An Empirical Analysis of the Pricing of Collateralized Debt Obligations

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three‐factor portfolio credit model explains virtually all of the time‐series and cross‐sectional variation in an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm‐specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.     

The performance of model based option trading strategies

This paper analyzes returns to trading strategies in options markets that exploit information given by a theoretical asset pricing model. We examine trading strategies in which a positive portfolio weight is assigned to assets which market prices exceed the price of a theoretical asset pricing model. We investigate portfolio rules which mimic standard mean-variance analysis is used to construct optimal model based portfolio weights. In essence, these portfolio rules allow estimation risk, as well as price risk to be approximately hedged. An empirical exercise shows that the portfolio rules give out-of-sample Sharpe ratios exceeding unity for S&P 500 options. Portfolio returns have no discernible correlation with systematic risk factors, which is troubling for traditional risk based asset pricing explanations.     

Portfolio rebalancing and the transmission of large-scale asset purchase programs: Evidence from the Euro area

The European Central Bank's large-scale asset purchase program targeted safe assets, but also aimed to impact prices of risky assets. The mechanism for this is the “portfolio rebalancing channel”, where financial institutions’ portfolio decisions impact financial prices more broadly. We examine this mechanism using cross-sectional heterogeneity in how the financial portfolios of different sectors of the European economy were affected around the purchase program. We find evidence of rebalancing. In vulnerable countries, where macroeconomic unbalances and relatively high risk premia remained, we document rebalancing towards riskier securities. In less vulnerable countries, based on granular information for large European banks, we document rebalancing toward bank loans.     

Strategic technology adoption and hedging under incomplete markets

We investigate the implications of technological innovation and non-diversifiable risk on entrepreneurial entry and optimal portfolio choice. In a real options model where two risk-averse individuals strategically decide on technology adoption, we show that the impact of non-diversifiable risk on the option timing decision is ambiguous and depends on the frequency of technological change. Compared to the complete market case, non-diversifiable risk may accelerate or delay the optimal investment decision. Moreover, strategic considerations regarding technology adoption play a central role for the entrepreneur’s optimal portfolio choice in the presence of non-diversifiable risk.     

Is Financial Flexibility a Priced Factor in the Stock Market?

This paper develops a factor analysis–based measure for shifts in corporate financial flexibility (FFLEX) that can be observed from public accounting information. Companies that experience positive shifts in FFLEX are associated with higher future investment growth opportunities. We show that FFLEX is a robust determinant of future stock returns. Firms that have increased their financial flexibility are associated with lower stock returns in the subsequent period. A zero‐cost return portfolio produces a significant positive monthly premium of 0.69%, which is driven by covariance (risk). Risk inherent in the flexibility factor is not explained away by either prominent pricing characteristics or factors.     

Risks and rewards for momentum and reversal portfolios

Rational asset pricing implies a positive relation between the expected risk-adjusted return and the volatility of a factor-mimicking portfolio. The relation for the momentum portfolio is weak after its return is adjusted for the risks associated with the market return, the size factor, and the book-to-market factor. However, the relation is significantly positive and captures most of the average return on the momentum portfolio after the return is adjusted for the market return and the risk associated with the short-term reversal portfolio return. The result supports the hypothesis that there is a common factor underlying both momentum and short-term reversal. The dynamics of the factor loadings and the correlation structure of the underlying factors have important implications for the risk prices associated with the factor-mimicking portfolios and the risk–return trade-off for momentum and reversal portfolios.     

A generalized coherent risk measure: The firm's perspective

This note extends the concept of a coherent risk measure to make it more consistent with a firm's capital budgeting perspective. A coherent risk measure defines the risk of a portfolio to be that amount of cash that must be added to the portfolio such that it becomes acceptable to a regulator. As such, a coherent risk measure implicitly assumes that the firm has already made its capital budgeting decision. Except for a cash infusion, the portfolio composition remains unchanged. We propose a generalized version of a coherent risk measure that also allows the portfolio composition to change as well. Once the investment decisions are fixed, our measure collapses to a coherent risk measure.     

Messages from market to management: the case of IPOs

An IPO's initial return contains new information about the true value of the firm and, hence, provides vital feedback for the investment decision. A high initial return encourages managers to expand, while a lower than expected post-IPO price leads to a reduction of the capital budget. Information production by market participants increases the precision of the market feedback captured in the first competitively determined stock price. Managers can entice investors to produce more information by selling larger stakes at lower prices. A too low offer price, however, attracts uninformed investors and decreases information production.     

The Performance Effect of Feedback Frequency and Detail: Evidence from a Field Experiment in Customer Satisfaction

This paper presents the results from a field experiment that examines the effects of nonfinancial performance feedback on the behavior of professionals working for an insurance repair company. We vary the frequency (weekly and monthly) and the level of detail of the feedback that the 800 professionals receive. Contrary to what we would expect if these professionals conformed to the model of the Bayesian decision maker, more (and more frequent) information does not always help improve performance. In fact, we find that professionals achieve the best outcomes when they receive detailed but infrequent (monthly) feedback. The treatment groups with frequent feedback, regardless of how detailed it is, perform no better than the control group (with monthly and aggregate information). The results are consistent with the information in the latest feedback report being most salient and professionals in the weekly treatments overweighting their most recent performance, hampering their ability to learn.     

The impact of keeping up with the Joneses behavior on asset prices and portfolio choice

This paper studies the asset pricing and portfolio choice implications of keeping up with the Joneses preferences. In terms of portfolio choice, we provide sufficient conditions on the utility function under which no portfolio bias can arise across agents in equilibrium. Regarding asset prices, we find that under Joneses behavior asset prices are a function of the economy's aggregate consumption, the agents preference parameters, the wealth endowment distribution and the weighting across agents in the Joneses definition. We present necessary and sufficient conditions such that equilibrium prices are only a function of aggregate wealth. Non-financial, non-diversifiable income is introduced in the model. In the presence of Joneses behavior, an under-diversified equilibrium emerges where investors will bias their portfolios towards the financial assets that better hedge their exposure to the non-financial income risk.     

Feedback from Stock Prices to Cash Flows

Feedback from financial market prices to cash flows arises when a firm's nonfinancial stakeholders, for example, its customers, employees, and suppliers, make decisions that are contingent on the information revealed by the price. Complementarities across stakeholders result in cascades, wherein relatively small stock price moves trigger substantial changes in asset values. This paper analyzes the relation between such feedback effects and parameters such as the information cost, the volatility of existing projects, the risk aversion of liquidity suppliers, and the precision of managerial information.     

Does an intertemporal tradeoff between risk and return explain mean reversion in stock prices?

When volatility feedback is taken into account, there is strong evidence of a positive tradeoff between stock market volatility and expected returns on a market portfolio. In this paper, we ask whether this intertemporal tradeoff between risk and return is responsible for the reported evidence of mean reversion in stock prices. There are two relevant findings. First, price movements not related to the effects of Markov-switching market volatility are largely unpredictable over long horizons. Second, time-varying parameter estimates of the long-horizon predictability of stock returns reject any systematic mean reversion in favour of behaviour implicit in the historical timing of the tradeoff between risk and return.     

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.     

A Time-Series Model of Stock Returns with a Positive Short-Term Correlation and a Negative Long-Term Correlation

We study portfolio stock return behavior that exhibits both a positive autocorrelation over short horizons and a negative autocorrelation over long horizons. These autocorrelations are more significant in small size portfolios. Among various forms of temporary components in stock prices, an AR(2) component is the simplest model compatible with this pattern of returns, which yields an ARMA(2,2) model of stock returns. We show that the significance of this model is that it requires the presence of feedback trading, which is a form of irrational trades, and the market's slow adjustment to the market fundamentals, which is consistent with recent modelings of stock prices. We find that the variation of the temporary component becomes greater as the firm size gets smaller. This implies that the deviation from the market fundamentals is larger in small size portfolios than in large size portfolios.     

Climate change financial risks: Implications for asset pricing and interest rates

In addition to tail macroeconomic events (e.g. wars, financial crises and pandemics), climate change poses a threat to financial stability — with extreme climatic events increasing in frequency and intensity and policy risks putting pressure on asset valuations. We study the effect of a changing climate on asset prices and interest rates through the lens of a dynamic CAPM with rare disasters, time-varying risk and recursive preferences. In our model, a changing climate makes tail events more frequent and less predictable, increasing the premium of climate risk; interestingly, this change may not be fully reflected in the overall market risk premium that includes both components of risk: macroeconomic and environmental. Our results also support the hypothesis of a declining real rate of interest as the planet warms, while the increasing risk of climate policy reduces the participation of brown assets in the market portfolio.     

Price and Volatility Transmission across Borders

Over the past forty years, financial markets throughout the world have steadily become more open to foreign investors. With open markets, asset prices are determined globally. A vast literature on portfolio choice and asset pricing has evolved to study the importance of global factors as well as local factors as determinants of portfolio choice and of expected returns on risky assets. There is growing evidence that risk premia are increasingly determined globally. An important outcome of this force of globalization is increased comovement in asset prices across markets. This survey study examines the literature on the dynamics of comovements in asset prices and volatility across markets around the world. The literature began in the 1970s in conjunction with early theoretical developments on international asset pricing models, but it blossomed in the late 1980s and early 1990s with the availability of comprehensive international stock market databases and the development of econometric methodology to model these dynamics.     

Portfolio Insurance Strategies when Hedging Affects Share Prices

Option-based portfolio insurance can result in coordinated buying and selling, which destabilizes markets such that hedgers fail to achieve their objective. Gennotte and Leland (1990) show portfolio insurance strategies can have an impact on price movements. Ramanlal and Mann (1996) show how price movements, in turn, can alter hedging strategies. In this paper, we combine these separate effects and develop an equilibrium, executable hedging strategy. This hedging strategy requires less rebalancing than traditional portfolio insurance; more important, it achieves downside protection with a less destabilizing impact on security prices.     

PORTFOLIO CHOICES,CONSUMPTION, AND PRICES IN A MARKET WITH DURABLE ASSETS

Recent research in investments has focused almost exclusively on financial assets such as corporate stocks. Although durable assets constitute an important part of investors' holdings, little effort has been made to explore their role in individuals' investments decisions and on assets pricing. This paper establishes results concerning the role of durable assets in the determination of optimum portfolio choices. The paper explores the effect of consumption considerations related to the service flows generated by durable assets on optimum portfolio considerations and asset prices. The main result is tied to the existence, or lack thereof, of efficient rental markets. In the absence of rental markets (or with restrictions on renting), investors' portfolio choices are not independent of consumption considerations as they are assumed to be in the standard CAPM. Individuals may thus hold different portfolios, and prices reflect the owner's inability to trade consumption flows. Under perfect market assumptions with unrestricted rental markets, optimum portfolio choices are undistinguishable from those implied by the standard CAPM in the sense that they are mean-variance efficient and identical for all individuals. Consumption is adjusted by trading service flows in the rental market. Prices, and the price of risk, however, reflect the existence of durable assets service flows as well as the risks involved in trading these flows in the rental market. In the model, risky rental income is introduced by uncertain rental costs. Equilibrium rental rates, an important part of the return expected from holding durable assets, are determined in the context of the mean-variance framework as a function of return and undiversifiable risk.     

The high-volume return premium: evidence from the Chinese stock market

Extreme trading activity contains valuable information about the future evolution of stock prices in the Chinese stock market. Over the next 30 trading days after the initial volume shocks, a high-low volume portfolio earns a net average cumulate return of 2.08% and a high-low volume and size portfolio earns 3.37%, suggesting that there exists a high-volume return premium and that Chinese investors favor high-volume small-size stocks. However, a volume momentum portfolio earns a −1.65% net average cumulative return, indicating that Chinese stocks exhibit a short-run reversal. Portfolio construction, market risk, and firm size do not seem to explain the results.     

Ambiguous Information,Portfolio Inertia,and Excess Volatility

I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, investors may not react to price changes even if there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.