Asymmetric and leptokurtic distribution for heteroscedastic asset returns: The SU-normal distribution

This paper proposes the S_U-normal distribution to describe non-normality features embedded in financial time series, such as: asymmetry and fat tails. Applying the S_U-normal distribution to the estimation of univariate and multivariate GARCH models, we test its validity in capturing asymmetry and excess kurtosis of heteroscedastic asset returns. We find that the S_U-normal distribution outperforms the normal and Student-t distributions for describing both the entire shape of the conditional distribution and the extreme tail shape of daily exchange rates and stock returns. The goodness-of-fit (GoF) results indicate that the skewness and excess kurtosis are better captured by the S_U-normal distribution. The exceeding ratio (ER) test results indicate that the S_U-normal is superior to the normal and Student-t distributions, which consistently underestimate both the lower and upper extreme tails, and tend to overestimate the lower tail in general.     

The independence axiom and asset returns

This paper integrates models of atemporal risk preference that relax the independence axiom into a recursive intertemporal asset-pricing framework. The resulting models are amenable to empirical analysis using market data and standard Euler equation methods. We are thereby able to provide the first nonlaboratory-based evidence regarding the usefulness of several new theories of risk preference for addressing standard problems in dynamic economics. Using both stock and bond returns data, we find that a model incorporating risk preferences that exhibit first-order risk aversion accounts for significantly more of the mean and autocorrelation properties of the data than models that exhibit only second-order risk aversion. Unlike the latter class of models which require parameter estimates that are outside of the admissible parameter space, e.g., negative rates of time preference, the model with first-order risk aversion generates point estimates that are economically meaningful. We also examine the relationship between first-order risk aversion and models that employ exogenous stochastic switching processes for consumption growth.     

Time varying betas and the unconditional distribution of asset returns

This paper draws attention to the fact that under standard assumptions the time varying betas model cannot capture the dynamics in beta. Conversely, evidence of time variation in beta using this model is equivalent to non-normality in the unconditional distribution of asset returns. Using the multivariate normal as a model for the joint distribution of returns on market indices and predetermined information variables, it is shown how to capture skewness and kurtosis in the unconditional distributions of asset returns. Under the assumptions of the model, asset returns are unconditionally distributed as an extended quadratic form (EQF) in normal variables. Expressions are given for the moment generating function and for the computation of the distribution and density functions. The market-timing model is derived formally using this model. The properties of bias when the standard linear betas model is used to estimate alpha when the correct model is the EQF are also investigated. It is shown that a different time varying betas model can arise as a consequence of portfolio selection. It is also shown that the predetermined information variables have the potential to account for the time series properties of returns, including heterogeneity of variance. An empirical study applies the model to returns on 46 UK bond funds. An analysis of the residuals shows that the model described in this paper is able to capture the dynamics of alpha and beta and properly account for other features of the time series of returns for 28 of these funds, of which 15 exhibit time variation in beta. The study reports the effect of the EQF model on the computation of VaR and CVaR and bias in the estimation of alpha.     

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.     

Testing for monotonicity in expected asset returns

Many postulated relations in finance imply that expected asset returns strictly increase in an underlying characteristic. To examine the validity of such a claim, one needs to take the entire range of the characteristic into account, as is done in the recent proposal of Patton and Timmermann (2010). But their test is only a test for the direction of monotonicity, since it requires the relation to be monotonic from the outset: either weakly decreasing under the null or strictly increasing under the alternative. When the relation is non-monotonic or weakly increasing, the test can break down and falsely ‘establish’ a strictly increasing relation with high probability. We offer some alternative tests that do not share this problem. The behavior of the various tests is illustrated via Monte Carlo studies. We also present empirical applications to real data.     

Displacement risk and asset returns

We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates a systematic risk factor, which we call “displacement risk.” This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.     

Modeling asymmetric comovements of asset returns

Existing time-varying covariance models usually impose strongrestrictions on how past shocks affect the forecasted covariancematrix. In this article we compare the restrictions imposedby the four most popular multivariate GARCH models, and introducea set of robust conditional moment tests to detect misspecification.We demonstrate that the choice of a multivariate volatilitymodel can lead to substantially different conclusions in anyapplication that involves forecasting dynamic covariance matrices(like estimating the optimal hedge ratio or deriving the riskminimizing portfolio). We therefore introduce a general modelwhich nests these four models and their natural 'asymmetric'extensions. The new model is applied to study the dynamic relationbetween large and small firm returns.     

Government financing decisions and asset returns

This paper presents an empirical investigation of the relation between government financing decisions and asset returns. In particular, the focus is on whether a substitution of debt financing for tax financing of a given level of expenditures is associated with an increase in interest rates. The paper brings a different perspective to empirical investigations of government fiscal policies by examining the response of asset prices in an efficient capital market to such policies rather than focusing on aggregate consumption behavior. The results are consistent with the idea that asset prices are unrelated to how the government finances its expenditures. The results, however, also indicate that the capital market is not indifferent with respect to the level of government expenditures as higher interest rates are associated with increases in government purchases.     

International asset returns and exchange rates

We present a consumption-based international asset-pricing model to study global equity premiums, the US riskfree rate and the cross section of international asset returns. The model entails idiosyncratic, country-specific consumption risk, which helps explain the magnitude of global equity premiums. It also features country-specific habit formation, which helps explain the level of the interest rate on the US short-term Treasury bills traded by domestic and international investors. We find that the model explains approximately 40–50% of the cross section of currency and equity premiums as well as expected returns from value and growth portfolios of at least a dozen countries. Changes in real exchange rates are responsible for explaining approximately half of the cross section of international asset returns.     

Inflation risk and international asset returns

We show that inflation risk is priced in international asset returns. We analyze inflation risk in a framework that encompasses the International Capital Asset Pricing Model (ICAPM) of Adler and Dumas (1983). In contrast to the extant empirical literature on the ICAPM, we relax the assumption that inflation rates are constant. We estimate and test a conditional version of the model for the G5 countries (France, Germany, Japan, the UK, and the US) over the period 1975–1998 and find evidence of statistically and economically significant prices of inflation risk (in addition to priced nominal exchange rate risk). Our results imply a rejection of the restrictions imposed by the ICAPM. In an extension of our analysis to 2003, we show that even after the termination of nominal exchange rate fluctuations in the euro area in 1999, differences in inflation rates across countries entail non-trivial real exchange rate risk premia.     

Cash, investments and asset returns

We use an investment-based asset pricing model to examine the effect of firms’ investments relative to cash holdings on stock returns, assuming holding cash lowers transaction costs. We find that mimicking portfolios based on investments relative to non-cash capital and based on investments relative to cash capital are priced for various testing portfolios. On average, momentum stocks and growth stocks are more sensitive to the factor constructed using investment relative to cash.     

Cryptocurrency returns under empirical asset pricing

This study examines the predictability of cryptocurrency returns based on investors' risk premia. Prior studies that have examined the predictability of cryptocurrencies using various economic risk factors have reported mixed results. Our out-of-sample evidence identifies the existence of a significant return predictability of cryptocurrencies based on the cryptocurrency market risk premium. Consistent with capital asset pricing theory (CAPM), our results show that investors often require higher positive returns before taking on any additional risks, particularly in terms of riskier assets like cryptocurrencies. Tests involving the CAPM model demonstrates that the three largest cryptocurrencies have significant exposures to the proposed market factor with insignificant intercepts, demonstrating that the market factor explains average cryptocurrency returns very well.     

The value of financing through cross-border asset sales: Shareholder returns and liquidity

We examine a sample of 1458 divestitures of domestic assets by U.S. firms to foreign and domestic buyers over the period 1998–2008. Cross-border asset sales yield higher abnormal returns to the seller than domestic sales. This incremental return is driven by liquidity-seeking sellers engaging in cross-border transactions. Larger seller returns in these international deals are associated with favorable economic conditions in foreign buyers' home markets relative to the U.S. We also find positive abnormal returns for buyers, albeit smaller than seller returns, but no significant difference between buyer returns in cross-border and domestic transactions.     

Predicting firm level stock returns: Implications for asset pricing and economic links

We examine the predictive ability of stock price ratios, stock return dispersion and distribution measures for firm level returns. Analysis typically focusses on market level returns, however, for the underlying asset pricing model to hold, firm-level predictability should be present. Additionally, we examine the economic content of predictability by considering whether the predictive coefficient has the theoretically correct sign and whether it is related to future output growth. While stock returns reflect investor expectations regarding future economic conditions, they are often too noisy to act as predictor. We use the time-varying predictive coefficient as it reflects investor confidence in the predictive relation. Results suggest that a subset of stock price ratios have predictive power for individual firm stock returns, exhibit the correct coefficient sign and has predictive power for output growth. Each of these ratios has a measure of fundamentals divided by the stock price and has a positive relation with stock returns and output growth. This implies that as investors expect future economic conditions to improve and earnings and dividends to rise, so expected stock returns will increase. This supports the cash flow channel as the avenue through which stock return predictability arises.     

The relationship between asset growth and the cross-section of stock returns

There is a large body of literature examining the association between stock characteristics and the cross-section of stock returns in international markets. Recently, Cooper et al. (2008) reported a strong association between total asset growth and stock returns in the US. In this paper, we show that an asset-growth effect also exists in the Australian equity market. Of particular interest, it is present amongst the largest Australian stocks. Over the 1983-2007 period, an equally-weighted portfolio of low-growth Big stocks outperforms a portfolio of high-growth Big stocks by an average 1% per month, equating to nearly 13% per annum. At an individual stock level of analysis, the asset-growth effect remains even after controlling for other variables whose association with the cross-section of returns is well known. Finally, we explicitly test whether asset growth is a priced risk factor using the common two-stage cross-sectional regression methodology. We find no evidence to support a risk-based explanation, thereby lending credence to Cooper et al.’s (2008) suggestion that the asset-growth effect is attributable to mispricing.     

The determinants of the volatility of returns on cross-border asset holdings

Using both panel and cross-sectional models for 28 industrialized countries observed from 2001–2009, we report a number of findings regarding the determinants of the volatility of returns on cross-border asset holdings (i.e., equity and debt). Greater portfolio concentration and an increase in assets held in emerging markets lead to an elevation in earning volatility, whereas more financial integration and a greater share held in Organization for Economic Cooperation and Development countries and by the household sector cause a reduction in the return volatility. Larger asset holdings by offshore financial corporations and non-bank financial institutions cause higher market volatility, although they affect volatility in the equity and bond markets in the opposite way. Overall, both panel and cross-sectional estimations provide very similar results (albeit of different magnitude) and are robust to the endogeneity problem.     

Expectations and volatility of consumption and asset returns

We find that conditional means and variances of consumptiongrowth vary through time, and this variation appears to be associatedwith the business cycle. A pricing model with fluctuating meansand variances of consumption growth provides implications aboutconditional moments of returns for both short and long investmenthorizons, and these implications are explored empirically. TheU-shaped pattern of first-order autocorrelations of returns,as well as business cycle patterns in the price of risk, appearsto be consistent with the model, but our exploration suggeststhat other implications about conditional return moments areat odds with the data.     

Conditional higher order moments in metal asset returns

This study examines the role of higher order moments in the returns of four important metals, aluminium, copper, gold and silver, using the asymmetric GARCH (AGARCH) model with a conditional skewed generalized-t (SGT) distribution. Implications of higher order moments in metal returns are evaluated by comparing the performances of conditional value-at-risk measures obtained from the AGARCH models with SGT distributions to those obtained from the AGARCH models with normal and student-t distributions. With the exception of gold, the AGARCH model with the SGT distribution appears to have the best fit for all metals examined.