A best choice among asset pricing models? The Conditional Capital Asset Pricing Model in Australia

We use Australian data to test the Conditional Capital Asset Pricing Model (Jagannathan and Wang, 1996). Our results are generally supportive: the model performs well compared with a number of competing asset pricing models. In contrast to the study by Jagannathan and Wang, however, we find that the inclusion of the market for human capital does not save the concept of the time‐independent market beta (it remains insignificant). We find support for the role of a small‐minus‐big factor in pricing the cross‐section of returns and find grounds to disagree with Jagannathan and Wang's argument that this factor proxies for misspecified market risk.     

The characteristics of informed trading: Implications for asset pricing

This paper investigates the linkage of microstructure, accounting, and asset pricing. We determine the relationship between firm characteristics as captured by accounting and market data and a firm's probability of private information-based trade (PIN) as estimated from trade data. This allows us to determine what types of firms have high information risk. We then use these data to create an instrument for PIN, the PPIN, which we can estimate from firm-specific data. We show that PPINs have explanatory power for the cross-section of asset returns in long sample tests. We also investigate whether information risk vitiates the influence of other variables on asset returns. We develop a PPIN factor and show that it dominates the Amihud factor in asset returns. Our results provide strong support for information risk affecting asset returns in long sample tests.     

The effect of corporate social responsibility on stock performance: new evidence for the USA and Europe

This paper provides new empirical evidence for the effect of corporate social responsibility on corporate financial performance. In contrast to former studies, we examine two different regions, namely the USA and Europe, and disentangle firm and sector specific impacts. Our econometric analysis shows that environmental and social activities of a firm compared with other firms within the industry are valued by financial markets in both regions. However, the respective positive effects on average monthly stock returns between 2003 and 2006 are more robust in the USA and, in addition, non-linear. Our analysis furthermore points to biased parameter estimates if incorrectly specified econometric models are applied: the seemingly significantly negative effect of environmental and social performance of the industry to which a firm belongs strongly declines and mostly becomes insignificant if the explanation of stock performance is based on the Fama–French three-factor or the Carhart four-factor models instead of the simple Capital Asset Pricing Model.     

Pricing the Chicago Board of Trade T-Bond futures

The aim of this paper is to investigate the pricing of the Chicago Board of Trade (CBOT) Treasury-Bond futures. The difficulty in pricing it arises from its multiple inter-dependent embedded delivery options, which can be exercised at various times and dates during the delivery month. We consider a general Markov diffusion process model for stochastic interest rates and propose a pricing algorithm that can handle all the delivery rules embedded in the CBOT T-Bond futures. Our procedure combines dynamic programming, finite-elements approximation, and fixed-point evaluation. Numerical illustrations are provided under the one-factor Vasicek and Cox–Ingesoll–Ross models, and under the time in-homogeneous Hull–White model.     

Leveraged Lévy processes as models for stock prices

Adopting a constant elasticity of variance formulation in the context of a general Lévy process as the driving uncertainty we show that the presence of the leverage effect? ?One explanation of the documented negative relation between market volatilities and the level of asset prices (the ‘smile’ or ‘skew’), we term the ‘leverage effect’, argues that this negative relation reflects greater risk taking by the management, induced by a fall in the asset price, with a view of maximizing the option value of equity shareholders. in this form has the implication that asset price processes satisfy a scaling hypothesis. We develop forward partial integro-differential equations under a general Markovian setup, and show in two examples (both continuous and pure-jump Lévy) how to use them for option pricing when stock prices follow our leveraged Lévy processes. Using calibrated models we then show an example of simulation-based pricing and report on the adequacy of using leveraged Lévy models to value equity structured products.     

Shaking the tree: an agency-theoretic model of asset pricing

Summary. In this paper, we develop an agency-theoretic extension of the Lucas asset pricing model and examine the resulting asset price dynamics. In the model, an agent of the firm can expand or contract the firms output and dividend payments in response to exogenous shocks, although expansions become increasingly costly for the agent to maintain. Analysis of numerical simulations shows that the time-series of equilibrium asset prices exhibits both significant time-varying conditional heteroskedasticity, and longer memory persistence.We would like to thank Beth Shorish for her patience and guidance during this project, as well as conference participants at the 1998 North American Econometric Society Summer Meetings, Montreal, and the 53rd Econometric Society European Meetings, Berlin for their many useful comments.     

Monotonicity in asset returns: New tests with applications to the term structure,the CAPM,and portfolio sorts

Many theories in finance imply monotonic patterns in expected returns and other financial variables. The liquidity preference hypothesis predicts higher expected returns for bonds with longer times to maturity; the Capital Asset Pricing Model (CAPM) implies higher expected returns for stocks with higher betas; and standard asset pricing models imply that the pricing kernel is declining in market returns. The full set of implications of monotonicity is generally not exploited in empirical work, however. This paper proposes new and simple ways to test for monotonicity in financial variables and compares the proposed tests with extant alternatives such as t-tests, Bonferroni bounds, and multivariate inequality tests through empirical applications and simulations.     

iShares Australia: a clinical study in international behavioral finance

Using iShares Australia returns as a proxy for the influence of overseas investors in the Australian market, we found that U.S.-based investors in the Australian market overreact to contemporaneous and lagged returns of the U.S. equity market, the U.S.-Australian dollar exchange rate, and past iShares Australia returns. In response to changing conditional risk, however, investors behave rationally: increasing (decreasing) expected risk is associated with falling (rising) prices. In light of these findings, we hypothesize that behavioral finance might explain the observed correlations between international equity markets.     

Structural asset pricing theory with wavelets

We apply Fourier and wavelet decompositions to structural asset pricing models with time non-separable utility. Through simulations, we show how Fourier decompositions of the utility function, coupled with isolating certain frequencies of the stochastic consumption process, reveal a preference for temporal allocations. We demonstrate the usefulness of wavelets by highlighting their ability to isolate frequency and time, simultaneously. While much work has been devoted to wavelet applications of financial data, we are unaware of papers that use wavelets to analyze structural aspects of asset pricing models.     

The other side of value: The gross profitability premium

Profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios. Controlling for profitability also dramatically increases the performance of value strategies, especially among the largest, most liquid stocks. These results are difficult to reconcile with popular explanations of the value premium, as profitable firms are less prone to distress, have longer cash flow durations, and have lower levels of operating leverage. Controlling for gross profitability explains most earnings related anomalies and a wide range of seemingly unrelated profitable trading strategies.     

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.