The Nature of Asset Pricing Anomalies : Characteristics versus Covariances of Factor Exposures

Abstract

In this thesis, I test whether the return premia associated with firm characteristics such as value, size, operating profitability, investment, momentum, and equity status are driven by firm characteristics or exposure to risk factors (covariances) in the U.S. stock market. I find that the value, operating profitability, investment, and market risk (equity status) premia are associated with firm characteristics rather than covariances with corresponding risk factors. The firms with these characteristics earn a return premium irrespective of their risk factor loadings, and the factor loadings explain the returns only to the extent to which they proxy for corresponding characteristics. On the contrary, the size premium is mostly driven by the covariances with the SMB factor, as the premium is evident even after controlling for the size characteristic. For the momentum premium, the covariance structure of returns is unstable, and no convincing conclusions can be drawn with the methodology used in this thesis.