The Network Factor of Equity Pricing: A Signed Graph Laplacian Approach

The connections among firms exhibit heterogeneity, complexity, and dynamism, posing a challenge for traditional unsigned network models. This article proposes a signed graph Laplacian approach to construct a dynamic network index (DNI), quantifying the aggregate changes in the market network over time. A larger DNI indicates more significant changes in firms' interconnectedness and in the market network structure. Firms with higher sensitivity to DNI exhibit lower expected returns. Incorporating DNI into conventional asset pricing models improves return predictability. Results are robust for multiple estimators, various factor models, and different selections of test assets. Our findings suggest that the network factor generates a significant equity risk premium.