Permanent and transitory components of GDP and stock prices: further analysis

Using the conventional VAR identification approach, Cochrane (Quarterly Journal of Economics 107: 241–65, 1994) finds that substantial amounts of variation in GDP growth and stock returns are due to transitory shocks. Following the common trend decomposition of King etal. (American Economic Review 81: 819–40, 1991), we show that Cochrane's results depend on the assumption of weak exogeneity of one of the variables with respect to the cointegration vector. When this assumption holds both approaches coincide. If not, the shocks Cochrane called transitory are not totally transitory. In this case, the conventional VAR approach with the assumption of the weak exogeneity may overstate the magnitude of transitory shocks and understate that of permanent shocks. We find that the permanent components of GDP and stock prices are much larger than those estimates of Cochrane, although substantial (but much smaller than in Cochrane 1994) variations in GDP growth and stock returns are attributed to transitory shocks.     

DETERMINANTS OF THE RATINGS AND YIELDS ON CORPORATE BONDS: TESTS OF THE CONTINGENT CLAIMS MODEL

A contingent claims model for corporate bonds is tested on newly issued bonds of firms with very simple capital structures. Two default risk measures derived from the model — firm return standard deviation (σ) and leverage (D/V) — explain approximately 78 percent of the variation in the agency ratings on the bonds, based on a probit analysis. Model yield premiums explain almost 60 percent of the variation in market yield premiums. In both analyses, however, firm size is a significant additional variable, suggesting that the contingent claims model is not robust to changes in scale. The assumption of nonstochastic interest rates also appears to be an important misspecification. Institutional restrictions on investments in speculative grade bonds, however, do not affect market yield premiums on such bonds, and thus do not appear to represent a serious misspecification.     

Uncertainty shocks are aggregate demand shocks

Search frictions in the labor market give rise to a new option-value channel through which uncertainty affects aggregate economic activity, and the effects of which are reinforced by the presence of nominal rigidities. With these features, an increase in uncertainty resembles an aggregate demand shock because it increases unemployment and lowers inflation. Using a new empirical measure of uncertainty based on the Michigan survey and a VAR model, we show that these theoretical patterns are consistent with US data. Using a calibrated DSGE model, we show that combining search frictions and nominal rigidities can match the qualitative VAR pattern and account for about 70 percent of the empirical increase in unemployment following an uncertainty shock.     

Bid-ask spread dynamics in foreign exchange markets

The aim of this paper is to examine the short term dynamics of foreign exchange rate spreads. Using a vector autoregressive model (VAR) we show that most of the variation in the spread comes from the long run dependencies between past and future spreads rather than being caused by changes in inventory, adverse selection, cost of carry or order processing costs. We apply the Integrated Cumulative Sum of Squares (ICSS) algorithm of Inclan and Tiao (1994) to discover how often spread volatility changes. We find that spread volatility shifts are relatively uncommon and shifts in one currency spread tend not to spillover to other currency spreads.     

Vector autoregressions and reduced form representations of DSGE models

The performance of dynamic stochastic general equilibrium models is often tested against estimated VARs. This requires that the data-generating process consistent with the DSGE theoretical model has a finite order VAR representation. This paper discusses the assumptions needed for a finite order VAR(p) representation of a DSGE model to exist. When a VAR(p) is only an approximation to the exact infinite order VAR, the truncated VAR(p) may return largely incorrect estimates of the impulse response function. The results do not hinge on small-sample bias or on incorrect identification assumptions. But the bias introduced by truncation can lead to bias in the identification of the structural shocks. Identification strategies that work in the exact VAR representation perform poorly in the truncated VAR.     

ON IMPROVING THE PERFORMANCE OF THE MARKET MODEL

Data on 4,087 securities from 1988 to 1990 are used to test the relation between market model R² and trading volume. Eliminating high-volume observations increases R² by about 10 percent, confirming results previously reported. This study indicates that this improvement is possible by eliminating a small number of observations. It also indicates that this relation between R² and volume is unrelated to firm size.     

A Note on Credit Risk of Vertical <Emphasis Type="Italic">Keiretsu</Emphasis> Firms: Preliminary Evidence from the Japanese Automobile Industry

This paper empirically examines the relationship between the credit risk of Toyota, Nissan and Honda keiretsu-affiliated firms and the credit risk of the respective parent company. As credit spread data for keiretsu-affiliated firms were not available we create a keiretsu default index, as a proxy, using expected default probabilities obtained from the KMV and Leland and Toft (J. Finance 51, 987–1019, 1996) option pricing models. We find parent credit spreads do not Granger cause our keiretsu default index and vice versa in a bivariate vector autoregressive (VAR) framework.JEL classification: G3, L62     

Identifying Noise Shocks: A VAR with Data Revisions

We propose a new Vector Autoregression (VAR) identification strategy to study the impact of noise, in the early releases of output growth figures, which exploits the informational advantage of the econometrician. Economic agents, uncertain about the underlying state of the economy, respond to noisy early data releases. Econometricians, with the benefit of hindsight, have access to data revisions as well, which we use to identify noise shocks. A surprising report of output growth produces qualitatively similar but quantitatively smaller effects than a demand shock. We also illustrate how a noise shock cannot be identified unless ex‐post information is used.     

Risk sharing,efficiency of capital allocation,and the connection between banks and the real economy

We propose a measure of the extent to which a financial institution is connected to the real economy. The Share of Core Assets (SCA) is a measure of the composition of assets – namely, the share of credit to the non-financial sectors (households, firms, and governments) out of total credit market instruments. We construct the SCA for more than 3700 U.S. bank holding companies. An asset weighted average of the SCA declines by 20 percentage points in the period 1995:1 to 2012:4 (from 76% to 56%); it then increases by about 10 percentage points in the period 2013:1 to 2016:4. We explore the extent to which risk-sharing among banks and efficiency of capital allocation can explain the cross-sectional dispersion of our measure, and we find that these two motives account for between 6% and 10% of the cross-sectional variation of the SCA, depending on the sample used. Finally, using a vector autoregression model (VAR), we find that an increase in the average connection between banks and the real economy increases the growth rate of the GDP.     

PORTFOLIO FORMATION,MEASUREMENT ERRORS,AND BETA SHIFTS: A RANDOM SAMPLING APPROACH

This article demonstrates that the portfolio approach could suffer a serious problem when the sorting variables contain not only true values but also measurement errors. The grouped measurement errors will be embedded into the data used to test financial models and further bias the testing results. To correct for this measurement‐error problem, I develop a random sampling approach to form portfolios. Results from this new methodology are unbiased and robust. By applying this methodology to investigate beta shifts, I show that the previous results about beta shifts are driven by measurement errors. The actual beta shift pattern is more complicated than that predicted by previous studies. The risk shift hypothesis is unlikely to explain the mean‐reversion puzzle for stock returns. JEL classification: Gil, C43.     

Cash-flow or return predictability at long horizons? The case of earnings yield

We examine the predictive ability of the aggregate earnings yield for both market returns and earnings growth by estimating variance decompositions at multiple horizons. Based on weighted long-horizon regressions, we find that most of the variation in the earnings yield is due to return predictability, with earnings growth predictability assuming a minor role. However, by using implied estimates from a first-order restricted VAR, we find an opposite predictability mix. The inconsistency in results stems from a misspecification of the restricted VAR. Using an unrestricted first-order VAR estimated by OLS, or alternatively, estimating the restricted VAR by the Projection Minimum Distance method, produces long-run variance decompositions that are substantially more similar to the decomposition obtained under the direct method. Hence, earnings yield is not fundamentally different from the dividend yield. These results suggest that the practice of analyzing long-run return and cash-flow predictability from a restricted VAR can be quite misleading.     

Financial progress and the stability of long-run money demand: Implications for the conduct of monetary policy in emerging economies

This paper examines whether recent financial changes in three emerging market economies in the Gulf region (Bahrain, the UAE, and Qatar) have distorted the character and the stability of their underlying long-run money demand relations. Money demand instability prompts concerns about the appropriateness of targeting monetary aggregates and could weaken the presumed link between monetary policy and its ultimate objectives. Our results suggest that the quick pace of financial changes in the three emerging market economies did not cause undue shifts in their equilibrium money demand relations. Further evidence from direct tests of cointegration stability indicates the superiority of targeting M1 in the UAE and M2 for Qatar. In Bahrain, both M1 and M2 prove equally appropriate to guide monetary policy. Thus, despite the wave of financial developments that have recently swept the three Gulf economies, the evidence suggests that monetary authorities in these countries should maintain a close watch on monetary growth as a principal policy guide.     

An Analysis of the Recommendations of the “Superstar” Money Managers at Barron's Annual Roundtable

We examine the performance of common stock recommendations made by prominent money managers at Barron's Annual Roundtable from 1968 to 1991. To avoid survivorship bias, we examine the performance of recommendations by all the participants. The buy recommendations earn significant abnormal returns of 1.91 percent from the recommendation day to the publication day, a period of about 14 days. However, the abnormal returns are essentially zero for one to three year postpublication day holding periods. Thus, an individual investing according to the Roundtable recommendations published in Barron's would not benefit from the advice.     

Revisiting local responses to mass violence

This study examines the extent to which individual and sociological factors relate to worry about mass violence, which, in this study, is investigated as worry about the recurrence of school shootings. First, it is expected that socio-demographic and vicarious event-related factors explain individual variation in worry about mass violence. Second, responses to a localized event may associate with negative perceptions of community solidarity. In addition, individual responses regarding school shootings cannot easily be separated from other forms of insecurity, such as concerns about societal disintegration (e.g. eroding moral values) and popular discussions about crime (e.g. terrorism). Two independent postal surveys were collected from the small Finnish community of Jokela approximately 6 (N = 330) and 18 (N = 278) months after the rampage school shootings in the local high school. Independent samples t tests and linear regression are used as analyses methods. Results from regression analyses of the six-month post-event responses indicate that knowing a victim of a school shooting event relates to increased worry about mass violence. Decreased perceptions of social solidarity are also associating with increased worry after controlling for other individual and sociological factors. After 18 months, both knowing a victim and having school-aged children within one’s household explain even more of the variation in worry, while perceptions of solidarity is no longer a statistically significant predictor. In addition, at both 6 and 18 months, the higher the perceptions of risks to Finnish society from social change and from crime, the higher the worry about mass violence at schools. Surprisingly, the positive association between self-reported subjective anxiety and worry about mass violence does not reach a statistical significance.     

The Comovement of US and UK Stock Markets

US and UK stock returns are highly positively correlated over the period 1918–99. Using VAR‐based variance decompositions, we investigate the nature of this comovement. Excess return innovations are decomposed into news about future dividends, real interest rates, and excess returns. We find that the latter news component is the most important in explaining stock return volatility in both the USA and the UK and that stock return news is highly correlated across countries. This is evidence against Beltratti and Shiller's (1993) finding that the comovement of US and UK stock markets can be explained in terms of a simple present value model. We interpret the comovement as indicating that equity premia in the two countries are hit by common real shocks.     

Does Greater Firm‐Specific Return Variation Mean More or Less Informed Stock Pricing?

Roll [1988] observes low R² statistics for common asset pricing models due to vigorous firm‐specific return variation not associated with public information. He concludes that this implies “either private information or else occasional frenzy unrelated to concrete information”[p. 56]. We show that firms and industries with lower market model R² statistics exhibit higher association between current returns and future earnings, indicating more information about future earnings in current stock returns. This supports Roll's first interpretation: higher firm‐specific return variation as a fraction of total variation signals more information‐laden stock prices and, therefore, more efficient stock markets.     

Evaluating Value at Risk Methodologies: Accuracy versus Computational Time

Recent research has shown that different methods of computing Value at Risk (VAR) generate widely varying results, suggesting the choice of VAR method is very important. This article examines six VAR methods, and compares their computational time requirements and their accuracy when the sole source of inaccuracy is errors in approximating nonlinearity. Simulations using portfolios of foreign exchange options showed fairly wide variation in accuracy and unsurprisingly wide variation in computational time. When the computational time and accuracy of the methods were examined together, four methods were superior to the others. The article also presents a new method for using order statistics to create confidence intervals for the errors and errors as a per cent of true value at risk for each VAR method. This makes it possible to easily interpret the implications of VAR errors for the size of shortfalls or surpluses in a firm's risk-based capital.     

An analysis of real-estate risk using the present value model

The current study uses a present value model that allows for a time-varying expected discount rate in conjunction with a VAR process to decompose real-estate risk. The study finds that the variance ofunexpected returns accounts for most of the total risk with cash-flow risk accounting for twice as much of the unexplained real-estate risk although discount rate risk is also an important factor. This dominance of cash-flow risk is found to result in a weaker mean reversion process for real estate relative to stocks. Another finding is that real estate investors tend to become apprehensive about the future when news on future cash flow is good, and thus they demand higher expected future returns.     

Investor protection and price informativeness about future earnings: international evidence

This study draws on the investor protection literature to identify structural factors in a country’s information environment that are likely to explain cross-country differences in the extent to which future earnings information is capitalized in current stock returns. Using a sample of 55,900 firm-years from 32 countries, we find that greater financial disclosure, higher quality earnings, and greater information dissemination through news media are associated with stock prices that are more informative about future earnings, whereas strong enforcement of insider trading laws is associated with stock prices that are less informative about future earnings. We also find that, on average, price informativeness about future earnings is greater in countries with strong investor protection. Our results illuminate the importance of structural factors constituting a country’s information environment in explaining cross-country variation in price informativeness about future earnings.     

Housing Collateral, Consumption Insurance, and Risk Premia: An Empirical Perspective

In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the United States, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains 80% of the cross‐sectional variation in annual size and book‐to‐market portfolio returns.