Introducing Non-Linearities and Interaction Terms in a Conditional Asset Pricing Model

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Rask, K. (2016). Introducing Non-Linearities and Interaction Terms in a Conditional Asset Pricing Model. Unc Charlotte Electronic Theses And Dissertations.
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Abstract

Throughout history of the conditional asset pricing literature the goal has been to find the best possible model to explain what determines a firm’s expected stock return. In Dickson (2015) the variables that prove to be best at explaining a firm’s stock return is book-to-market, market capitalization, gross profitability, investment, short-term reversal, and momentum. The aim of this study is to further examine improvements in Dickson (2015) by changing the functional form and adding interaction terms between the variables. The chosen methodology is a version of the popular Fama-Macbeth regressions which are well documented in the literature to determine the added risk premium associated with firm characteristics. By allowing for the possibility of non-linear characteristics and interaction terms, this study shows that market capitalization follows a significant non-linear relationship with the average stock return and by adding the squared regressor to the model, the explanatory power and risk premium for market capitalization improves. The study further shows that including the interaction between investment and market capitalization improves the explanatory power of the investment variable and the market capitalization variable.

Details
Author

Rask, Kristoffer

Title

Introducing Non-Linearities and Interaction Terms in a Conditional Asset Pricing Model

Physical Description

1 online resource (40 pages) : PDF

Date

2016

Degree Granting Institution

University of North Carolina at Charlotte

Abstract

Throughout history of the conditional asset pricing literature the goal has been to find the best possible model to explain what determines a firm’s expected stock return. In Dickson (2015) the variables that prove to be best at explaining a firm’s stock return is book-to-market, market capitalization, gross profitability, investment, short-term reversal, and momentum. The aim of this study is to further examine improvements in Dickson (2015) by changing the functional form and adding interaction terms between the variables. The chosen methodology is a version of the popular Fama-Macbeth regressions which are well documented in the literature to determine the added risk premium associated with firm characteristics. By allowing for the possibility of non-linear characteristics and interaction terms, this study shows that market capitalization follows a significant non-linear relationship with the average stock return and by adding the squared regressor to the model, the explanatory power and risk premium for market capitalization improves. The study further shows that including the interaction between investment and market capitalization improves the explanatory power of the investment variable and the market capitalization variable.

Genre

masters theses

Subjects--Topics

Finance
Economics

Degree

M.S.

Keywords

Fama-Macbeth Regression
Functional Form
Interaction Terms
Stock-Picking

Subject Area

Economics

Advisor(s)

Depken, Craig

Committee Members

Dickson, Robert
Kirby, Christopher
Clark, Steven

Degree Note

Thesis (M.S.)--University of North Carolina at Charlotte, 2016.

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Rights Holder Information

Copyright is held by the author unless otherwise indicated.

Identifier

Rask_uncc_0694N_11084

Permalink

http://hdl.handle.net/20.500.13093/etd:1187