Lessons from the evolution of foreign exchange trading strategies

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and US equities. The results show that a backtesting procedure to choose optimal portfolios improves upon the performance of nonadaptive rules. We also find that forex trading alone dramatically outperforms the S&P 500, with much larger Sharpe ratios over the whole sample, but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have been markedly superior to an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.     

A stochastic dominance analysis of yen carry trades

Yen carry trades have made headline news for over a decade. We examine the profitability of such trades for the period 2001–2009. Yen carry trades generated high mean returns and Sharpe ratios prior to the recent financial crisis. They continued to outperform major stock markets for the full sample period. Given the non-normality of carry trade returns, we apply non-parametric tests based on stochastic dominance (SD) to evaluate whether the high returns of yen carry trades are compatible with risk as reflected in returns on US and global stock market indices. We apply a general test for SD developed recently by Linton, Maasoumi and Whang (2005) to six currencies as well as portfolios of these currencies. For a large class of risk-averse investors, profits from yen carry trades cannot be attributed to risks.     

Leverage constraints and asset prices: Insights from mutual fund risk taking

Prior theory suggests that time variation in the degree to which leverage constraints bind affects the pricing kernel. We propose a measure for this leverage constraint tightness by inverting the argument that constrained investors tilt their portfolios to riskier assets. We show that the average market beta of actively managed mutual funds—intermediaries facing leverage restrictions—captures their desire for leverage and thus the tightness of constraints. Consistent with theory, it strongly predicts returns of the betting-against-beta portfolio, and is a priced risk factor in the cross-section of mutual funds and stocks. Funds with low exposure to the factor outperform high-exposure funds by 5% annually, and for stocks this difference reaches 7%. Our results show that the tightness of leverage constraints has important implications for asset prices.     

Leverage Constraints and the International Transmission of Shocks

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage‐constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro comovements. When leverage constraints bind, however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel that results in a positive comovement of production, independently of the size of international trade linkages. In addition, the paper shows that with binding leverage constraints, the type of financial integration is critical for international comovement. If international financial markets allow for trade only in noncontingent bonds, but not equities, then the international comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.     

Abnormal Returns from Takeover Prediction Modelling: Challenges and Suggested Investment Strategies

While takeover targets earn significant abnormal returns, studies tend to find no abnormal returns from investing in predicted takeover targets. In this study, we show that the difficulty of correctly identifying targets ex ante does not fully explain the below‐expected returns to target portfolios. Target prediction models’ inability to optimally time impending takeovers, by taking account of pre‐bid target underperformance and the anticipation of potential targets by other market participants, diminishes but does not eliminate the potential profitability of investing in predicted targets. Importantly, we find that target portfolios are predisposed to underperform, as targets and distressed firms share common firm characteristics, resulting in the misclassification of a disproportionately high number of distressed firms as potential targets. We show that this problem can be mitigated, and significant risk‐adjusted returns can be earned, by screening firms in target portfolios for size, leverage and liquidity.     

Size matters: Optimal calibration of shrinkage estimators for portfolio selection

We carry out a comprehensive investigation of shrinkage estimators for asset allocation, and we find that size matters—the shrinkage intensity plays a significant role in the performance of the resulting estimated optimal portfolios. We study both portfolios computed from shrinkage estimators of the moments of asset returns (shrinkage moments), as well as shrinkage portfolios obtained by shrinking the portfolio weights directly. We make several contributions in this field. First, we propose two novel calibration criteria for the vector of means and the inverse covariance matrix. Second, for the covariance matrix we propose a novel calibration criterion that takes the condition number optimally into account. Third, for shrinkage portfolios we study two novel calibration criteria. Fourth, we propose a simple multivariate smoothed bootstrap approach to construct the optimal shrinkage intensity. Finally, we carry out an extensive out-of-sample analysis with simulated and empirical datasets, and we characterize the performance of the different shrinkage estimators for portfolio selection.     

TRADING OF NASDAQ STOCKS ON THE CHICAGO STOCK EXCHANGE

We use a linear programming model to form two portfolios with approximately equal levels of attributes such as financial leverage. One portfolio comprises stocks that trade exclusively on NASDAQ and the other, stocks that trade on both the Chicago Stock Exchange (CSE) and NASDAQ (CSE/NASDAQ). We find that spreads are lower for the CSE/NASDAQ portfolio, but so is the percentage of quotes at spreads of $0.125. In fact, the lower spreads observed for the CSE/NASDAQ portfolio arise from fewer quotes with spreads of more than $0.25.     

Corporate leverage and the collateral channel

We investigate whether and how corporate leverage depends on the structure of corporate assets. Based on a large panel dataset of US firms from 1990 to 2010, we show that property, plant and equipment are important drivers of the collateral channel, while inventories and receivables are less important. The collateral channel is more pronounced for firms that have to rely on banks and trade creditors to raise debt finance, but it has become weaker for these firms after the start of the financial crisis. Our study provides new evidence on the cross-sectional and time-varying importance of the collateral channel for corporate leverage.     

A Model of Shadow Banking

We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry‐ups when investors neglect tail risks.     

Institutional stock trading on loan market information

One of the most important developments in the corporate loan market over the past decade has been the growing participation of institutional investors. As lenders, institutional investors routinely receive private information about borrowers. However, most of these investors also trade in public securities. This leads to a controversial question: Do institutional investors use private information acquired in the loan market to trade in public securities? This paper examines the stock trading of institutional investors whose portfolios also hold loans. Using the Securities and Exchange Commission filings of loan amendments, we identify institutional investors with access to private information disclosed during loan amendments. We then look at abnormal returns on subsequent stock trades. We find that institutional participants in loan renegotiations subsequently trade in the stock of the same company and outperform trades by other managers and trades in other stocks by approximately 5.4% in annualized terms.     

Leverage and debt maturity choices by undiversified owner-managers

We examine the financing choices of undiversified owner-managers in a continuous-time model. Managers' financing choices as well as their dynamic equity stakes, which trade off their private benefits and the costs they incur due to their lack of diversification, are simultaneously and endogenously determined. Our analysis leads to the novel, empirically testable implications that leverage increases with the drift or expected growth rate of the firm's earnings. Debt maturity varies non-monotonically in a U-shaped manner with the project's drift and with its volatility. The predicted variations of leverage and debt maturity with the actual drift of earnings (controlling for the risk-neutral drift) are key implications of our theory that arise from the incorporation of agency conflicts between undiversified managers and well-diversified outside investors. They cannot, therefore, be obtained in traditional capital structure models in which all agents are well-diversified. Our predictions for the variation of leverage and debt maturity with project characteristics potentially reconcile empirical findings that are not consistent with previous theories. We also derive additional novel implications that link manager-specific characteristics - the discount rate or “degree of myopia” and the risk aversion - to leverage and debt maturity. These implications provide support for growing empirical evidence of the significant impact of manager characteristics and manager “fixed effects” on corporate financial policies.     

ARE PAIRS TRADING PROFITS ROBUST TO TRADING COSTS?

We examine the impact of trading costs on pairs trading profitability in the U.S. equity market, 1963 to 2009. After controlling for commissions, market impact, and short selling fees, pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk‐adjusted return of about 30 basis points per month among portfolios of well‐matched pairs that are formed within refined industry groups. Pairs trading exhibits a lower risk and lower return profile than a short‐term reversal strategy that sorts stocks relative to their industry peers. Notably, both these types of contrarian investing are largely unprofitable after 2002.     

A comparison of buy‐side and sell‐side analysts

There is very little research on the topic of buy-side analyst performance, and that which does exist yields mixed results. We use a large sample from both the buy-side and the sell-side and report several new results. First, while the contemporaneous returns to portfolios based on sell-side recommendations are positive, the returns for buy-side analysts, proxied by changes in institutional holdings, are negative. Second, the buy-side analysts' underperformance is accentuated when they trade against sell-side analysts' recommendations. Third, abnormal returns positively relate to both the portfolio size and the portfolio turnover of buy-side analysts' institutions, suggesting that large institutions employ superior analysts and that superior analysts frequently change their recommendations. Abnormal returns are also positively related to buy-side portfolios with stocks that have higher analyst coverage, greater institutional holding, and lower earnings forecast dispersion. Fourth, there is substantial persistence in buy-side performance, but even the top decile performs poorly. These findings suggest that sell-side analysts still outperform buy-side analysts despite the severe conflicts of interest documented in the literature.     

Optimal Number of Stock Holdings in Mutual Fund Portfolios Based on Market Performance

Among the decisions that most mutual fund portfolio managers make is the number of stocks to hold. We posit that there is an optimal number of stocks for each mutual fund, reflecting the trade‐off between diversification benefits versus transactions and monitoring costs. We find a significant quadratic relation between number of stock holdings and risk‐adjusted returns for U.S. equity mutual fund portfolios during 1992–2000. Moreover, we find that changes in the number of stocks held over time are more highly correlated with mutual fund flows than with funds' investment returns.     

Individual investor perceptions and behavior during the financial crisis

Combining monthly survey data with matching trading records, we examine how individual investor perceptions change and drive trading and risk-taking behavior during the 2008–2009 financial crisis. We find that investor perceptions fluctuate significantly during the crisis, with risk tolerance and risk perceptions being less volatile than return expectations. During the worst months of the crisis, investors’ return expectations and risk tolerance decrease, while their risk perceptions increase. Towards the end of the crisis, investor perceptions recover. We document substantial swings in trading and risk-taking behavior that are driven by changes in investor perceptions. Overall, individual investors continue to trade actively and do not de-risk their investment portfolios during the crisis.     

Hedge fund portfolio construction: A comparison of static and dynamic approaches

This article studies the impact of modeling time-varying covariances/correlations of hedge fund returns in terms of hedge fund portfolio construction and risk measurement. We use a variety of static and dynamic covariance/correlation prediction models and compare the optimized portfolios’ out-of-sample performance. We find that dynamic covariance/correlation models construct portfolios with lower risk and higher out-of-sample risk-adjusted realized return. The tail-risk of the constructed portfolios is also lower. Using a mean-conditional-value-at-risk framework we show that dynamic covariance/correlation models are also successful in constructing portfolios with minimum tail-risk.     

Risk‐Adjusted Long‐Term Contrarian Profits: Evidence from Non‐S&P 500 High‐Volume Stocks

Can trading volume help unravel the long‐term overreaction puzzle? With portfolios of non‐S&P 500 NYSE stocks, we show that (1) both the high‐ and low‐volume (abnormal volume) contrarian portfolios earn a much higher market‐adjusted excess return than the normal‐volume contrarian portfolio, (2) however, when leverage‐induced risk is factored in, excess returns from contrarian portfolios with normal‐ and low‐volume stocks are insignificant, (3) only excess returns from high‐volume contrarian stocks are significant and cannot be explained by the time‐varying risk and return framework, and (4) such high‐volume, risk‐adjusted excess returns arise mainly from winner (glamour) stocks.     

Crash-neutral currency carry trades

Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies deliver significant excess returns with annualized Sharpe ratios equal to or greater than those of equity market factors (1990–2012). Using data on out-of-the-money foreign exchange options, I compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems. A comparison of the returns to hedged and unhedged trades indicates crash risk premia account for at most one-third of the excess return to currency carry trades.     

DOES FINANCIAL FLEXIBILITY REDUCE INVESTMENT DISTORTIONS?

The average U.S. firm has less leverage than one would expect based on the trade‐off between tax shields and bankruptcy costs. We focus on firms’ financial flexibility and examine whether firms preserve debt capacity to reduce investment distortions in the future. We find that firms with high unused debt capacity invest more in future years than do firms with low unused debt capacity. Furthermore, firms that are reluctant to borrow in unconstrained periods are more likely to issue debt in periods in which access to capital markets is more constrained.     

Countercyclical currency risk premia

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.