Quantity, Risk, and Return

Abstract

We propose a new model of expected stock returns that incorporates quantity information from market trading activities into the factor pricing framework. We posit that the expected return of a stock is determined by not only its factor risk exposures (beta) but also the factor's quantity fluctuations (q) induced by trading flows, and hence term the model beta times quantity (BTQ). The rationale is that sophisticated investors should demand a higher factor premium when they have absorbed noise trading flows of stocks with high loadings to that factor. The BTQ model provides a compelling risk-based explanation for stock returns, which is otherwise obscured without considering the quantity information. The cross-sectional risk-return association, which is nearly flat unconditionally, strongly depends on the quantity variable. The structured BTQ model reliably predicts monthly stock returns out of sample, and addresses the factor zoo problem by selecting a small number of factors.