Expected Returns,Time-varying Risk,and Risk Premia

A new empirical model for intertemporal capital asset pricing is presented that allows both time-varying risk premia and betas where the latter are identified from the dynamics of the conditional covariance of returns. The model is more successful in explaining the predictable variations in excess returns when the returns on the stock market and corporate bonds are included as risk factors than when the stock market is the single factor. Although changes in the covariance of returns induce variations in the betas, most of the predictable movements in returns are attributed to changes in the risk premia.     

TIME VARIATIONS IN RISK PREMIA,VOLATILITY, AND REWARD-TO-VOLATILITY

In this paper I relate the risk premia in the stock and bond markets to the conditional volatility of returns and time-varying reward-to-volatility variables. I find that the relation between the expected returns on the stocks and bonds and the volatility of returns is time varying. I provide an approach for evaluating the relative importance of the time-varying volatility of returns and reward-to-volatility variables to explain the predictability of risk premia for stock and bond returns. I show that changing reward-to-volatility variables explain more predictable variation in the risk premia for stocks and bonds than changing volatility of returns.     

Hedging effectiveness of the Athens stock index futures contracts

This paper examines the hedging effectiveness of the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 stock index futures contracts in the relatively new and fairly unresearched futures market of Greece. Both in-sample and out-of-sample hedging performances using weekly and daily data are examined, considering both constant and time-varying hedge ratios. Results indicate that time-varying hedging strategies provide incremental risk-reduction benefits in-sample, but under-perform simple constant hedging strategies out-of-sample. Moreover, futures contracts serve effectively their risk management role and compare favourably with results in other international stock index futures markets. Estimation of investor utility functions and corresponding optimal utility maximising hedge ratios yields similar results, in terms of model selection. For the FTSE/ATHEX Mid-40 contracts we identify the existence of speculative components, which lead to utility-maximising hedge ratios, that are different to the minimum variance hedge ratio solutions.     

The impact of (global) business cycle risk on the German and British stock markets: Evidence from the first age of globalization

In the period from 1880 to 1913, time-varying German and British stock market returns are related to business cycle variables such as the deviation of industrial production from trend. Common British and German business cycle dynamics Granger cause stock returns and explain more than 20% of time variation in one-year ahead stock market returns. The link between business cycle variables and stock returns is less pronounced in the modern era of financial globalization. A potential explanation for this finding is the fact that during the first globalization period stock indices were dominated by industrial companies and stock prices varied in line with dividends. In the modern era of globalization stock price dynamics predominantly reflect time-varying risk premia.     

Is the Market Portfolio a Dynamic Factor? Evidence from Individual Stock Returns

This paper uses a factor model to test whether the market portfolio is a dynamic factor in the sense that individual stock returns contain a premium linked to the conditional risk of the market portfolio. The market conditional risk is based on a decomposition of the market variance into a time-varying trend component and a transitory component. The evidence shows that the conditional market premium is rising when the permanent trend rises relative to the conditional variance. The evidence for individual stock returns supports the notion that the market portfolio is a dynamic factor. Individual stock return autocorrelations are fully explained by the time variation in the market premium. The risk premia attributed to static factors are statistically insignificant.     

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.     

CAPM over the long run: 1926–2001

A conditional one-factor model can account for the spread in the average returns of portfolios sorted by book-to-market ratios over the long run from 1926 to 2001. In contrast, earlier studies document strong evidence of a book-to-market effect using OLS regressions over post-1963 data. However, the betas of portfolios sorted by book-to-market ratios vary over time and in the presence of time-varying factor loadings, OLS inference produces inconsistent estimates of conditional alphas and betas. We show that under a conditional CAPM with time-varying betas, predictable market risk premia, and stochastic systematic volatility, there is little evidence that the conditional alpha for a book-to-market trading strategy is different from zero.     

The Lead‐Lag Relationship Between Cash and Stock Index Futures in a New Market

This paper investigates the lead‐lag relationship in daily returns and volatilities between price movements of the FTSE/ATHEX‐20 and FTSE/ATHEX Mid‐40 stock index futures and the underlying cash indices in the relatively new futures market of Greece. Empirical results show that there is a bi‐directional relationship between cash and futures prices. However, futures lead the cash index returns, by responding more rapidly to economic events than stock prices. This speed is much higher in the more liquid FTSE/ATHEX‐20 market. Moreover, results indicate that futures volatilities spill information over to the corresponding cash market volatilities in both investigated futures markets, but volatilities in the cash markets have no effect on the volatilities of futures markets. Overall, it seems that new market information is disseminated faster in the futures market compared to the stock market. This implies that the futures markets can be used as price discovery vehicles, providing further evidence that derivatives markets contribute to completing and stabilising capital markets in Greece. A further finding of this study is that futures volume and disequilibrium effects between cash and futures prices are important variables in the explanation of volatilities in cash and futures markets.     

Predictability of Emerging Market Local Currency Bond Risk Premia

This article investigates the source of predictability of emerging market (EM) local currency bond risk premia by using a dynamic factor approach based on a large panel of economic and financial time series. We find strong predictable variation in EM local currency excess bond returns that is associated with macroeconomic activity. We provide evidence that the main predictor variables are the factors based on real economic activity that are highly correlated with measures of industrial and manufacturing production; however, factors based on global financial factors also contain information about the future local currency bond returns. The predictive power of the extracted factors is both statistically significant and economically important. Our research has important implications for policymakers and pension fund managers.     

The Risk and Predictability of International Equity Returns

We investigate predictability in national equity market returns,and its relation to global economic risks. We show how to consistentlyestimate the fraction of the predictable variation that is capturedby an asset pricing model for the expected returns. We use amodel in which conditional betas of the national equity marketsdepend on local information variables, while global risk premiadepend on global variables. We examine single- and multiple-betamodels, using monthly data for 1970 to 1989. The models capturemuch of the predictability for many countries. Most of thisis related to time variation in the global risk premia.     

Out-of-sample density forecasts with affine jump diffusion models

We conduct out-of-sample density forecast evaluations of the affine jump diffusion models for the S&P 500 stock index and its options’ contracts. We also examine the time-series consistency between the model-implied spot volatilities using options & returns and only returns. In particular, we focus on the role of the time-varying jump risk premia. Particle filters are used to estimate the model-implied spot volatilities. We also propose the beta transformation approach for recursive parameter updating. Our empirical analysis shows that the inconsistencies between options & returns and only returns are resolved by the introduction of the time-varying jump risk premia. For density forecasts, the time-varying jump risk premia models dominate the other models in terms of likelihood criteria. We also find that for medium-term horizons, the beta transformation can weaken the systematic effect of misspecified AJD models using options & returns.     

The Variation of Economic Risk Premiums in Real Estate Returns

We examine the predictable components of returns on stocks, bonds, and real estate investment trusts (REITs). We employ a multiple-beta asset pricing model and find that there are varying degrees of predictability among stocks, bonds, and REITs. Furthermore, we find that most of the predictability of returns is associated with the economic variables employed in the asset pricing model. The stock market risk premium is highly important in capturing the predictable variation in stock portfolios, and the bond market risk premiums (term and risk structure of interest rates) are important in capturing the predictable variation in bond portfolios. For REITs, however, both the stock and bond market risk premiums capture the predictable variation in returns. REITs have comparable return predictability to stock portfolios. We conclude that there is an important economic risk premium for REITs that are not captured by traditional multiple-beta asset pricing models.     

Mean reversion in Southeast Asian stock markets

This paper assesses the predictable component of South East Asian stock markets using a bootstrap resampling method to estimate the small sample distributions of variance ratio statistics. We find evidence of mean reversion in long horizon dollar adjusted excess returns. The robustness of the results is assessed by adjusting stock returns for potential time-varying expected returns and partial integration of these emerging markets into world capital markets. In all but one case, mean reversion is shown to be due to either time-variation of risk exposure and prices of risk or partial integration of the local market into world stock markets. These results clearly illustrate the dangers of testing market efficiency without carefully adjusting stock returns for time variation in expected returns and the partial integration of local markets into world markets.     

Risk premia in crude oil futures prices

If commercial producers or financial investors use futures contracts to hedge against commodity price risk, the arbitrageurs who take the other side of the contracts may receive compensation for their assumption of nondiversifiable risk in the form of positive expected returns from their positions. We show that this interaction can produce an affine factor structure to commodity futures prices, and develop new algorithms for estimation of such models using unbalanced data sets in which the duration of observed contracts changes with each observation. We document significant changes in oil futures risk premia since 2005, with the compensation to the long position smaller on average in more recent data. This observation is consistent with the claim that index-fund investing has become more important relative to commerical hedging in determining the structure of crude oil futures risk premia over time.     

Asymmetric Volatility,Skewness, and Downside Risk in Different Asset Classes: Evidence from Futures Markets

This study examines the cross‐sectional variation of futures returns from different asset classes. The monthly returns are positively correlated with downside risk and negatively correlated with coskewness. The asymmetric volatility effect generates negatively skewed returns. Assets with high coskewness and low downside betas provide hedges against market downside risk and offer low returns. The high returns offered by assets with low coskewness and high downside betas are a risk premium for bearing downside risk. The asset pricing model that incorporates downside risk partially explains the futures returns. The results indicate a unified risk perspective to jointly price different asset classes.     

Currency risk premia and uncovered interest parity in the International CAPM

Zero-investment uncovered interest parity (UIP) portfolio positions provide perfect factor-mimicking portfolios for currency risk in the International CAPM context. Their returns are the currency risk premia. Since the UIP positions on average provide low returns, the currency risk premia must be low so that currency risk appears not to be priced in an unconditional model. However, previous research has shown that UIP returns are predictable and may be quite substantial conditionally. We use this observation to generate a specific conditional version of the International CAPM. A GMM approach shows that the conditional model performs well, while the unconditional International CAPM is (marginally) rejected. The paper thus argues that previous rejections of the International CAPM stem from the fact that currency risk premia are by nature low over extended periods of time and do not provide evidence against the International CAPM.     

Ex Ante Hedging Effectiveness of UK Stock Index Futures Contracts: Evidence for the FTSE 100 and FTSE Mid 250 Contracts

Ex ante hedging effectiveness of the FTSE 100 and FTSE Mid 250 index futures contracts is examined for a range of portfolios, consisting of stock market indexes and professionally managed portfolios (investment trust companies). Previous studies which focused on ex post hedging performance using spot portfolios that mirror market indexes are shown to overstate the risk reduction potential of index futures. Although ex ante hedge ratios are found to be characterised by intertemporal instability, ex ante hedging performance of direct hedges and cross hedges approaches that of the ex post benchmark when hedge ratios are estimated using a sufficient window size.     

Macrofactor Conditional Volatilities, Time-Varying Risk Premia and Stock Return Behavior

An Arbitrage Pricing Model is estimated in which the risk premia vary in proportion to the conditional volatilities of the macroeconomic innovations which follow an autoregressive specification. The conditional volatilities of the macroeconomic innovations exhibit strong timevariation from month to month. For size-ranked portfolios of all the shares traded on the Toronto Stock Exchange over the period from March 1962 through March 1988, five macrofactors (namely, the lag of industrial production, the Canadian index of 10 leading indicators, the U.S. composite index of 12 leading indicators, the exchange rate and the residual market factor) have time-varying and priced risk premia. The small-firm effect is absent in the risk-adjusted returns, and a significant portion of the observed January seasonality is explained by the model with time-varying risk premia.     

Futures prices as risk-adjusted forecasts of monetary policy

Many researchers have used federal funds futures rates as measures of financial markets’ expectations of future monetary policy. However, to the extent that federal funds futures reflect risk premia, these measures require some adjustment. In this paper, we document that excess returns on federal funds futures have been positive on average and strongly countercyclical. In particular, excess returns are surprisingly well predicted by macroeconomic indicators such as employment growth and financial business-cycle indicators such as Treasury yield spreads and corporate bond spreads. Excess returns on eurodollar futures display similar patterns. We document that simply ignoring these risk premia significantly biases forecasts of the future path of monetary policy. We also show that risk premia matter for some futures-based measures of monetary policy shocks used in the literature.     

Do Beta Pricing Models Explain January Mean Reversion in Stock Returns?

Jegadeesh (1991) finds evidence of January mean reversion in stock returns. In this paper we attempt to distinguish between two competing economic explanations of January mean reversion in returns: (1) mispricing in irrational markets versus (2) predictable time variation in security risk premia. Excess portfolio returns are decomposed into “explained” and “unexplained” components using the Fama-French (1993) pricing model. The explained excess returns exhibit January mean reversion. The unexplained excess returns are not mean reverting. Mean reversion is therefore consistent with rational pricing in the framework of the Fama-French model. Mean reversion can be attributed to the component of return related to a relative distress factor (SMB). A comparison with the Chen, Roll, and Ross (1986) macroeconomic factors reveals that mean reversion is due to the components related to SMB and bond default premium.