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Two essays on empirical asset pricing : 1. Forecasted earnings per share and the cross section of expected returns and 2. The limits to arbitrage and the fundamental value-to-price trading strategies

Forecasted earnings per share and the cross section of expected returns

Limits to arbitrage and the fundamental value-to-price trading strategies

Authors Zhang, Jie
Issue Date 2006
Summary Essay 1: Forecasted Earnings per Share and the Cross Section of Expected Returns. In this paper, we document that analysts' forecasted earnings per share (FEPS) can predict subsequent stock returns. More specifically, stocks with higher FEPS earn substantially higher future returns than do stocks with lower FEPS, even after controlling for the market risk, the size, value and earnings-to-price effects, and price and earnings momentum. This FEPS effect is the strongest in stocks that are small in firm size, low in stock prices, low in analyst coverage, and past losers. Furthermore, the FEPS effect sustains over a long period of time without any subsequent reversal. We also find that trading strategies based on FEPS are not fundamentally riskier. The abnormal returns on FEPS trading strategies are even countercyclical to the overall market performance. Further analysis indicates that stocks with lower FEPS show larger ex ante forecast errors measured by (FEPS - Actual)/\Actual\) relative to stocks with higher FEPS, and the abnormal returns are partially concentrated over the three-day windows around future earnings announcements. This evidence is consistent with the errors-in-expectations explanation that investors overvalue (undervalue) stocks when their expectations about EPS are low (high). Our results are robust to several risk-adjustment techniques, various measures of earnings, and are not due to outliers or sample selections. Essay 2: The Limits to Arbitrage and the Fundamental Value-to-Price Trading Strategies. Shleifer and Vishny (1997) [56] argue that arbitrage can be both costly and risky. As a result, arbitrageurs will not exploit arbitrage opportunities if the costs and risk of arbitrage exceed its benefits, thereby allowing mispricing to survive for long periods of time. Frankel and Lee (1998) [32] document that the fundamental value-to-price (Vf/P) ratio predicts cross-sectional returns for up to three years, where Vf is an estimate of fundamental value based on a residual income model that uses analyst earnings forecasts. Ali, Hwang and Trombley (2003a) [1] further show that their results seem consistent with the mispricing explanation rather than with the risk explanation of the Vf/P effect. Thus, the Vf/P effect provides a good means to examine the limits of arbitrage. We find that the Vf/P effect is extremely weak in stocks of short history of listing, low investor sophistication, high divergence of opinion, high idiosyncratic return volatility, and high transaction costs. Further analysis shows that firm age, earnings quality, and divergence of opinion have incremental power beyond other measures of risk in explaining the cross-sectional variation in the Vf/P effect. Our results appear to be consistent with the argument of the limits of arbitrage. More specifically, when arbitrageurs exploit arbitrage opportunities, they seek to avoid mispriced stocks with the greatest arbitrage risk.
Note Thesis (Ph.D.)--Hong Kong University of Science and Technology, 2006
Language English
Format Thesis
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