Literatures of Stock market Yaofei Xu

Maps of how Stock interacted with attended parties and Macroeconomy – Figure 1

Maps of how Stock interacted with industries and inside working mechanism – Figure 2

（1) Stock valuation under structure option pricing theory Conclusion: Eisdorfer et al., (2019) argue default options (abandon the firm) are mispriced in equity values by using structural option pricing theory and combining firm-specific accounting inputs in US. They find, longing the undervalued and shorting the overvalued stocks in USA can obtain 11% four-factor alpha, by using the ratio of model value to market value of equity. They address two problems in equity valuation: 1) estimate future cash flow better; 2) doing the pricing under Q-measure which deal with the problem of discount rate. Motivation: The sources of equity misvaluation are attributed primarily to investors’ cognitive biases; In literature, the equity of a firm with debt in its capital structure is analogous to a call option written on the assets of the firm. Research Questions: 1 ) whether analysts and investors incorporate this option-based approach in their equity valuations? 2) whether their failure to do so gives rise to misvaluation? .

Logic and methodology behind this paper

Define Cash flow/ driver of cash flow Project inflow (driver of CF) Valuation Model Define Cash flow/ driver of cash flow Outflow(PS: interest, principle of debts)

Drift of driver (state x: gross margin) at P-measure Authors assume that, P-measure drift of operating cash flows is same as P-measure drift of gross margin (state variable: x)

P-measure drift changes to Q-measure / define volatility Authors assume, P-measure dividend equals to Q-measure dividend. And then, Q-measure drift of x can be obtained.

Valuation of equity under this model

equity value = operating firm forever + value of default option

Other findings: considering the factor loadings, overvalued stocks are closer to small, value, past return loser, and unprofitable stocks than are undervalued stocks. the degree of mispricing is higher for firms with lower information transparency (analyst coverage, institutional ownership, and availability of listed options). considering the time-series variation of mispricing, their long-short strategy performs better in recessions and during times of high sentiment, in line with their conjecture that valuation difficulties are more pronounced during such times. considering the post-formation variables (equity issuance, institutional ownership, insider trading, probability of mergers, and acquisitions), they find that overvalued firms are more likely to issue equity, have lower institutional ownership, are sold more actively by insiders, and have a lower probability of being acquired than undervalued firms.

(2) predictive power on future return by using firm characteristics Conclusion: Green et al., (2017) examines the 94 firm characteristics on monthly stock return. They find that only 12 of 94 characteristics provide independent information in non-microcaps from 1980 to 2014 and that just 2 characteristics matter after 2003. Explanation: characteristics-based predictability reflects mispricing and that mispricing declines as the cost of exploiting it declines. 2003 Market changes made it cheaper and technologically easier to rapidly implement quantitative long/short trading strategies. Thus, consistent with the costly-limits-to-arbitrage arguments. Methodology: Fama-MacBeth regressions Motivation: John H. Cochrane (2011) challenges researchers to identify the firm characteristics that provide independent information about average U.S. stock returns.

Thinking Macroeconomy is the most important one, directly influencing the discount rate/future cash flow of company’s projects, and driving the belief of insiders (CEO and manager) and outsiders (traders and information disclosure parties). Investors’ belief dispersion creates the stock price fluctuation, while agreed belief creates the one price. Moreover, The abnormal alpha under traditional asset pricing model is directly related to the mis-valuation of stock price. If the research question is When the stock price’ mis-valuation will happen ? and how long the stock price’ mis-valuation will disappear ? We need to solve two questions: 1) What is the optimal stock price valuation model ? (can we incorporate macroeconomic process in model of Eisdorfer et al., (2019)) 2) What is the dynamic process of investors’ belief dispersion ? ( around the announcement days – intense information period ; non-announcement days – less information period)

Reference EISDORFER, A. , GOYAL, A. and ZHDANOV, A. (2019), Equity Misvaluation and Default Options. The Journal of Finance, 74: 845-898. doi:10.1111/jofi.12748 Green, J., Hand, J. R., & Zhang, X. F. (2017). The characteristics that provide independent information about average us monthly stock returns. The Review of Financial Studies, 30(12), 4389-4436.