Income hedging and portfolio decisions

We examine whether the decision to participate in the stock market and other related portfolio decisions are influenced by income hedging motives. Economic theory predicts that the market participation propensity should increase as the correlation between income growth and stock market returns decreases. Surprisingly, empirical studies find limited support for the income hedging motive. Using a rich, unique Dutch data set and the National Longitudinal Survey of the Youth (NLSY) from the United States, we show that when the income-return correlation is low, individuals exhibit a greater propensity to participate in the market and allocate a larger proportion of their wealth to risky assets. Even when the income risk is high, individuals exhibit a higher propensity to participate in the market when the hedging potential is high. These findings suggest that income hedging is an important determinant of stock market participation and asset allocation decisions.     

Diversification benefits of NFTs for conventional asset investors: Evidence from CoVaR with higher moments and optimal hedge ratios

This study investigates the risk and returns on one of the newest digital asset classes instruments, non-fungible tokens (NFTs), by accounting for tail dependence of higher-order moments and portfolio characteristics. We used a wide range of asset classes, encompassing equites, fixed income securities, and commodities, and document the desirable hedging and portfolio attributes of NFTs by employing Conditional Value-at-Risk (CoVaR) and ∆CoVaRs with various copula functions. We found that NFTs exhibit beneficial investment and hedging attributes under all market conditions, including the Covid-19 pandemic. Our findings have important implications for investors, risk managers, and regulators.     

The choice of the distribution of asset returns: How extreme value theory can help?

One of the issues of risk management is the choice of the distribution of asset returns. Academics and practitioners have assumed for a long time (for more than three decades) that the distribution of asset returns is a Gaussian distribution. Such an assumption has been used in many fields of finance: building optimal portfolio, pricing and hedging derivatives and managing risks. However, real financial data tend to exhibit extreme price changes such as stock market crashes that seem incompatible with the assumption of normality. This article shows how extreme value theory can be useful to know more precisely the characteristics of the distribution of asset returns and finally help to chose a better model by focusing on the tails of the distribution. An empirical analysis using equity data of the US market is provided to illustrate this point.     

General equilibrium pricing of options on the market portfolio with discontinuous returns

When the price process for a long-lived asset is of a mixedjump-diffusion type, pricing of options on that asset by arbitrageis not possible if trading is allowed only in the underlyingasset and a risk-less bond. Using a general equilibrium framework,we derive and analyse option prices when the underlying assetis the market portfolio with discontinuous returns. The premiumfor the risk of jumps and the diffusions risk forms a significantpart of the prices of the options. In this economy, an attemptedreplication of call and put options by the Black-Scholes typeof trading strategies may require substantial infusion of fundswhen jumps occur. We study the cost and risk implications ofsuch dynamic hedging plans.     

An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence

We extend Campbell's (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.     

Income Hedging,Dynamic Style Preferences,and Return Predictability

We propose a theoretical measure of income hedging demand and show that it affects asset prices. We focus on the value factor and first demonstrate that our demand estimates are correlated with the actual demands of retail and mutual fund investors. We then show that the aggregate high‐minus‐low (HML) demand predicts HML returns. Exploiting the state‐level variation in income risk, we demonstrate that state‐level hedging demands predict state‐level HML returns. A long‐short portfolio that exploits this hedging‐induced predictability earns an annualized risk‐adjusted return of 6%.     

Arbitrage Asset Pricing under Exchange Risk

This paper extends the APT to an international setting. Specifying a linear factor return-generating model in local currency terms, we show that the usual risk-diversification rule in the APT does not yield a riskless portfolio unless currency fluctuations obey the same factor model as asset returns. We then consider an arbitrage portfolio whose exchange risk is hedged by foreign riskless bonds. Under the resulting no-arbitrage conditions, the expected returns are not on the same hyperplane, unlike the closed-economy APT, unless they are adjusted by the cost of exchange risk hedging.     

Hedging Strategies of Financial Intermediaries: Pricing Options with a Bid-Ask Spread

This paper uses a model similar to the Boyle-Vorst and Ritchken-Kuo arbitrage-free models for the valuation of options with transactions costs to determine the maximum price to be charged by the financial intermediary writing an option in a non-auction market. Earlier models are extended by recognizing that, in the presence of transactions costs, the price-taking intermediary devising a hedging portfolio faces a tradeoff: to choose a short trading interval with small hedging errors and high transactions costs, or a long trading interval with large hedging errors and low transactions costs. The model presented here also recognizes that when transactions costs induce less frequent portfolio adjustments, investors are faced with a multinomial distribution of asset returns rather than a binomial one. The price upper bound is determined by selecting the trading frequency that will equalize the marginal gain from decreasing hedging errors and the marginal cost of transactions.     

Tail Dependence in International Real Estate Securities Markets

??Tail dependence?? characterizes the cross market linkages during stressful times. Analyzing tail dependence is of primary interest to portfolio managers who systematically monitor the co-movements of asset markets. However, the relevant literature on real estate securities markets is very thin. Our study extends the literature by using the flexible symmetrized Joe-Clayton (SJC) copula to estimate the tail dependences for six major global markets (U.S., U.K., Japan, Australia, Hong Kong, and Singapore). In implementing the SJC copula, we model the marginal distributions of returns through a semi-parametric method which has never been applied to real estate returns. Our major findings suggest that international markets display different strength and dynamics of tail dependence. We extensively discuss the implications of our findings for financial practices such as portfolio tail diversifications, portfolio selections, portfolio risk management and hedging strategies. Our study also demonstrates that the widely used linear correlation is an inadequate measure of market linkages, especially during periods of crisis.     

Stock and Bond Liquidity and its Effect on Prices and Financial Policies

An asset is liquid if it can be traded at the prevailing market price quickly and at low cost. We show that in addition to risk, liquidity affects asset prices and returns. Theories of asset pricing suggest that the expected return of an asset is increasing in its risk, because risk-averse investors require compensation for bearing more risk. Because investors are also averse to the costs of illiquidity and want to be compensated for bearing them, asset returns are increasing in illiquidity. Thus, asset prices should depend on two asset characteristics: risk and liquidity. This paper surveys research on the effects of liquidity on asset prices and returns, showing that liquidity is an important factor in capital asset pricing.     

The performance of model based option trading strategies

This paper analyzes returns to trading strategies in options markets that exploit information given by a theoretical asset pricing model. We examine trading strategies in which a positive portfolio weight is assigned to assets which market prices exceed the price of a theoretical asset pricing model. We investigate portfolio rules which mimic standard mean-variance analysis is used to construct optimal model based portfolio weights. In essence, these portfolio rules allow estimation risk, as well as price risk to be approximately hedged. An empirical exercise shows that the portfolio rules give out-of-sample Sharpe ratios exceeding unity for S&P 500 options. Portfolio returns have no discernible correlation with systematic risk factors, which is troubling for traditional risk based asset pricing explanations.     

Variable Selection for Portfolio Choice

We study asset allocation when the conditional moments of returns are partly predictable. Rather than first model the return distribution and subsequently characterize the portfolio choice, we determine directly the dependence of the optimal portfolio weights on the predictive variables. We combine the predictors into a single index that best captures time variations in investment opportunities. This index helps investors determine which economic variables they should track and, more importantly, in what combination. We consider investors with both expected utility (mean variance and CRRA) and nonexpected utility (ambiguity aversion and prospect theory) objectives and characterize their market timing, horizon effects, and hedging demands.     

Consumption, Aggregate Wealth, and Expected Stock Returns

This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption–wealth ratio are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the dividend payout ratio, and several other popular forecasting variables. Why should the consumption–wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption–aggregate wealth (human capital plus asset holdings) ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and labor income. The framework implies that these variables are cointegrated, and that deviations from this shared trend summarize agents' expectations of future returns on the market portfolio.     

Measuring large comovements in financial markets

A general, copula-based framework for measuring the dependence among financial time series is presented. Particular emphasis is placed on multivariate conditional Spearman's rho (MCS), a new measure of multivariate conditional dependence that describes the association between large or extreme negative returns—so-called tail dependence. We demonstrate that MCS has a number of advantages over conventional measures of tail dependence, both in theory and in practical applications. In the analysis of univariate financial series, data are filtered to remove temporal dependence as a matter of routine. We show that standard filtering procedures may strongly influence the conclusions drawn concerning tail dependence. We give empirical applications to two large data sets of high-frequency asset returns. Our results have immediate implications for portfolio risk management, derivative pricing and portfolio selection. In this context we address portfolio tail diversification and tail hedging. Amongst other aspects, it is shown that the proposed modeling framework improves the estimation of portfolio risk measures such as the value at risk.     

Gold and US sectoral stocks during COVID-19 pandemic

In this study, we examine the hedging relationship between gold and US sectoral stocks during the COVID-19 pandemic. We employ a multivariate volatility framework, which accounts for salient features of the series in the computation of optimal weights and optimal hedging ratios. We find evidence of hedging effectiveness between gold and sectoral stocks, albeit with lower performance, during the pandemic. Overall, including gold in a stock portfolio could provide a valuable asset class that can improve the risk-adjusted performance of stocks during the COVID-19 pandemic. In addition, we find that the estimated portfolio weights and hedge ratios are sensitive to structural breaks, and ignoring the breaks can lead to overestimation of the hedging effectiveness of gold for US sectoral stocks. Since the analysis involves sectoral stock data, we believe that any investor in the US stock market that seeks to maximize risk-adjusted returns is likely to find the results useful when making investment decisions during the pandemic.     

Risk factors in Australian bond returns

This study examines the risk factors in Australian bond returns. The study quantifies bond liquidity and estimates a liquidity risk factor in the Australian setting. We develop a three‐factor asset pricing framework that uses term, default and liquidity risk factors to explain the variation of Australian bond returns. Our findings corroborate the US evidence on the pervasiveness of these risk factors faced by bond investors. The three‐factor model developed in this study has practical applications when calculating the cost of debt, evaluating the performance of an active bond fund manager and hedging underlying risk in a bond portfolio.     

Options Trading and the CAPM

This article studies equilibrium asset pricing when agents facenonnegative wealth constraints. In the presence of these constraintsit is shown that options on the market portfolio are nonredundantsecurities and the economy's pricing kernel is a function ofboth the market portfolio and the nonredundant options. Thisimplies that the options should be useful for explaining riskyasset returns. To test the theory, a model is derived in whichthe expected excess return on any risky asset is linearly related(via a collection of betas) to the expected excess return onthe market portfolio and to the expected excess returns on thenonredundant options. The empirical results indicate that thereturns on traded index options are relevant for explainingthe returns on risky asset portfolios.     

Multi-regime nonlinear capital asset pricing models

A multiple-regime threshold generalized autoregressive conditionally heteroskedastic capital asset pricing model is introduced. The model captures asymmetric risk through allowing market beta to change discretely between regimes that are driven by market information. Asymmetric volatility and mean equation dynamics are also captured. We confirm the time-varying nature of market risk, in response to changes in the market, and that this discrete time variation can differ across assets. These findings could have important implications for optimizing investment decisions: e.g. in risk assessment, portfolio selection and hedging decisions.     

Size and Value Anomalies under Regime Shifts

This paper finds strong evidence of time-variations in the jointdistribution of returns on a stock market portfolio and portfoliostracking size- and value effects. Mean returns, volatilitiesand correlations between these equity portfolios are found tobe driven by underlying regimes that introduce short-run markettiming opportunities for investors. The magnitude of the premiaon the size and value portfolios and their hedging propertiesare found to vary across regimes. Regimes are shown to havea large impact both on the optimal asset allocation—especiallyunder rebalancing—and on investors' utility. Regimes alsohave a considerable impact on hedging demands, which are positivewhen the investor starts from more favorable regimes and negativewhen starting from bad states. Recursive out-of-sample forecastingexperiments show that portfolio strategies based on models thataccount for regimes dominate single-state benchmarks.     

Dynamic correlations and volatility effects in the Balkan equity markets

This paper investigates the presence of time-varying comovements, volatility implications and dynamic correlations in major Balkan and leading mature equity markets, in order to provide quantified responses to international asset allocation decisions. Since asset returns and correlation dynamics are critical inputs in asset pricing, portfolio management and risk hedging, emphasis is placed on the respective (constant and dynamic) equity market correlations produced by alternative multivariate GARCH forms, the Constant Conditional Correlation and the Asymmetric Dynamic Conditional Correlation models. The Balkan stock markets are seen to exhibit time-varying correlations as a peer group, although correlations with the mature markets remain relatively modest. In conjunction with sensitivity analysis on the asymmetric variance–covariance matrix, active portfolio diversification to the Balkan equity markets indicates to potentially improve investors’ risk-return trade-off.