A Tale of Two Market Returns: The Broad Market Factor and The Idiosyncratic Financial Factor

Part of the Lubar Research Seminar Series

Speaker:  Johnathan Loudis, University of Notre Dame

We construct a broad market factor (BMF) which reflects the value-weighted return on all firms in the US economy (public and private). The BMF differs from the standard value-weighted market factor (VMF), the value-weighted return on public firms in the US economy. The difference between the VMF and the BMF is the idiosyncratic financial factor (IFF): the IFF carries no risk premium and is uncorrelated with all macroeconomic proxies for investor marginal utility we consider. Consistent with a model featuring selection into public markets, we provide evidence that market risk is underestimated when measured with respect to the VMF compared to the BMF for most assets, and that using the BMF in place of the VMF resolves the size anomaly and renders size factors redundant in standard multi-factor models. Moreover, the BMF implies a substantially stronger intertemporal risk-return tradeoff. The IFF adds unpriced risk to the VMF, distorting both cross-sectional and time-series estimates of exposure to priced market risk. Thus, we provide both theoretical and empirical evidence for how the IFF explains three long-standing asset pricing “puzzles”: 1) the CAPM underestimates discount rates for most assets, 2) the size anomaly, and 3) the weak intertemporal risk-return relation.

About the Speaker:
Johnathan Loudis is an Assistant Professor of Finance at the University of Notre Dame. His research focuses on empirical asset pricing, asset pricing theory, and macro-finance. He received his PhD in financial economics from the University of Chicago through a joint degree program between the Booth School of Business and the Kenneth C. Griffin Department of Economics. Johnathan also holds masters degrees in economics from the University of Chicago and materials science from Dartmouth College.