A Stability Approach to Mean‐Variance Optimization

I jointly treat two critical issues in the application of mean‐variance portfolios, that is, estimation risk and portfolio instability. I find that theory‐based portfolio strategies, which are known to outperform naive diversification () in the absence of transaction costs, heavily underperform it under transaction costs. This is because they are highly unstable over time. I propose a generic method to stabilize any given portfolio strategy while maintaining or improving its efficiency. My empirical analysis confirms that the new method leads to stable and efficient portfolios that offer equal or lower turnover than and larger Sharpe ratio, even under high transaction costs.     

Information Transmission in the World Money Markets

Using 1,966 daily observations since the introduction of the euro, we apply cointegration and error correction tests to examine information transmission in the major world money markets as represented by the domestic CD markets and the Eurocurrency market for the US dollar, euro, Japanese yen, and British pound sterling. Our inter‐market tests show a high degree of integration and interdependency among inter‐market interest rates. Our intra‐market results show that $ LIBOR and LIBOR rates drive LIBOR and £ LIBOR. Application of Johansen's (1988) multivariate test procedure and Gonzalo and Granger's (1995) long‐memory components technique confirms and reinforces our intra‐market findings that the system of four LIBOR rates is fully integrated (i.e., three cointegrating vectors), with the single common trend driven by $ LIBOR and LIBOR. These results are consistent with the strength of the dollar and yen relative to the pound sterling and the euro during the developing world financial crisis in late 2008.     

Temperature and Growth: A Panel Analysis of the United States

We document that seasonal temperatures have significant and systematic effects on the U.S. economy, both at the aggregate level and across a wide cross section of economic sectors. This effect is particularly strong for the summer: a F increase in the average summer temperature is associated with a reduction in the annual growth rate of state‐level output of 0.15 to 0.25 percentage points. We combine our estimates with projected increases in seasonal temperatures and find that rising temperatures could reduce U.S. economic growth by up to one‐third over the next century.     

An Alternative Testable Form of the Consumption CAPM

This paper develops a consumption-oriented model of asset prices in a multigood economy that is, in principle, testable even when aggregate consumption of goods and their market prices are only partially observable. Previous studies show that, when there are m consumption goods, equilibrium expected excess returns on securities are functions of their covariances with $m+1$ variables—aggregate consumption expenditure and market prices of consumption goods. Without making any further assumptions, the present model shows that a similar equilibrium relationship can be expressed in terms of covariances of asset returns with the following $m+1$ variables: market prices of k consumption goods and aggregate consumption of $m+1?k$ goods. Because the author's result provides researchers with some flexibility in choosing the set of $m+1$ variables that measure riskiness of securities, it should lead to more powerful tests of the model.     

Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events ${(\lambda }^{?})$, but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single‐factor model with ${\lambda }^{?}$ following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in ${\lambda }^{?}$ are found to be economically significant and co‐vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy.     

R2

Even with hindsight, the ability to explain stock price changes is modest. $R^2$s were calculated for the returns of large stocks as explained by systematic economic influences, by the returns on other stocks in the same industry, and by public firm-specific news events. The average adjusted $R^2$ is only about .35 with monthly data and .20 with daily data. There is little relation between explanatory power and either the firm's size or its industry. There is little improvement in $R^2$ from eliminating all dates surrounding news reports in the financial press. However, the sample kurtosis is quite different when such news events are eliminated, thereby revealing a mixture of return distributions. Non-news dates also indicate the presence of a distributional mixture, perhaps due to traders acting on private information.     

On the Effects of Barriers to International Investment

A simple model is presented in which it is costly for domestic investors to hold foreign assets. The implications of the model for the composition of optimal portfolios at home and abroad are derived. It is shown that all foreign assets with a beta larger than some beta ${\beta }^{*}$ plot on either one of two security market lines. Some foreign assets with a beta smaller than ${\beta }^{*}$ are not held by domestic investors even if their expected return is increased slightly.     

Assessing Goodness-of-Fit of Asset Pricing Models: The Distribution of the Maximal R2

The development of asset pricing models that rely on instrumental variables together with the increased availability of easily-accessible economic time-series have renewed interest in predicting security returns. Evaluating the significance of these new research findings, however, is no easy task. Because these asset pricing theory tests are not independent, classical methods of assessing goodness-of-fit are inappropriate. This study investigates the distribution of the maximal $R^2$ when k of m regressors are used to predict security returns. We provide a simple procedure that adjusts critical $R^2$ values to account for selecting variables by searching among potential regressors.     

Patterns of Productivity in the Finance Literature: A Study of the Bibliometric Distributions

This study finds a bibliometric regularity in the finance literature that the number of authors publishing n papers is about $1/n^c$ of those publishing one paper. We find that the finance literature conforms very well to the inverse square law $(c=2)$ if data are taken from a large collection of journals. When applied to individual finance journals, we find that values of c range from 1.95 to 3.26. We also find that top-rated journals have higher concentrations among their contributors. This implies that the phenomenon “success breeds success” is more common in higher quality publications.     

Growth Opportunities and Risk-Taking by Financial Intermediaries

We show that growth opportunities which cannot be converted to cash under conditions of financial distress $\left(G_z\right)$ are a critical determinant of an intermediary's choice of risk. Financial institutions in which $G_z$ is a low proportion of total assets will be much more likely to engage in go-for-broke behavior. The model leads to a reevaluation of the effectiveness of several traditional remedies for dealing with banks that take excessive risks such as raising insurance premiums, intervening before capital is depleted, and restricting investment options. The model also has implications about a new approach to the examination of financial intermediaries.     

Superkurtosis

Very little is known on how traditional risk metrics behave under intraday trading. We fill this void by examining the finiteness of the returns' moments and assessing the impact of their infinity in a risk management framework. We show that when intraday trading is considered, assuming finite higher order moments, potential losses are materially larger than what the theory predicts, and they increase exponentially as the trading frequency increases—a phenomenon we call $superkurtosis$. Hence, the use of the current risk management techniques under intraday trading imposes threats to the stability of financial markets, as capital ratios are severely underestimated.     

Internal Capital Markets in Business Groups: Evidence from the Asian Financial Crisis

This paper examines capital reallocation among firms in Korean business groups ( $chaebol$) in the aftermath of the 1997 Asian financial crisis, and the consequences of this capital reallocation for the investment and performance of $chaebol$ firms. We show that $chaebol$ transferred cash from low‐growth to high‐growth member firms, using cross‐firm equity investments. This capital reallocation allowed chaebol firms with greater investment opportunities to invest more than control firms after the crisis. These firms also showed higher profitability and lower declines in valuation than control firms following the crisis. Our results suggest that chaebol internal capital markets helped them mitigate the negative effects of the Asian crisis on investment and performance.     

Asset-pricing Tests under Alternative Distributions

Given the normality assumption, we reject the mean-variance efficiency of the Center for Research in Security Prices value-weighted stock index for three of the six consecutive ten-year subperiods from 1926 to 1986. However, the normality assumption is strongly rejected by the data. Under plausible alternative distributional assumptions of the elliptical class, the efficiency can no longer be rejected. When the normality assumption is violated but the ellipticity assumption is maintained, many tests tend to be biased toward overrejection and both the accuracy of estimated beta and $R^2$ are usually overstated.     

Restaurant Prices and the Minimum Wage

In this paper, we examine the effect of the minimum wage on restaurant prices. We contribute both to the study of economic impact of the minimum wage and to the study of microeconomic patterns of price stickiness. For this purpose, we use a unique data set of individual price quotes collected to calculate the Consumer Price Index in France and we estimate a price rigidity model based on a flexible rule. We find a positive and significant impact of the minimum wage on prices. The effect of the minimum wage on prices is, however, very protracted. A change in the minimum wage takes more than a year to fully pass through to retail prices.     

Assessing Specification Errors in Stochastic Discount Factor Models

In this article we develop alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly. Unlike comparisons based on ${\chi }^2$ statistics associated with null hypotheses that models are correct, our measures of model performance do not reward variability of discount factor proxies. One of our measures is designed to exploit fully the implications of arbitrage-free pricing of derivative claims. We demonstrate empirically the usefulness of our methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature.     

Predictive Regressions: A Present‐Value Approach

We propose a latent variables approach within a present‐value model to estimate the expected returns and expected dividend growth rates of the aggregate stock market. This approach aggregates information contained in the history of price‐dividend ratios and dividend growth rates to predict future returns and dividend growth rates. We find that returns and dividend growth rates are predictable with $R^2$ values ranging from 8.2% to 8.9% for returns and 13.9% to 31.6% for dividend growth rates. Both expected returns and expected dividend growth rates have a persistent component, but expected returns are more persistent than expected dividend growth rates.     

Portfolio Inefficiency and the Cross-section of Expected Returns

The Capital Asset Pricing Model implies that (i) the market portfolio is efficient and (ii) expected returns are linearly related to betas. Many do not view these implications as separate, since either implies the other, but we demonstrate that either can hold nearly perfectly while the other fails grossly. If the index portfolio is inefficient, then the coefficients and $R^2$ from an ordinary least squares regression of expected returns on betas can equal essentially any values and bear no relation to the index portfolio's mean-variance location. That location does determine the outcome of a mean-beta regression fitted by generalized least squares.     

A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market

In an efficient market, the fundamental value of a security fluctuates randomly. However, trading costs induce negative serial dependence in successive observed market price changes. In fact, given market efficiency, the effective bid-ask spread can be measured by $\text{Spread}=2\sqrt{?\text{cov}}$ where “cov” is the first-order serial covariance of price changes. This implicit measure of the bid-ask spread is derived formally and is shown empirically to be closely related to firm size.     

A Theoretical Framework for Evaluating the Impact of Universal Reserve Requirements

This paper provides an appropriate framework to evaluate the impact of the universal reserve requirements called for by the new DIDMC Act of 1980. We derived the optimal reserve ratios for a dual banking system under the objective of controlling the monetary aggregates and the level of output. Then optimal reserve requirements were calculated from illustrative money market and macroeconomic parameters since the usual comparative statics were not useful. The results, generally, suggested optimal reserve ratios which were significantly higher than the old dual or the new universal reserve regimes for all targets. However, the calculation of values for the loss functions under various reserve regimes suggests that attainment of $r_1^{*},r_2^{*}$ and $t^{*}$ may not be imperative, since the discrepancy between losses for optimal and various nonoptimal reserve schemes were not large. A major result of this paper, observed for both monetary and real targets, was that the differences in the instability of the targets for the old dual reserve ratios and the Fed's new universal reserve scheme were small. This result clearly suggests that although the DIDMC Act may solve the Federal Reserve's membership problem, it will not significantly enhance the Fed's effectiveness in controlling monetary or real sector aggregates.     

A Multivariate Linear Regression Test for the Arbitrage Pricing Theory

A test for the arbitrage pricing theory which employs a multivariate linear regression model is developed. Given a sample of return premiums for a set of N assets which includes a subset of k linearly independent portfolios, the k factor APT hypothesis is accepted if the intercept term is zero in the multivariate regression of the $(N?k)$ returns on the k portfolios. The test may be carried out simply, by using univariate multiple regression software. The relation of this test to the concept of performance potential and Sharpe's measure of performance is also discussed. If the performance potential of the k portfolios is not significantly less than the performance potential of the complete set of N assets, then the k factor APT hypothesis is accepted.