Cross hedging under multiplicative basis risk

Cross hedging price risk in an incomplete financial market creates basis risk. We propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way. Under this specification, positive prudence is a necessary and sufficient condition for underhedging in an unbiased market. Using the example of cross hedging jet fuel price risk with crude oil futures, we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model.     

International transmission of information: evidence from the Euroyen and Eurodollar futures markets

This paper examines the information transmission between Japan and the US by using the Tokyo Euroyen and Chicago Eurodollar futures. These two interest rate futures markets provide a better understanding of international information transmission than stock markets, which have been shown to exhibit nonsynchronous trading and market segmentation. The results show that traders in Tokyo (Chicago) use information that is revealed overnight in Chicago (Tokyo). The bivariate EGARCH-t model provides no evidence of volatility spillovers in either direction, suggesting that the opening price rapidly reflects foreign information. The overall results support the hypothesis that the domestic market efficiently adjusts to foreign news. The results are also broadly consistent with the covered interest arbitrage effects.     

The impacts of large trades by trader types on intraday futures prices: Evidence from the Taiwan Futures Exchange

We find that China's P/E ratio is comparable to that of the U.S. S&P 1500 index, a broad based index covering large, middle, and small capitalization firms. We provide an explanation as to why China's seemingly low P/E ratio is not surprising in light of the economic growth that it has experienced. Specifically, we show that (i) the P/E ratio is negatively associated with earnings volatility in both the Chinese and U.S. stock markets with an economically significant magnitude; and (ii) historical earnings volatility is considerably higher in China than in the U.S. Higher earnings volatility in China offsets higher growth prospect in setting the P/E ratio, making its P/E ratio much closer to what is observed empirically than otherwise implied by its growth rate.     

A multi-country test of the Fisher model for stock returns

This article provides a test of the Fisher model, linking expected stock returns and inflation, based on international data. Since the Fisher model is ‘universal’ and calls for a slope of 1 in any country, we improve the testing power by conducting a joint test over eight countries. The pooling of data for several countries seems to reduce the small-sample bias. We test the Fisher model, using an instrumental variable approach, for holding-period horizons ranging from 1–12 months. The Fisher model is not rejected at any horizon: however, the magnitude of the slope coefficient lends stronger support at long horizons. This study using multi-country panel data provides evidence corroborating the finding of Boudoukh and Richardson (1993) that the Fisher model holds at long horizons (5 years), using 180 years of US data.     

Testing weak form efficiency on the Toronto Stock Exchange

In order to test for weak form efficiency in the market a vast pool of individual stocks must be analyzed rather than a stock market index. In this paper, a model-based bootstrap is used to generate a series of simulated trials and a modified chart pattern recognition algorithm is applied to all stocks listed on the Toronto Stock Exchange (TSX). The number of patterns detected in the original price series is compared with the number of patterns found in the simulated series. By simulating the price path specific time dependencies present in real data are eliminated, making price changes purely random. Patterns, if consistently identified, carry information which adds value to the investment process, however, this informativeness does not guarantee profitability. Conclusions are drawn on the relative efficiency of some sectors of the economy. Although the null hypothesis of weak form efficiency on the TSX cannot be rejected, some sectors of the Canadian economy appear to be less efficient than others. In addition, pattern frequencies appear to be negatively dependent on the two moments of return distributions, variance and kurtosis.     

The economic value of range-based covariance between stock and bond returns with dynamic copulas

The covariance between stock and bond returns plays important roles in the setting up of asset allocation strategies and portfolio diversification. In the present study, we propose a multivariate range-based volatility model incorporating dynamic copulas into a range-based volatility model to describe the volatility and dependence structures of stock and bond returns. We then go on to assess the economic value of the covariance forecasts based on our proposed model under a mean-variance framework. The out-of-sample forecasting performance reveals that investors would be willing to pay between 39 and 2081 basis points per year to switch from a dynamic trading strategy under the return-based volatility model to a dynamic trading strategy under the range-based volatility model, with more risk-averse investors being willing to pay even higher switching fees. Furthermore, additional economic gains of between 33 and 1471 annualized basis points are achieved when taking the leverage effect into consideration.     

Habit-based asset pricing with limited participation consumption

We calibrate and estimate a consumption-based asset pricing model with habit formation using limited participation consumption data. Based on survey data of a representative sample of American households, we distinguish between assetholder and non-assetholder consumption, as well as the standard aggregate consumption series commonly used in the CCAPM literature. We show that assetholder consumption outperforms non-assetholder and aggregate consumption data in explaining bond returns, bond yields, and the volatility of bond yields. We further show that the high volatility of assetholder consumption enables the model to explain the equity premium puzzle and the risk-free rate puzzle simultaneously for a reasonable value of relative risk aversion.     

Macroeconomic risk and the cross-section of stock returns

We develop a conditional version of the consumption capital asset pricing model (CCAPM) using the conditioning variable from the cointegrating relation among macroeconomic variables (dividend yield, term spread, default spread, and short-term interest rate). Our conditioning variable has a strong power to predict market excess returns in the presence of competing predictive variables. In addition, our conditional CCAPM performs approximately as well as Fama and French’s (1993) three-factor model in explaining the cross-section of the Fama and French 25 size and book-to-market sorted portfolios. Our specification shows that value stocks are riskier than growth stocks in bad times, supporting the risk-based story.     

Control-ownership wedge and investment sensitivity to stock price

This study examines whether insiders’ incentives for private control benefits affect investment sensitivity to stock price. While Chen et al. (2007) link stock price informativeness to firms’ learning from the stock market, we offer an alternative agency-cost based explanation. Using a total of 2822 firms from 22 countries in East Asia and Western Europe, we document a strong negative association between control-ownership wedge and investment-q sensitivity, suggesting that insiders’ incentives for private control benefit reduce their propensity to listen to the market. Furthermore, the negative impact of wedge on investment-q sensitivity is primarily driven by sub-optimal investments. Overall, we provide evidence that agency problem is an important factor that determines the learning from the stock market in capital allocation.     

Determinants of the guarantee circles: The case of Chinese listed firms

China's external capital market has been developing rapidly since the establishment of its stock markets. However, financing from the internal capital market, especially through the guarantee system provided by other associated firms (the guarantee circle), remains significant for some Chinese firms. We analyze the importance associated with the guarantee system in China with a focus on the macro and micro determinants that affect Chinese firms' participation in the guarantee circle. Our findings suggest that both macroeconomic and microeconomic factors have significant impact on a firm's involvement in the guarantee circle. Firms in regions with higher economic growth, less developed banking system and worse legal protection are more likely to receive guarantee from firms associated with the controlling shareholders. On the other hand, firms controlled by the state are less likely to receive guarantee but more likely to provide guarantee, while firms with alternative financing sources are more likely to provide guarantee. Firms within a complex group with more pyramidal layers are more likely to get involved in the guarantee circle, either as a guarantor or a guarantee. Our findings have implications to general guarantee systems with the presence of agency and moral hazard problems.     

Return on capital analysis: U.S.-based multinational corporations versus U.S. domestic corporations

We study the difference between U.S.-based multinational corporations (MNCs) and U.S. domestic corporations (DCs) in terms of management efficiency with return on capital as the measure of management efficiency. We use a fixed effect model to account for heterogeneity and/or the time-specific effect and find that MNCs have lower management efficiency than DCs, which holds after we control for the effects of firm size, GDP growth rate, and growth opportunity on management efficiency. One reason for the low efficiency is the MNCs’ inability to manage their assets well relative to DCs. We also find that there is an inverted U-shaped relationship between return on capital and degree of internationalization, which implies an optimal degree of internationalization. Our result does not confirm the recently proposed three-stage model.     

Cross-country IPOs: What explains differences in underpricing?

We study the impacts of country-level information asymmetry, investors' home-country bias, effectiveness of contract enforcement mechanisms, and accessibility of legal recourse on IPO underpricing in 36 countries around the globe. We find evidence consistent with all four of our hypotheses. First, we find a positive and significant effect of country-level information asymmetry on IPO underpricing. Second, our empirical evidence is consistent with the agency-cost-based explanation of IPO underpricing. We find that lower cost to entice the block holders, measured by domestic investors' home-country bias, reduces IPO underpricing. Third, we find that effective contract enforcement mechanisms help to reduce IPO underpricing. Finally, we find a positive relation between the accessibility of legal recourse and IPO underpricing.     

Predicting dividends in log-linear present value models

In a present value model, high dividend yields imply that either future dividend growth must be low, or future discount rates must be high, or both. While previous studies have largely focused on the predictability of future returns from dividend yields, dividend yields also strongly predict future dividends, and the predictability of dividend growth is much stronger than the predictability of returns at a one-year horizon. Inference from annual regressions over the 1927–2000 sample imputes over 85% of the variation of log dividend yields to variations in dividend growth. Point estimates of the predictability of both dividend growth and discount rates are stronger when the 1990–2000 decade is omitted.     

Strategic trading by index funds and liquidity provision around S&P 500 index additions

We examine the trades of index funds and other institutions around S&P 500 index additions. We find index funds begin rebalancing their portfolios with the announcement of composition changes and do not fully establish their positions until weeks after the effective date. Trading away from the effective date is more prevalent for stocks with lower levels of liquidity and among large index funds, which is consistent with index funds accepting higher tracking error in order to reduce the price impact of their trades. Small and mid-cap funds provide liquidity to index funds around additions, and added stocks with a greater proportion of these natural liquidity providers experience lower inclusion returns.     

Common asset pricing factors in volatilities and returns in futures markets

Factor-based asset pricing models have been used to explain the common predictable variation in excess asset returns. This paper combines means with volatilities of returns in several futures markets to explain their common predictable variation. Using a latent variables methodology, tests do not reject a single factor model with a common time-varying factor loading. The single common factor accounts for up to 53% of the predictable variation in the volatilities and up to 14% of the predictable variation in the means. S&P500 futures volatility predicted by the factor model is highly correlated with volatility implied in S&P500 futures options. But both the factor and implied volatilities are significant in predicting future volatility. In derivatives pricing, both implied volatility from options and factors extracted from asset pricing models should be employed.     

Announcement effects of convertible bond loans and warrant-bond loans: An empirical analysis for the Dutch market

This study investigates the announcement effects of offerings of convertible bond loans and warrant-bond loans using data for the Dutch market. The event study analysis shows that announcement effects of convertible bonds are associated with positive but insignificant abnormal returns and that announcements of warrant-bonds are associated with significant positive abnormal returns. These findings are similar to the results for Japanese hybrid debt, as reported by Kang et al. (1995) (Kang, J.K., Kim, Y.C., Park, K.J., Stulz, R.M., 1995. Journal of Financial and Quantitative Analysis, pp. 257–270) and Kang and Stulz (1996) (Kang, J.K., Stulz, R.M., 1996. Review of Financial Studies, pp. 109–139), but they contrast with studies for the United States that generally find significant negative abnormal returns for convertible bond loans and insignificant negative abnormal returns for warrant-bond loans. Our results cannot be attributed to differences in the corporate governance structures of the Netherlands and the United States. We find that the positive abnormal returns for the warrant-bond loans are caused by the packaging of the announcements with other (good) firm-specific news.     

Automation, speed, and stock market quality: The NYSE's Hybrid

Automation and trading speed are increasingly important aspects of competition among financial markets. Yet we know little about how changing a market's automation and speed affects the cost of immediacy and price discovery, two key dimensions of market quality. At the end of 2006 the New York Stock Exchange introduced its Hybrid Market, increasing automation and reducing the execution time for market orders from 10 seconds to less than one second. We find that the change raises the cost of immediacy (bid-ask spreads) because of increased adverse selection and reduces the noise in prices, making prices more efficient.     

A stubborn persistence: Is the stability of leverage ratios determined by the stability of the economy?

The choice of capital structure firms make is a fundamental issue in the financial literature. According to a recent finding, the capital structure of firms remains almost unchanged during their lives. This stability of leverage ratios is mainly generated by an unobserved firm-specific effect that is liable for the majority of the variation in capital structure. We demonstrate that even substantial changes in the economic environment do not affect the stability of firms' leverage due to the presence of credit constraints. Financially unconstrained firms are more responsive to economic changes and adjust to the target substantially faster than constrained firms. Moreover, accounting for the ownership structure of firms boosts the explanatory power of the model in the subsample of unconstrained firms, suggesting that annual information on ownership and ownership changes together with financial constraints have the potential to be an answer to the puzzle of stability in capital structure.     

Time-varying risk The case of the American computer industry

A bivariate GARCH-in-mean model for individual stock returns and the market portfolio is designed to model volatility and to test the conditional Capital Asset Pricing Model versus the conditional Residual Risk Model. We find that a univariate model of volatility for individual stock returns is misspecified. A joint modelling of the market return and the individual stock return shows that a major force driving the conditional variances of individual stocks is the history contained in the market return variance. We find that a conditional residual risk model, where the variance of the individual stock return is used to explain expected returns, is preferred to a conditional CAPM. We propose a partial ordering of securities according to their market risk using first and second order dominance criteria.