The intertemporal relation between expected returns and risk

This paper explores the time-series relation between expected returns and risk for a large cross section of industry and size/book-to-market portfolios. I use a bivariate generalized autoregressive conditional heteroskedasticity (GARCH) model to estimate a portfolio's conditional covariance with the market and then test whether the conditional covariance predicts time–variation in the portfolio's expected return. Restricting the slope to be the same across assets, the risk-return coefficient is highly significant with a risk–aversion coefficient (slope) between one and five. The results are robust to different portfolio formations, alternative GARCH specifications, additional state variables, and small sample biases. When conditional covariances are replaced by conditional betas, the risk premium on beta is estimated to be in the range of 3% to 5% per annum and is statistically significant.     

The intertemporal relationship between market return and variance: an Australian perspective

In this paper we investigate the intertemporal relationship between the market risk premium and its conditional variance in an Australian setting. Using a bivariate EGARCH‐M model combined with the dynamic conditional correlation (DCC) framework as proposed by Engle (2000), we find evidence of a positive relationship between the market risk premium and its variance and evidence of two distinct interest rate effects. Furthermore, while the bond market's own variance is not priced by investors, we find that the covariance between equity and bond markets is a significant risk factor that is priced in the market.     

A model for tax advantages of portfolios with many assets

Taxable portfolios present challenges for optimization models with even a limited number of assets. Holding many assets, however, has a distinct tax advantage over holding few assets. In this paper, we develop a model that takes an extreme view of a portfolio as a continuum of assets to gain the broadest possible advantage from holding many assets. We find the optimal strategy for trading in this portfolio in the absence of transaction costs and develop bounding approximations on the optimal value. We compare the results in a simulation study to a portfolio consisting only of a market index and show that the multi-asset portfolio’s tax advantage can lead either to significant consumption or bequest increases.     

How do policy and information shocks impact co-movements of China’s T-bond and stock markets?

We investigate the impacts of policy and information shocks on the correlation of China’s T-bond and stock returns, using originally the asymmetric dynamic conditional correlation (DCC) model that allows for the coexistence of opposite-signed asymmetries. The co-movements of China’s capital markets react to large macroeconomic policy shocks as evidenced by structural breaks in the correlation following the drastic 2004 macroeconomic austerity. We show that the T-bond market and the bond–stock correlations bear more of the brunt of the macroeconomic contractions. We also find that the bond–stock correlations respond more strongly to joint negative than joint positive shocks, implying that investors tend to move both the T-bond and stock prices in the same direction when the two asset classes have been hit concurrently by bad news, but tend to shift funds from one asset class to the other when hit concurrently by good news. However, the stock–stock correlation is found to increase for joint positive shocks, indicating that investors tend to herd more for joint bullish than joint bearish stock markets in Shanghai and Shenzhen.     

Reference point formation by market investors

The disposition effect [Shefrin, H., Statman M., 1985, The disposition to sell winners too early and ride losers too long. Journal of Finance, 40, 777–790], investors’ tendency to sell gaining assets and hold on to loosing assets, relies on the notion of a reference point distinguishing between losses and gains. While literature using aggregated market data documented the existence of such a reference point affecting investors’ decisions, it had not pinpointed it. The main goal of our work is to shed light on the mechanism of reference point formation. We hypothesize that salient events taking place during a stock’s holding period influence investors’ perceptions and make them update the stock’s reference point. Using analysts’ earnings forecasts, stock price data, and firms’ quarterly earnings announcements, we document that company-specific events indeed affect the reference points. We discover that the earnings announcements played a role in reference point formation when they were not anticipated, i.e., when (i) analysts’ earnings forecasts failed to provide accurate predictions; and (ii) the earnings announcements were followed by market price reactions. Moreover, the reference points were affected more profoundly for low market capitalization, high beta firms, pointing that the reference point updating process is more reactive to events when information flow is low and prices are sensitive to market fluctuations. Our results also corroborate the attention hypothesis, i.e., the observation that agents facing numerous alternatives may consider primarily those that have caught their attention.     

Optimizing international portfolios with options and forwards

We develop a stochastic programming model to address in a unified manner a number of interrelated decisions in international portfolio management: optimal portfolio diversification and mitigation of market and currency risks. The goal is to control the portfolio’s total risk exposure and attain an effective balance between risk and expected return. By incorporating options and forward contracts in the portfolio optimization model we are able to numerically assess the performance of alternative tactics for mitigating exposure to the primary risks. We find that control of market risk with options has more significant impact on portfolio performance than currency hedging. We demonstrate through extensive empirical tests that incremental benefits, in terms of reducing risk and generating profits, are gained when both the market and currency risks are jointly controlled through appropriate means.     

How important is asymmetric covariance for the risk premium of international assets?

This paper empirically investigates the importance of asymmetric conditional covariance when computing the risk premium of international assets. Conditional second moment asymmetry of equity indices is significant and varies over time. The risk premia estimated allowing for asymmetry are statistically and economically different from risk premia estimated without allowing for asymmetry. In particular, an international investor who ignores covariance asymmetry overestimates required returns for equities of the G4 countries and for the world market, on average.     

Forecasting time-varying covariance with a range-based dynamic conditional correlation model

This paper proposes a range-based dynamic conditional correlation (DCC) model combined by the return-based DCC model and the conditional autoregressive range (CARR) model. The substantial gain in efficiency of volatility estimation can boost the accuracy for estimating time-varying covariances. As to the empirical study, we use the S&P 500 stock index and the 10-year treasury bond futures to examine both in-sample and out-of-sample results for six models, including MA100, EWMA_, CCC_, BEKK, return-based DCC, and range-based DCC. Of all the models considered, the range-based DCC model is largely supported in estimating and forecasting the covariance matrices.     

Corporate valuation around the world: The effects of governance,growth, and openness

The purpose of this paper is to provide a comprehensive analysis of corporate valuation around the world. Specifically, we (i) document and compare corporate valuation around the world, and (ii) identify the key factors that drive cross-country differences in valuation. In doing so, we utilize the country-level Tobin’s q (CTQ), computed as the ratio of the aggregate market value to book value of all assets held by all public firms domiciled in a country, which amounts to the Tobin’s q for the ‘market portfolio’ of the country. The key findings of the paper are: First, CTQ varies greatly across countries, ranging from 0.73 for Venezuela to 2.11 for Finland, with the international mean of 1.30 during our sample period 1999–2004. Despite the steady integration of the world economy in recent years, corporate valuation remains starkly different across countries. Second, apart from the effect of corporate governance, cross-country differences in corporate valuation are significantly driven by the growth options of countries represented by the R&D intensities, capital expenditures, and GDP growth. In addition, the degree of capital market openness has a significant, independent effect on valuation. Third, our regression analyses show that CTQ varies directly with shareholder rights, enforcement of insider trading laws, GDP growth, R&D intensity, and the degree of capital market openness. The key findings remain robust to the inclusion of inflation and industry effects.     

On market price of risk in Asian capital markets around the Asian flu

This study investigates a contemporaneous relationship between realized market risk premia, and conditional variance and covariance in nine Asian markets and the US. The time period for this study is before, during, and after the Asian financial crisis. A contemporaneous state-dependent capital asset pricing model (CAPM) that allows for negative and positive market prices of variance and covariance risk is investigated. In the light of significant upstate and downstate reward to local and world variance risk for all markets and all periods, we conclude that a market return-generating process is a piecewise function of local and world variance over time. Furthermore, a cross-sectional analysis of upstate and downstate market prices of variance and covariance risk indicates that reward to risk is a mix of reward to local and world variance, depending on the ever-changing correlation with the world market. Our findings are consistent with the one-factor conditional international CAPM.     

Foreign Shocks on Chilean Financial Markets: Spillovers and Comovements Between Bond and Equity Markets

Abstract:

The domestic impact of external shocks will depend on the degree of coupling of domestic assets to foreign markets, but also on the spillovers among assets. The covariance between different types of assets could be affected by new information. Changes in the covariance, for example, could come from a stronger rebalancing between stocks and bonds. Therefore, we will analyze four different assets-government bonds, corporate bonds, money market instruments, and equities-and study the conditional correlation between them. We find that the corporate bond market tends to increase coupling in turbulent times, while the money market decreases coupling. We propose to test international spillovers taking into account a methodology for estimating the conditional mean, variance, and covariance on domestic bond and equity markets, while considering that shocks may have asymmetric effects depending on whether the news is good or bad.     

An alternative measure of the “world market portfolio”: Determinants, efficiency, and information content

The world market portfolio plays an important role in international asset pricing, but is unobservable in practice. We first propose a framework for constructing a market proxy that corresponds to the “market portfolio” of financial theory. We then construct this proxy, analyze its determinants and test its efficiency and explanatory power over the period 1975-2007 with respect to the return generating processes of a broad asset universe. We show that its major determinants are traded assets and that it is not efficient. However, it is significant for explaining individual asset returns over an asset universe that includes stocks, bonds, money markets and commodities. The explanatory information is incremental to what is available in traded asset prices and the significance of this information is robust with respect to diversified portfolios generated by factor analysis and to characteristic-sorted portfolios as well as to various model specifications, including the single-index model, the Fama-French (1992) three factor model for stocks, and various specifications of multi-index models hedged and unhedged for foreign currency risk.     

Time-series and cross-sectional excess comovement in stock indexes

This paper is an empirical investigation of the excess comovement among 82 industry indexes in the U.S. stock market between January 5, 1976 and December 31, 2001. We define excess comovement as the covariation between two assets beyond what can be explained by fundamental factors. In our analysis, the fundamental factors are sector groupings and the three Fama-French factors. We then estimate residuals of joint (FGLS) rolling regressions of these fundamentals on industry returns. Finally, we compute excess comovement as the mean of square unconditional, statistically significant correlations of these residuals. We show that excess comovement is high (about 0.07, i.e., equivalent to an average absolute correlation of 0.26), statistically significant, and represents an economically significant portion (almost 30%) of the average gross square return correlation. Excess comovement is also uniformly significant across industries and over time and only weakly asymmetric, i.e., not significantly different in rising or falling markets.We explain more than 23% of this market-wide (and up to 73% of sector-wide) excess square correlation by its positive relation to proxies for information heterogeneity and U.S. monetary and real conditions, and its negative relation to market volatility and the level of the short-term interest rate. This evidence is consistent with the implications of portfolio rebalancing and product market theories of financial contagion, but offers little or no support for the correlated liquidity shock channel.     

Returns and option activity over the option-expiration week for S&P 100 stocks

For S&P 100 stocks, we find that the weekly returns over option-expiration (OE) weeks (a month’s third-Friday week) tend to be high, relative to: (1) the third-Friday weekly returns of other stocks with less option activity, (2) the own stock’s other weekly returns, (3) the risk, based on asset-pricing alphas. For these same stocks, a month’s fourth-Friday weekly returns underperform modestly. We suggest the following two avenues are likely partial contributors towards understanding these return patterns: (1) delta-hedge rebalancing by option market makers, with a reduction in short-stock hedge positions over the OE week, and (2) declining risk perceptions over the OE week, as measured by option-derived implied volatilities. Our findings suggest option activity can induce reliable patterns in the weekly returns of option-active large-cap stocks.     

The world price of liquidity risk

This paper empirically tests the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.     

An Analysis of Covariance Risk and Pricing Anomalies

This article examines the link between several well-known assetpricing "anomalies" and the covariance structure of returns.I find size, book-to-market, and momentum strategies exhibita strong, weak, and negligible relation to covariance risk,respectively. A size factor helps predict future volatilityand covariation, improving the efficiency of investment strategies.Moreover, its premium rises following increases in both itsvolatility and covariation with other assets. These effectsare amplified in recessions. No such relations exist for book-to-marketor momentum. These findings may shed light on explanations forthese premia and present a challenging set of facts for futuretheory.     

ASYMMETRIC COVARIANCE,VOLATILITY, AND THE EFFECT OF NEWS

We propose that covariance (rather than beta) asymmetry provides a superior framework for examining issues related to changing risk premiums. Accordingly, we investigate whether the conditional covariance between stock and market returns is asymmetric in response to good and bad news. Our model of conditional covariance accommodates both the sign and magnitude of return innovations, and we find significant covariance asymmetry that can explain, at least in part, the volatility feedback of stock returns. Our findings are consistent across firm size, firm leverage, and temporal and cross‐sectional aggregations.     

Moments of multivariate regime switching with application to risk-return trade-off

We use a Fourier transform to derive multivariate conditional and unconditional moments of multi-horizon returns under a regime-switching model. These moments are applied to examine the relevance of risk horizon and regimes for buy-and-hold investors. We analyze the impact of time-varying expected returns and risk (variance and covariance) on portfolio allocations' “term structure”—portfolio allocations as a function of the investment horizon. Using monthly observations on S&P composite index and 10-year Government Bond, we find that the term structure of the optimal allocations depends on market conditions measured by the probability of being in bull state. At short horizons and when this probability is low, buy-and-hold investors decrease their holdings of risky assets. We also find that the conditional optimal portfolio performs quite well at short and intermediate horizons and less at long horizons.     

U.S. and Latin American stock market linkages

This paper examines to what extent the Latin American equity markets of Argentina, Brazil, Chile and Mexico have become more integrated with the US equity market. We empirically measure integration by finding the dynamic conditional correlation (DCC) between each market and that in the U.S. using a DCC multivariate GARCH model. We then track how these correlations evolve over time using a smooth transition model which not only shows when greater integration first occurred but also how long it took these correlations to transition to their new levels. Our sample period stretches from December 30th, 1988 to March 26th, 2004. Results show an increase in the degree of co-movement between these countries’ equity returns and those in the U.S. although the magnitude and speed of these increases greatly varies across these four countries.     

Heterogeneous Background Risks and Portfolio Choice: Evidence from Micro‐level Data

We construct a set of household‐level background risk variables to capture the covariance structure of three nonfinancial assets and two financial assets. These risks are in general statistically significant and economically important for a household's stock market participation and stockholdings. A one‐standard‐deviation increase in background risks reduces the participation probability by 11% and the stockholdings‐to‐wealth ratio by 4%. The volatilities of labor income, housing value, and business income reduce a household's participation and stockholdings. A household with labor income highly correlated with stock (bond) returns is less (more) likely to invest in stock.