Expected Returns and Volatility of Fama-French Factors

In this paper, I show that the variance of Fama-French factors, the variance of the momentum factor, as well as the correlation between these factors, predict an important fraction of the timeseries variation in post-1990 aggregate stock market returns. This predictability is particularly strong from one month to one year, and it dominates that afforded by the variance risk premium and other popular predictor variables such as P/D ratio, the P/E ratio, the default spread, and the consumption-wealth ratio. In a simple representative agent economy with recursive preferences, I model the portfolio weight in each asset as a function of a stock’s characteristics and show that the market return can be predicted by these variances. (JEL C22, C51, C52, G12, G13, G14) ∗Fousseni CHABI-YO is from the Fisher College of Business, The Ohio State University. I am grateful to Kewei Hou, Rene Stulz, Hao Zhou, Ingrid Werner, and seminar participants at the Ohio State University. I thank Kenneth French for making a large amount of historical data publicly available in his online data library. I welcome comments, including references to related papers I have inadvertently overlooked. I thank the Dice Center for Financial Economics for financial support. Correspondence Address: Fousseni Chabi-Yo, Fisher College of Business, Ohio State University, 840 Fisher Hall, 2100 Neil Avenue, Columbus, OH 43210-1144. email: chabi-yo [email protected] Expected Returns and Volatility of Fama-French Factors Abstract In this paper, I show that the variance of Fama-French factors, the variance of the momentum factor, as well as the correlation between these factors, predict an important fraction of the timeseries variation in post-1990 aggregate stock market returns. This predictability is particularly strong from one month to one year, and it dominates that afforded by the variance risk premium and other popular predictor variables such as P/D ratio, the P/E ratio, the default spread, and the consumption-wealth ratio. In a simple representative agent economy with recursive preferences, I model the portfolio weight in each asset as a function of a stock’s characteristics and show that the market return can be predicted by these variances. (JEL C22, C51, C52, G12, G13, G14)In this paper, I show that the variance of Fama-French factors, the variance of the momentum factor, as well as the correlation between these factors, predict an important fraction of the timeseries variation in post-1990 aggregate stock market returns. This predictability is particularly strong from one month to one year, and it dominates that afforded by the variance risk premium and other popular predictor variables such as P/D ratio, the P/E ratio, the default spread, and the consumption-wealth ratio. In a simple representative agent economy with recursive preferences, I model the portfolio weight in each asset as a function of a stock’s characteristics and show that the market return can be predicted by these variances. (JEL C22, C51, C52, G12, G13, G14)