A0719
Title: News-implied linkages and local dependency in the equity market
Authors: Shuyi Ge - University of Nankai (China) [presenting]
Oliver Linton - University of Cambridge (United Kingdom)
Shaoran Li - Peking University (China)
Abstract: The purpose is to study a heterogeneous coefficient spatial factor model that separately addresses both common factor risks (strong cross-sectional dependence) and local dependency (weak cross-sectional dependence) in the equity returns. From the asset pricing perspective, we derive the theoretical implications of no asymptotic arbitrage for the heterogeneous spatial factor model. In empirical work, it is challenging to measure granular firm-to-firm connectivity for a high-dimensional panel of equity returns. We use extensive business news to construct firms' links via which local shocks transmit, and we use those news-implied linkages as a proxy for the connectivity among firms. Empirically, we document a considerable degree of local dependency among S\&P 500 stocks, and the spatial component does a great job in capturing the remaining correlations in the de-factored returns. We find that adding spatial interactions to factor models reduces mispricing and mean-squared errors. We also show that our news-implied linkages provide a comprehensive and integrated proxy for firm-to-firm connectivity, and it out-performs other existing networks in the literature.
