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What Does the Cross‐Section Tell About Itself? Explaining Equity Risk Premia with Stock Return Moments

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  • ILAN COOPER
  • LIANG MA
  • PAULO MAIO

Abstract

We derive a parsimonious equilibrium three‐factor asset pricing model (cross‐sectional CAPM, CS‐CAPM) in which the realized cross‐sectional second and third moments of long‐short equity portfolio returns are the driving forces in terms of pricing cross‐sectional equity risk premia. Stock market segmentation implies that these two (nonmarket) factors are priced in equilibrium. The three‐factor model offers a large fit for the joint cross‐sectional risk premia associated with 26 prominent CAPM anomalies, with explanatory ratios around or above 40%. The CS‐CAPM compares favorably with multifactor models widely used in the literature. The cross‐sectional factors are not subsumed by traditional ICAPM risk factors.

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  • Ilan Cooper & Liang Ma & Paulo Maio, 2022. "What Does the Cross‐Section Tell About Itself? Explaining Equity Risk Premia with Stock Return Moments," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(1), pages 73-118, February.
    • Handle: RePEc:wly:jmoncb:v:54:y:2022:i:1:p:73-118
    DOI: 10.1111/jmcb.12823
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