Essays in asset pricing

This dissertation follows on an asset pricing theme. Overall, it explores asset pricing tests in the equity and the bond markets and attempts to identify the common risk factors that best explain cross sectional variation in stock and bond returns. The first three studies use US data, while the last study explores European bonds data. The sample period is from January 2002 to December 2012 and the Fama and French (1993) time series framework is used in each of the studies. The first two studies in this dissertation focus on equity markets, while the third and fourth study encompasses the US and European corporate bond markets respectively.

There has been extensive research on asset pricing models. However, despite being a well-researched area, there is little consensus as to which model is most appropriate. Motivated by this gap in literature, this thesis builds on the work of Fama and French (1993) and applies their time series framework to both equity and bonds.

Chapter 2 draws on the link between firm leverage and stock returns as supported by capital structure theory. It examines whether a leverage (LEV) factor exhibits explanatory power over the US stock return variations. The analysis indicates that the LEV factor significantly contributes towards the explanatory power of the fitted models and thus appears to have some explanatory power over U.S. stock returns.

Chapter 3 addresses the question of whether ex-post returns should be used in testing ex-ante asset pricing models. This chapter explores the impact of using IBES mean target price as a proxy for expected price in tests of the CAPM, Fama and French (1993) three factor and the Cahart (1997) four factor models. The analysis suggests that the expectation based proxy of returns performs in a similar manner to realized returns in asset pricing tests and thus the use of realized returns should not adversely bias asset pricing tests.

Chapter 4 and 5 add to the bond pricing literature by applying time-series studies to US and European bonds. Chapter 4 investigates common risk factors within the US corporate bond returns. The analysis shows that stock market factors do not add explanatory power to the bond return models used in this study. The bond market factor, DEF, dominates all other explanatory variables in regression analysis.

Chapter 5 of this dissertation examines the common risk factors explaining variation within the European corporate bond returns. The results are consistent with Chapter 4 indicating that the European DEF factor also captures much of the variation in European bond returns.

This dissertation enhances our understanding of the asset pricing models within a Fama and French (1993) time series framework for both equity and bond markets. Support is provided for the importance of leverage in asset pricing. The choice between realised returns and expected returns is also explored in this thesis, with the results suggesting that this choice has little impact on the results from time series asset pricing tests. The pricing of corporate bonds is also explored with evidence to confirm the Fama and French (193) result that equity and bond pricing models differ considerably in US market. Finally, it is found that the key pricing factors are common to both US and European corporate bonds.