returns, and additionally, the FF-factor betas have lower cross-sectional power than the proxy for innovation betas. The cross-sectional differences in the test portfolios’ sensitivity to instruments such as the short-term Treasury bill rate and term spread survive the presence of FF-factor betas.