Profitability of momentum strategies in international markets: The role of business cycle variables and behavioural biases

The paper investigates whether business cycle variables and behavioural biases can explain the profitability of momentum trading in three major European markets. Unlike previous studies, the paper nests both risk-based and behavioural-based variables in a two-stage model specification in an attempt to explain momentum profits. The findings show that, although momentum profitability in European markets is unexplained by conditional asset pricing models, it is attributable to asset mispricing that systematically varies with global business conditions. In addition, behavioural variables do not appear to matter much. Thus risk factors, which are undetected thus far and are largely attributable to the business cycle, could explain the momentum payoffs in European stock markets.     

Varying risk premia in international bond markets

Cochrane and Piazzesi [Cochrane, J.H., Piazzesi, M., 2005. Bond risk premia. American Economic Review 95, 138–160] use forward rates to forecast future bond returns. We extend their approach by applying their model to international bond markets. Our results indicate that the unrestricted Cochrane and Piazzesi (2005) model has a reasonable forecasting power for future bond returns. The restricted model, however, does not perform as well on an international level. Furthermore, we cannot confirm the systematic tent shape of the estimated parameters found by Cochrane and Piazzesi (2005). The forecasting models are used to implement various trading strategies. These strategies exhibit high information ratios when implemented in individual countries or on an international level and outperform alternative approaches. We introduce an alternative specification to forecast future bond returns and achieve superior risk-adjusted returns in our trading strategy. Bayesian model averaging is used to enhance the performance of the proposed trading strategy.     

On the power of cross-sectional and multivariate tests of the CAPM

This paper examines the power of the cross-sectional and multivariate tests of the CAPM under ideal conditions. When the CAPM is true the positively weighted market portfolio is MV-efficient and securities plot on the security market line. When the CAPM is false an alternative asset pricing model determines prices. An examination of the population intercepts, slopes and R² from cross-sectional regressions of expected returns on betas indicates that all three are unreliable indicators of whether the CAPM holds. Simulation analysis of the power of the cross-sectional tests expands on and reinforces the analysis based on the population values. The Gibbons et al. (1989) multivariate test fares much better.     

Asset Pricing and Welfare Analysis with Bounded Rational Investors

Motivated by the fact that investors have limited ability to process information, I model investors’ bounded rational behavior in processing information and investigate its implications for asset pricing. Investors can make mistakes in processing information and thus have inaccurate estimates of fundamentals. This process generates “bounded rational risk.” I find that the volatility of stock and bond return increases in the presence of bounded rational investors, which can help explain the excessive volatility puzzle. The stock‐bond return correlation becomes time varying and even negative and rational investors benefit from the trading with bounded rational investors.     

Asset fire sales (and purchases) in equity markets

This paper examines institutional price pressure in equity markets by studying mutual fund transactions caused by capital flows from 1980 to 2004. Funds experiencing large outflows tend to decrease existing positions, which creates price pressure in the securities held in common by distressed funds. Similarly, the tendency among funds experiencing large inflows to expand existing positions creates positive price pressure in overlapping holdings. Investors who trade against constrained mutual funds earn significant returns for providing liquidity. In addition, future flow-driven transactions are predictable, creating an incentive to front-run the anticipated forced trades by funds experiencing extreme capital flows.     

Speculations in option markets enhance allocation efficiency with heterogeneous beliefs and learning

Many studies investigate the impact of heterogeneous beliefs in the first moment, while very few in the second moment. This is partially due to continuous-time setup which makes it difficult to incorporate heterogeneous beliefs in the second moment. In a two-period exponential–normal model with Bayesian learning, I demonstrate that heterogeneous prior variances give rise to the economic value of option markets. Investors speculate in option market and public information improves allocation efficiency of markets only when there is heterogeneity in prior variances. Heterogeneity in mean is neither a necessary nor a sufficient condition for generating speculations in option markets. With heterogeneous beliefs, options are non-redundant assets which can facilitate side-betting and enable investors to take advantage of the disagreements and the differences in confidence. This fact leads to a higher growth rate in the investors’ certainty equivalents and, thus, a higher equilibrium interest rate. Furthermore, option exhibits a unique feature of enabling signal precision to affect the ex ante risk premium of underlying asset, which quadratic derivative and stock do not have.     

A careful re-examination of seasonality in international stock markets: Comment on sentiment and stock returns

In questioning Kamstra, Kramer, and Levi’s (2003) finding of an economically and statistically significant seasonal affective disorder (SAD) effect, Kelly and Meschke (2010) make errors of commission and omission. They misrepresent their empirical results, claiming that the SAD effect arises due to a “mechanically induced” effect that is non-existent, labeling the SAD effect a “turn-of-year” effect (when in fact their models and ours separately control for turn-of-year effects), and ignoring coefficient-estimate patterns that strongly support the SAD effect. Our analysis of their data shows, even using their low-power statistical tests, there is significant international evidence supporting the SAD effect. Employing modern, panel/time-series statistical methods strengthens the case dramatically. Additionally, Kelly and Meschke represent the finance, psychology, and medical literatures in misleading ways, describing some findings as opposite to those reported by the researchers themselves, and choosing selective quotes that could easily lead readers to a distorted understanding of these findings.     

Assessing the risk-return trade-off in loan portfolios

This paper proposes a methodology to analyse the risk and return of large loan portfolios in a joint setting. I propose a tractable model to obtain the distribution of loan returns from observed interest rates and default frequencies. I follow a sectoral approach that captures the heterogeneous cyclical features of different kinds of loans and yields moments in closed form. I investigate the validity of mean–variance analysis with a value at risk constraint and study its relationship with utility maximisation. Finally, I study the efficiency of corporate and household loan portfolios in an empirical application to the Spanish banking system.     

A Bayesian approach to detecting nonlinear risk exposures in hedge fund strategies

This paper proposes a model that allows for nonlinear risk exposures of hedge funds to various risk factors. We introduce a flexible threshold regression model and develop a Bayesian approach for model selection and estimation of the thresholds and their unknown number. In particular, we present a computationally flexible Markov chain Monte Carlo stochastic search algorithm which identifies relevant risk factors and/or threshold values. Our analysis of several hedge fund returns reveals that different strategies exhibit nonlinear relations to different risk factors, and that the proposed threshold regression model improves our ability to evaluate hedge fund performance.     

Investing in mutual funds when returns are predictable

This paper forms investment strategies in US domestic equity mutual funds, incorporating predictability in (i) manager skills, (ii) fund risk loadings, and (iii) benchmark returns. We find predictability in manager skills to be the dominant source of investment profitability—long-only strategies that incorporate such predictability outperform their Fama-French and momentum benchmarks by 2 to 4%/year by timing industries over the business cycle, and by an additional 3 to 6%/year by choosing funds that outperform their industry benchmarks. Our findings indicate that active management adds significant value, and that industries are important in locating outperforming mutual funds.     

Detecting structural breaks and identifying risk factors in hedge fund returns: A Bayesian approach

Extending previous work on asset-based style factor models, this paper proposes a model that allows for the presence of structural breaks in hedge fund return series. We consider a Bayesian approach to detecting structural breaks occurring at unknown times and identifying relevant risk factors to explain the monthly return variation. Exact and efficient Bayesian inference for the unknown number and positions of the breaks is performed by using filtering recursions similar to those of the forward–backward algorithm. Existing methods of testing for structural breaks are also used for comparison. We investigate the presence of structural breaks in several hedge fund indices; our results are consistent with market events and episodes that caused substantial volatility in hedge fund returns during the last decade.     

On the integrability of money-demand functions by the Sidrauski and the shopping-time models

This paper investigates which properties money-demand functions must satisfy so that they are consistent with Lucas’s [Lucas Jr., R.E., 2000. Inflation and welfare. Econometrica 68, 247–274] versions of the Sidrauski and the shopping-time models. We conclude that shopping-time-integrable money-demand functions are necessarily also Sidrauski-integrable, but that the converse is not necessarily true, unless a boundedness assumption on the nominal interest rate is made. Both the log–log with an interest-rate elasticity greater than or equal to one and the semi-log money demands may serve as counterexamples. All the models and results are also extended to the case in which there are several assets in the economy performing monetary functions.     

Hidden liquidity: An analysis of order exposure strategies in electronic stock markets

Many stock exchanges choose to reduce market transparency by allowing traders to hide some or all of their order size. We study the costs and benefits of order exposure and test hypotheses regarding hidden order usage using a sample of Euronext-Paris stocks, where hidden orders represent 44% of the sample order volume. Our results support the hypothesis that hidden orders are associated with a decreased probability of full execution and increased average time to completion, and fail to support the alternate hypothesis that order exposure causes defensive traders to withdraw from the market. However, exposing rather than hiding order size increases average execution costs. We assess the extent to which non-displayed size is truly hidden and document that the presence and magnitude of hidden orders can be predicted to a significant, but imperfect, degree based on observable order attributes, firm characteristics, and market conditions. Overall, the results indicate that the option to hide order size is valuable, in particular, to patient traders.     

Dynamic linkages between the center and periphery in international stock markets

This paper examines the dynamic linkages between the equity market of US representing the center and emerging markets using the Granger-causality test. The findings show that causality runs from the S&P500 to the stock prices of the 15 emerging markets but not vice versa.     

Offsetting the implicit incentives: Benefits of benchmarking in money management

Money managers are rewarded for increasing the value of assets under management. This gives a manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. The misaligned incentives create potentially significant deviations of the manager’s policy from that desired by fund investors. In the context of a familiar continuous-time portfolio choice model, we demonstrate how a simple risk management practice that accounts for benchmarking can ameliorate the adverse effects of managerial incentives. Our results contrast with the conventional view that benchmarking a fund manager is not in the best interest of investors.     

Payout yield,risk, and mispricing: A Bayesian analysis

We develop a simple parametric model in which hypotheses about predictability, mispricing, and the risk-return tradeoff can be evaluated simultaneously, while allowing for time variation in both risk and expected return. Most of the return predictability based on aggregate payout yield is unrelated to market risk. We consider a range of Bayesian prior beliefs about the risk-return tradeoff and the extent to which predictability is driven by mispricing. The impact of these beliefs on an investor's certainty-equivalent return when choosing between a market index and riskless T-bills is economically significant, in both ex ante and out-of-sample analyses.     

Predicting stock returns

This paper studies whether incorporating business cycle predictors benefits a real time optimizing investor who must allocate funds across 3,123 NYSE-AMEX stocks and cash. Realized returns are positive when adjusted by the Fama-French and momentum factors as well as by the size, book-to-market, and past return characteristics. The investor optimally holds small-cap, growth, and momentum stocks and loads less (more) heavily on momentum (small-cap) stocks during recessions. Returns on individual stocks are predictable out-of-sample due to alpha variation, whereas the equity premium predictability, the major focus of previous work, is questionable.     

Hedge fund pricing and model uncertainty

This article uses Bayesian model averaging to study model uncertainty in hedge fund pricing. We show how to incorporate heteroscedasticity, thus, we develop a framework that jointly accounts for model uncertainty and heteroscedasticity. Relevant risk factors are identified and compared with those selected through standard model selection techniques. The analysis reveals that a model selection strategy that accounts for model uncertainty in hedge fund pricing regressions can be superior in estimation/inference. We explore potential impacts of our approach by analysing individual funds and show that they can be economically important.     

Technical analysis: An asset allocation perspective on the use of moving averages

In this paper, we analyze the usefulness of technical analysis, specifically the widely employed moving average trading rule from an asset allocation perspective. We show that, when stock returns are predictable, technical analysis adds value to commonly used allocation rules that invest fixed proportions of wealth in stocks. When uncertainty exists about predictability, which is likely in practice, the fixed allocation rules combined with technical analysis can outperform the prior-dependent optimal learning rule when the prior is not too informative. Moreover, the technical trading rules are robust to model specification, and they tend to substantially outperform the model-based optimal trading strategies when the model governing the stock price is uncertain.     

The price of sin: The effects of social norms on markets

We provide evidence for the effects of social norms on markets by studying “sin” stocks—publicly traded companies involved in producing alcohol, tobacco, and gaming. We hypothesize that there is a societal norm against funding operations that promote vice and that some investors, particularly institutions subject to norms, pay a financial cost in abstaining from these stocks. Consistent with this hypothesis, we find that sin stocks are less held by norm-constrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs, and they receive less coverage from analysts than do stocks of otherwise comparable characteristics. Sin stocks also have higher expected returns than otherwise comparable stocks, consistent with them being neglected by norm-constrained investors and facing greater litigation risk heightened by social norms. Evidence from corporate financing decisions and the performance of sin stocks outside the US also suggest that norms affect stock prices and returns.