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THE JOURNAL OF FINANCE • VOL. LVI, NO. 2 • APRIL 2001
Explaining the Cross-Section of Stock
Returns in Japan:
Factors or Characteristics?
KENT DANIEL, SHERIDAN TITMAN, and K. C. JOHN WEI*
ABSTRACT
Japanese stock returns are even more closely related to their book-to-market ratios
than are their U.S. counterparts, and thus provide a good setting for testing whether
the return premia associated with these characteristics arise because the charac-
teristics are proxies for covariance with priced factors. Our tests, which replicate
the Daniel and Titman 1997 tests on a Japanese sample, reject the Fama and
French 1993 three-factor model, but fail to reject the characteristic model.
FINANCIAL ECONOMISTS HAVE EXTENSIVELY STUDIED the cross-sectional determi-
nants of U.S. stock returns, and contrary to theoretical predictions, find very
little cross-sectional relation between average stock returns and systematic
risk measured either by market betas or consumption betas. In contrast, the
cross-sectional patterns of stock returns are closely associated with charac-
teristics like book-to-market ratios, capitalizations, and stock return momen-
tum.1 More recent research on the cross-sectional patterns of stock returns
documents size, book-to-market, and momentum in most developed countries.
Fama and French 1993, 1996, and 1998 argue that the return premia
associated with size and book-to-market are compensation for risk, as de-
scribed in a multifactor version of Merton’s 1973 Intertemporal Capital
Asset Pricing Model ICAPM or Ross’s 1976 Arbitrage Pricing Theory.
They propose a three-factor model in which the factors are spanned by
three zero-investment portfolios: Mkt is long
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