An empirical examination of market maker profits on the London stock exchange

This article uses transaction data to analyze the impact of asymmetric information and market marker risk aversion on the size of market maker profits. The observed bid-ask spread across the 14 stocks in the sample lies in the range of 1–5%. In the absence of asymmetric information and risk aversion, market makers would expect to receive half the spread on average as profit. In fact, their profit is less than half of this for all shares in the sample, and in half the stocks it is actually negative. A methodology is developed to identify separately the impact of information effects and risk aversion, but the results are inconclusive.     

Which time-frequency domain dominates spillover in the Chinese energy stock market?

Previous studies detected the spillover relations among stocks and identified the spillover roles of stocks. However, due to the participants with different dealing frequencies, the spillover effects in the stock market present multiscale features, then which time-frequency domain dominates the spillover in the stock market? Take Chinese energy stocks as an example, this paper examines the return spillover effects of the energy stock market under each time-frequency domain. We find significant return spillover in the Chinese energy stock market under different time scales, and the spillover effect under the time scale of 32–64 days contributes the most to the spillover in the whole energy stock market. Then we take further research on the directional spillovers, spillovers between energy stocks and spillovers between energy industries to detect who plays leading positions under each time scale. We divide the stocks into four roles, and find that it is different role that plays a leading position under each time scale. Furthermore, a small number of spillover relationships between energy stocks carry a large part of the total spillover quantities, and coal and consumable fuel-related stocks play an important role in the spillover of Chinese energy stocks. The robustness of our results is proved by additional tests with different forecast horizons. Our paper contributes to the literature by examining the multiscale spillover effect in the Chinese energy stock market, which provides references for market participants on investment horizons choosing, stocks selection and risk aversion.     

Preferred risk habitat of individual investors

The preferred risk habitat hypothesis, introduced here, is that individual investors select stocks whose volatilities are commensurate with their risk aversion. The data, 1995–2000 holdings of over 20,000 clients at a large German broker, are consistent with the predictions of the hypothesis: the returns of stocks within each portfolio have remarkably similar volatilities, when stocks are sold they are replaced by stocks of similar volatilities, and the more risk-averse customers indeed hold less volatile stocks. Greater volatility specialization is associated with lower Sharpe ratios, primarily because more specialized investors hold fewer stocks and thereby expose themselves to more unsystematic risk.     

Stock market aversion? Political preferences and stock market participation

We find that left-wing voters and politicians are less likely to invest in stocks, controlling for income, wealth, education, and other relevant factors. This finding from unique data sets in Finland is robust both at the zip code and at the individual level. A moderate left voter is 17–20% less likely to own stocks than a moderate right voter. The results are consistent with the idea that personal values are a factor in important investment decisions, in this case leading to “stock market aversion.” The results are inconsistent with alternative explanations such as wealth effects, risk aversion, reverse causality, return expectations, or social capital.     

Do aggressive funds reallocate their portfolios aggressively?

This study examines pairs of asset allocation mutual funds that are controlled for all informational attributes, except for the level of risk aversion. Standard mean‐variance models of portfolio choice suggest that the percentage rebalancing of common stocks in aggressive funds would be the same as that in conservative funds. However, this study finds the rebalancing of common stocks in aggressive funds to be disproportionally less intense.     

Liquidity and conditional portfolio choice: A nonparametric investigation

This paper studies the relation between liquidity and optimal portfolio allocations. Given that the portfolio problem of a constant relative risk aversion investor does not have a closed-form solution, we use a nonparametric approach to estimate the optimal allocations. Using a sample of NYSE stocks from 1963–2000, we find that the optimal portfolio weight in small stocks is strongly increasing in liquidity at short daily and weekly horizons. This result is consistent for three different measures of liquidity: price impact, dollar volume, and turnover. However, liquidity does not influence the optimal portfolio choice for large stocks, nor for longer monthly investment horizons.     

Long‐Run Stockholder Consumption Risk and Asset Returns

We provide new evidence on the success of long‐run risks in asset pricing by focusing on the risks borne by stockholders. Exploiting microlevel household consumption data, we show that long‐run stockholder consumption risk better captures cross‐sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross‐section of stocks.     

A Monte Carlo Method for Optimal Portfolios

This paper proposes a new simulation-based approach for optimal portfolio allocation in realistic environments with complex dynamics for the state variables and large numbers of factors and assets. A first illustration involves a choice between equity and cash with nonlinear interest rate and market price of risk dynamics. Intertemporal hedging demands significantly increase the demand for stocks and exhibit low volatility. We then analyze settings where stock returns are also predicted by dividend yields and where investors have wealth-dependent relative risk aversion. Large-scale problems with many assets, including the Nasdaq, SP500, bonds, and cash, are also examined.     

Asymmetry of information flow between volatilities across time scales

Conventional time series analysis, focusing exclusively on a time series at a given scale, lacks the ability to explain the nature of the data-generating process. A process equation that successfully explains daily price changes, for example, is unable to characterize the nature of hourly price changes. On the other hand, statistical properties of monthly price changes are often not fully covered by a model based on daily price changes. In this paper, we simultaneously model regimes of volatilities at multiple time scales through wavelet-domain hidden Markov models. We establish an important stylized property of volatility across different time scales. We call this property asymmetric vertical dependence. It is asymmetric in the sense that a low volatility state (regime) at a long time horizon is most likely followed by low volatility states at shorter time horizons. On the other hand, a high volatility state at long time horizons does not necessarily imply a high volatility state at shorter time horizons. Our analysis provides evidence that volatility is a mixture of high and low volatility regimes, resulting in a distribution that is non-Gaussian. This result has important implications regarding the scaling behavior of volatility, and, consequently, the calculation of risk at different time scales.     

TIME VARIABILITY IN MARKET RISK AVERSION

We adopt realized covariances to estimate the coefficient of risk aversion across portfolios and through time. Our approach yields second moments that are free from measurement error and not influenced by a specified model for expected returns. Supporting the permanent income hypothesis, we find risk aversion responds to consumption-smoothing behavior. As income increases, or as the consumption-to-income ratio falls, relative risk aversion decreases. We also document variation in risk aversion across portfolios: risk aversion is highest for small and value portfolios.     

Stock market expectations and risk aversion of individual investors

We study the relationship between stock market return expectations and risk aversion of individuals and test whether the joint effects arising from the interaction of these two variables affect investment decisions. Using data from the Dutch National Bank Household Survey, we find that higher risk aversion is associated with lower stock market expectations. We identify significant and negative effects on the probability that individuals invest in stocks arising from the interaction between stock market expectations and risk aversion. These effects are in addition to a significant and positive impact from stock market return expectations as well as a significant and negative effect from risk aversion separately. However, once individuals participate in the stock market, their stock market expectations alone remain significant in determining their portfolio allocation decisions.     

Saving and investing for early retirement: A theoretical analysis

We study optimal consumption and portfolio choice in a framework where investors adjust their labor supply through an irreversible choice of their retirement time. We show that investing for early retirement tends to increase savings and reduce an agent's effective relative risk aversion, thus increasing her stock market exposure. Contrary to common intuition, an investor might find it optimal to increase the proportion of financial wealth held in stocks as she ages and accumulates assets, even when her income and the investment opportunity set are constant. The model predicts a decrease in risk aversion following strong market gains like those observed in the nineties.     

Institutional trading,investor sentiment,and lottery-like stock preferences

This paper explores the time-varying institutional investor preference for lottery-like stocks. On average, institutional investor holdings reflect an aversion to lottery-like stocks. However, I find that an institutions’ aversion to lottery-like stocks is reduced when investor sentiment is low. Moreover, I find that during low sentiment periods, institutional investors have abnormally high trading profits in more positively skewed stocks. These results suggest that institutions reduce their aversion toward lottery-like stocks during low sentiment periods to profitably trade in lottery-like stocks.     

Inflation and the stock market: Understanding the “Fed Model”

The so-called Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data there is indeed a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation is often attributed to the fact that both bond and equity yields comove strongly and positively with expected inflation. Contrary to some of the extant literature, we show that this effect is consistent with modern asset pricing theory incorporating uncertainty about real growth prospects and habit-based risk aversion. In the US, high expected inflation has tended to coincide with periods of heightened uncertainty about real economic growth and unusually high risk aversion, both of which rationally raise equity yields.     

Multi-scale variation,path risk and long-term portfolio management

Mean–variance analysis is constrained to weight the frequency bands in a return time series equally. A more flexible approach allows the user to assign preference weightings to short or longer run frequencies. Wavelet analysis provides further flexibility, removing the need to assume asset returns are stationary and encompassing alternative return concepts. The resulting portfolio choice methodology establishes a reward–energy efficient frontier that allows the user to trade off expected reward against path risk, reflecting preferences as between long or short run variation. The approach leads to dynamic analogues of mean–variance such as band pass portfolios that are more sensitive to variability at designated scales.     

Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence

We show that a life‐cycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein–Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks.     

The Effect of Temporal Risk Aversion on Optimal Consumption,the Equity Premium,and the Equilibrium Interest Rate

This paper demonstrates that temporal risk aversion makes smoothing consumption over time less attractive, while the usual risk aversion makes it more attractive. As temporal risk aversion increases, the equilibrium interest rate decreases and the equity premium increases. This paper also shows a striking and novel result that an increase in time impatience can lead to either a decrease or an increase in the interest rate, depending on the nature of the nonseparability.     

Stock performance by utility indifference pricing and the Sharpe ratio

We compare stock performance based on utility indifference pricing and the Sharpe ratio assuming that stock returns follow the class of discrete normal mixture distributions. The utility indifference price with an exponential utility function satisfies several desirable properties that a suitable value measure should satisfy. For utility indifference pricing, we employ the inner rate of risk aversion proposed by Miyahara [Evaluation of the scale risk. RIMS Kokyuroku, No. 1886, Financial Modeling and Analysis (2013/11/20-2013/11/22), 181–188, 2014], which is the degree of risk aversion that makes the utility indifference price with the exponential utility function zero in order to evaluate stock performance. Using a selection of U.S. stocks, the results show that the evaluation of stock performance based on the inner rate of risk aversion is more relevant for risk-averse investors than that based on the Sharpe ratio, which represents performance by the first two moments.     

Capital market equilibrium with heterogeneous investors

As a two-parameter model that satisfies stochastic dominance, the mean-extended Gini model is used to build efficient portfolios. The model quantifies risk aversion heterogeneity in capital markets. In a simple Edgeworth box framework, we show how capital market equilibrium is achieved for risky assets. This approach provides a richer basis for analysing the pricing of risky assets under heterogeneous preferences. Our main results are: (1) identical investors, who use the same statistic to represent risk, hold identical portfolios of risky assets equal to the market portfolio; and (2) heterogeneous investors as expressed by the variance or the extended Gini hold different risky assets in portfolios, and therefore no one holds the market portfolio.     

The Effect of Market Regimes on Style Allocation

We analyse time-varying risk premia and the implications for portfolio choice. Using Markov Chain Monte Carlo (MCMC) methods, we estimate a multivariate regime-switching model for the Carhart (1997) four-factor model. We find two clearly separable regimes with different mean returns, volatilities, and correlations. In the High-Variance Regime, only value stocks deliver a good performance, whereas in the Low-Variance Regime, the market portfolio and momentum stocks promise high returns. Regime-switching induces investors to change their portfolio style over time depending on the investment horizon, the risk aversion, and the prevailing regime. Value investing seems to be a rational strategy in the High-Variance Regime, momentum investing in the Low-Variance Regime. An empirical out-of-sample backtest indicates that this switching strategy can be profitable, but the overall forecasting ability for the regime-switching model seems to be weak compared to the iid model.