Implied Equity Duration: A New Measure of Equity Risk

Abstract

Duration is an important and well-established risk characteristic for fixed income securities. We use recent developments in financial statement analysis research to construct a measure of duration for equity securities. We find that the standard empirical predictions and results for fixed income securities extend to equity securities. We show that stock price volatility and stock beta are both positively correlated with equity duration. Moreover, estimates of common shocks to expected equity returns extracted using our measure of equity duration capture a strong common factor in stock returns. Additional analysis shows that the book-to-market ratio provides a crude measure of equity duration and that our more refined measure of equity duration subsumes the Fama and French (1993) book-to-market factor in stock returns. Our research shows how structured financial statement analysis can be used to construct superior measures of equity security risk.

Aggregate earnings and stock market returns: The good, the bad, and the state-dependent

“…Specifically, prior research finds that the share prices of small firms are more sensitive to changes in interest rates (i.e., risk-free rate) ( Gertler and Gilchrist, 1994;Christiano et al, 1996;Perez-Quiros and Timmerman, 20 0 0 ). Prior research also shows that the stocks of growth firms have higher equity duration ( Dechow et al, 2004 ), which implies that the share prices of growth firms are more sensitive to changes in interest rates. Given our conclusion above that market participants interpret aggregate earnings surprises in state 1-but not in state 2-to be informative primarily about changes in the risk-free rate, it follows that in state 1-but not in state 2-the effect of aggregate earnings surprises on share prices will be greater for small-cap (growth) firms than for large-cap (value) firms.…”

A Theory of Housing Collateral, Consumption Insurance and Risk Premia

“…Growth stocks (value stocks) can be thought of as a basket of consumption strips that is heavily weighted towards longer (shorter) maturities (Dechow, Sloan, and Soliman (2002) and Lettau and Wachter (2004)). Consumption strips are claims to period t + k aggregate consumption (c t+k ), where k is the horizon in years.…”

“…The corresponding baskets have a duration between 2.3 years and 43 years. We think of the basket with duration of 5 years as the value stock and the basket with duration of 40 years as the growth stock (Dechow, Sloan, and Soliman (2002)). The value spread is 3.9 percent for γ = 5 and 5.7 percent for γ = 8.…”

A New Measure of Equity Duration: The Duration-Based Explanation of the Value Premium Revisited

“…3 This work is related to several recent studies that examine the relation of a firm's equity or cash-flow duration to the cross-section of stock returns and, more particular, the value premium. Dechow et al (2004) and Da (2009) show that cross-sectional differences in the firms' duration can explain a substantial part of the cross-section of stock returns. Similar to us, Dechow et al (2004) demonstrate that equity duration and B/M ratio are closely related to each other, suggesting that both concepts capture similar risk.…”