I’m working on a business discussion question and need an explanation to help me learn.
1. A common factor in the cross section of stock returns is a factor that has significant impact for all the firms across time. For example, Fama and French (in a series of academic papers back in the 90s) propose common factors, size and value premium, in addition to market risk premium. What do you think can be a common factor in the cross section of stock returns? Discuss the reason.
2. Read the article below. Study the definition of “factor investing” and “smart beta strategy“. Comment on how do real-time trading frictions (transaction costs, re-balancing costs, etc) affect practitioners when trading on theoretical asset pricing models (factor models, anomalies, etc).
- Make your initial post.
- Reply to at least two other students’ posts.
POSTS
student1:
1. Another common factor in the cross-section of stock returns is operational profitability as noted in Fama and French’s five factor model. I think this makes intuitive sense being that profitability is what allows for a company to stay in business over time. There is a difference between operational and financial profitability, with the exception of financial institutions, because operational profitability is considered a part of the core business and much more stable than financial profitability which can be more opportunistic and is commonly reflected in the cash flows from investing.
2. Simply put, real-time trading frictions affect the assumptions that practitioners rely on. In theoretical models, the environments are much more controlled and constant as opposed to the real markets. Coupled with this are assumptions such as estimated trading costs and assumed liquidity. In actual markets, trading costs are vary based on liquidity causing real price impacts to vary from modeled estimates. Lastly, the timing of trades when re-balancing or opportunistic trades can vary outside of modeled deviations causing large differences in the ability and cost to execute trades.
student 2
I think profitability can be considered as the common factor because the companies that report higher future earnings can generate higher stock returns. Investment is another common factor because companies that put money in growth projects will likely receive negative returns in the stock market.
When theoretical asset pricing models show arbitrage opportunities, practitioners may not receive excess returns by trading due to the real-time trading frictions. For a given trading time horizon, as the trade size goes up, the transaction costs go up at a decreasing rate. However, for a given trade size, if the practitioners are flexible with the trading horizon, the transaction costs will decrease with longer trading horizons.
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