Private Equity Performance and Liquidity Risk

Private equity has traditionally been thought to provide diversification benefits. However, these benefits may be lower than anticipated as we find that private equity suffers from significant exposure to the same liquidity risk factor as public equity and other alternative asset classes. The unconditional liquidity risk premium is about 3% annually and, in a four‐factor model, the inclusion of this liquidity risk premium reduces alpha to zero. In addition, we provide evidence that the link between private equity returns and overall market liquidity occurs via a funding liquidity channel.     

On the systematic volatility of unpriced earnings

Some important puzzles in macro finance can be resolved in a model featuring systematically varying volatility of unpriced shocks to firms? earnings. In the data, the correlation between corporate debt and stock market valuations is low. The model accounts for this via the opposing effect of unpriced earnings risk on levered debt and equity prices. The model also explains the low (or nonexistent) risk-reward relation for the market portfolio of levered equity via the opposing effects of unpriced and priced uncertainty (both components of stock volatility) on the levered equity risk premium. Versions of the model calibrated to empirical measures of both types of fundamental risk can quantitatively substantiate these explanations. Variation in residual earning dispersion accounts for a significant fraction of observed disagreement between debt and equity valuations and of realized stock volatility. The implication that the two components of risk should forecast the levered equity risk premium with opposite signs is also supported in the data. The results are a notable advance for risk-based asset pricing.     

Local risk factors in emerging markets: Are they separately priced?

We provide new evidence on the pricing of local risk factors in emerging stock markets. We investigate whether there is a significant local currency premium together with a domestic market risk premium in equity returns within a partial integration asset pricing model. Given previous evidence on currency risk, we conduct empirical tests in a conditional setting with time-varying prices of risk. Our main results support the hypothesis of a significant exchange risk premium related to the local currency risk. Exchange rate and domestic market risks are priced separately for our sample of seven emerging markets. The empirical evidence also suggests that although statistically significant, local currency risk is on average smaller than domestic market risk but it increases substantially during crises periods, when it can be almost as large as market risk. Disentangling these two factors is thus important in tests of international asset pricing for emerging markets.     

Is size dead? A review of the size effect in equity returns

Beginning with Banz (1981), I review 30 years of research on the size effect in equity returns. Since Fama and French (1992), there has been a vigorous, ongoing debate on whether the size premium is a compensation for systematic risk. Since the late 1990s, research on the size effect has been characterized by two developments that are seemingly contradictory. At last, theoretical models have emerged in which the size effect arises endogenously as a result of systematic risk. However, recent empirical studies assert that the size effect has disappeared after the early 1980s. In this review, I address this disconnect between recent theoretical and empirical research.     

From boom ‘til bust: How loss aversion affects asset prices

This article studies the impact of heterogeneous loss averse investors on asset prices. In very good states loss averse investors become gradually less risk averse as wealth rises above their reference point, pushing up equity prices. When wealth drops below the reference point the investors become risk seeking and demand for stocks increases drastically, eventually leading to a forced sell-off and stock market bust in bad states. Heterogeneity in reference points and initial wealth of the loss averse investors does not change the salient features of the equilibrium price process, such as a relatively high equity premium, high volatility and counter-cyclical changes in the equity premium.     

Value Relevance of Inflation-adjusted Equity and Income

This paper investigates the role incremental information content of inflation-adjusted data plays in explaining the market value of equity and stock returns on the Istanbul Stock Exchange (ISE). We show the effect of inflation accounting application on basic financial ratios, and we test the value relevance of inflation-adjusted and historical cost-based book value and earnings. The findings show that inflation adjustment affects financial ratios significantly, which may create different risk assessments for the selected firms. Furthermore, the results indicate that both inflation-adjusted and historical cost-based earnings and book values are significantly value relevant. The two sets of data are not to be used as substitutes, but, rather, they are complementary. For this reason, inflation-adjusted data should be required as supplementary data to the historical cost information rather than in place of historical cost data.     

A new approach to measuring riskiness in the equity market: Implications for the risk premium

We introduce a new approach to measuring riskiness in the equity market. We propose option implied and physical measures of riskiness and investigate their performance in predicting future market returns. The predictive regressions indicate a positive and significant relation between time-varying riskiness and expected market returns. The significantly positive link between aggregate riskiness and market risk premium remains intact after controlling for the S&P 500 index option implied volatility (VIX), aggregate idiosyncratic volatility, and a large set of macroeconomic variables. We also provide alternative explanations for the positive relation by showing that aggregate riskiness is higher during economic downturns characterized by high aggregate risk aversion and high expected returns.     

Cost of Capital for Exempt Foreign Private Issuers: Information Risk Effect or Earnings Quality Effect? It Depends

We examine whether the information risk accompanying Foreign Private Issuers' (FPIs) exemptions from the U.S. Securities and Exchange Commission (SEC) reporting requirements is associated with capital market penalties (measured by a higher cost of equity capital) and, further, the extent to which this information risk is mitigated by earnings quality. Our overall results indicate that exempt FPIs exhibit a higher cost of equity capital than reporting FPIs, and this relation still persists after controlling for earnings quality. Furthermore, we partition our sample into firms from strong and weak investor protection environments. Interestingly, similar to the results in Francis et al. (2008), for FPIs from strong investor protection regimes we find no difference in the cost of capital between exempt and filing FPIs, even after controlling for earnings quality. To the contrary, for FPIs from weak investor protection regimes, we find that the exemption is associated with a higher cost of equity capital, and that earnings quality does not significantly reduce the premium paid by these issuers.     

The risk in hedge fund strategies: Theory and evidence from long/short equity hedge funds

Theory suggests that long/short equity hedge funds' returns come from directional as well as spread bets on the stock market. Empirical analysis finds persistent net exposures to the spread between small vs large cap stocks in addition to the overall market. Together, these factors account for more than 80% of return variation. Additional factors are price momentum and market activity. Combining two major branches of hedge fund research, our model is the first that explicitly incorporates the effect of funding (stock loan) on alpha. Using a comprehensive dataset compiled from three major database sources, we find that among the three thousand plus hedge funds with similar style classification, less than 20% of long/short equity hedge funds delivered significant, persistent, stable positive non-factor related returns. Consistent with the predictions of the Berk and Green (2004) model we find alpha producing funds decays to “beta-only” over time. However, we do not find evidence of a negative effect of fund size on managers' ability to deliver alpha. Finally, we show that non-factor related returns, or alpha, are positively correlated to market activity and negatively correlated to aggregate short interest. In contrast, equity mutual funds and long-bias equity hedge funds have no significant, persistent, non-factor related return. Expressed differently, L/S equity hedge funds, as the name suggests, do benefit from shorting. Besides differences in risk taking behavior, this is a key feature distinguishing L/S funds from long-bias funds.     

Life Insurer Cost of Equity with Asymmetric Risk Factors

This study presents an improved model for estimating life insurer cost of capital with the inclusion of upside and downside risk factors and controlling for life insurer characteristics. Although various asymmetric measures of market risk have been shown to be priced factors for the broader equity market, life insurer realized equity returns include a much larger premium for bearing downside risk, even after controlling for firm characteristics and other measures of risk. Cross‐sectional regression analysis finds a positive (negative) premium for downside (upside) betas, conditional on down and up markets, respectively. Coskewness and cokurtosis are also priced factors.     

Do jumps contribute to the dynamics of the equity premium?

This paper investigates whether risks associated with time-varying arrival of jumps and their effect on the dynamics of higher moments of returns are priced in the conditional mean of daily market excess returns. We find that jumps and jump dynamics are significantly related to the market equity premium. The results from our time-series approach reinforce the importance of the skewness premium found in cross-sectional studies using lower-frequency data; and offer a potential resolution to sometimes conflicting results on the intertemporal risk-return relationship. We use a general utility specification, consistent with our pricing kernel, to evaluate the relative value of alternative risk premium models in an out-of-sample portfolio performance application.     

Loss aversion,asymmetric market comovements,and the home bias

Loss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the first-order-different utility impact of wealth gains and losses leads loss-averse investors to behave similarly to investors with high risk aversion. But if so, should those agents not perceive larger gains from international diversification than standard expected-utility investors with plausible levels of risk aversion? They might not, because comovements in international stock markets are asymmetric: correlations are higher in market downturns than in upturns. This asymmetry dampens the gains from diversification relatively more for loss-averse investors. We analyze the portfolio problem of such an investor who has to choose between home and foreign equities in the presence of asymmetric comovement in returns. Perhaps surprisingly, in the context of the home bias puzzle we find that loss-averse investors behave similarly to those with standard expected-utility preferences and plausible levels of risk aversion. We argue that preference specifications that appear to perform well with respect to the equity premium puzzle should be subjected to this “test”.     

Habit-based asset pricing with limited participation consumption

We calibrate and estimate a consumption-based asset pricing model with habit formation using limited participation consumption data. Based on survey data of a representative sample of American households, we distinguish between assetholder and non-assetholder consumption, as well as the standard aggregate consumption series commonly used in the CCAPM literature. We show that assetholder consumption outperforms non-assetholder and aggregate consumption data in explaining bond returns, bond yields, and the volatility of bond yields. We further show that the high volatility of assetholder consumption enables the model to explain the equity premium puzzle and the risk-free rate puzzle simultaneously for a reasonable value of relative risk aversion.     

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.     

Locals, foreigners, and multi-market trading of equities: Intraday evidence from Thailand

We study stock market orders and trades in a developing country, Thailand, where foreign ownership limits partially segment local and foreign investors into two distinct markets. Some foreigners forgo voting rights and distributions to trade on the “local board”, while some locals forgo such benefits and pay a price premium to trade on the “foreign board”. Regardless of nationality, these cross-market traders typically submit orders when liquidity is high, fill orders at relatively beneficial prices, exploit patterns in stock prices across markets, display profitable holding-period returns, and enhance price discovery. This suggests that skilled, informed trading that affects market quality does not depend on trader nationality.     

International variations in expected equity premia: Role of financial architecture and governance

Estimates of ex-ante equity premia are important in planning investments in pension funds, life insurance pools, and for other long-term financial obligations or goals. However, while global cross-border investment positions and flows have been rising, there is little research on non-US ex-ante equity premia or on their determinants in a global setting. This paper uses data on a recent 8-year period from 33 countries and models simultaneously our estimate of the ex-ante equity premium as a dependent variable and our measure of financial architecture as an instrumental variable. We document that ex-ante equity premia are larger in countries that have a more bank-oriented financial architecture, are wealthier, and have better governance. These results are robust to alternative model specifications and estimation techniques. Given the importance of equity premia and financial architecture, these results should be of much interest to scholars, managers, regulators, and policy makers.     

Market incompleteness and the equity premium puzzle: Evidence from state-level data

This paper investigates the importance of market incompleteness by comparing the rates of risk aversion estimated from complete and incomplete markets environments. For the incomplete-markets case, we use consumption data for the 50 US states. We find that the rate of risk aversion under the incomplete-markets setup is much lower. Furthermore, including the second and third moments of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle.     

Comparative measures of performance for U.S.-based international equity mutual funds

This paper compares an international two-index model to an International Arbitrage Pricing Theory (IAPT) two-factor model to evaluate the performance of 37 U.S.-based international mutual funds over the 1985–1993 period. Results from the index model confirm prior research that international funds perform as well as the market proxy. In contrast, the IAPT model implies superior investment performance by the international funds. Moreover, the two models produce different relative performance rankings. Intertemporal comparisons of the models indicate that the multifactor IAPT model better reflects the international equity return-generating process.     

A consumption-based model of the term structure of interest rates

This paper proposes a consumption-based model that accounts for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated to data on consumption, inflation, and the aggregate market, the model produces realistic means and volatilities of bond yields and accounts for the expectations puzzle. The model also captures the high equity premium and excess stock market volatility.     

The value of the voting right: a study of the Milan Stock Exchange experience

I study the large premium (82 percent) attributed to votingshares on the Milan Stock Exchange. The premium varies accordingto the ownership structure and the concentration of the votingrights, and it can be rationalized in the presence of enormousprivate benefit of control A case study seems to indicate thatin Italy private benefits of control can easily be worth morethan 60 percent of the value of nonvoting equity. A tentativeexplanation for these findings is provided.