Are idiosyncratic volatility and MAX priced in the Canadian market?

The negative relationship between realized idiosyncratic volatility (RIvol) and future returns uncovered by Ang et al. (2006) for the U.S. market has been attributed to return reversals. For the Canadian market where return reversals are considerably less important, we find that RIvol is positively related to future returns, even after controlling for risk loadings, illiquidity and reversals. Unlike the findings of Bali et al. (2001) for the U.S. market, we find that the relationship between extreme positive returns (MAX) and future returns for the Canadian market is positive and that idiosyncratic volatility continues to be consistently positively related to future returns after controlling for MAX. We find evidence that suggests that reversals for stocks with extreme daily returns are confined to (typically small) stocks with low institutional holdings.     

Is information risk priced? Evidence from abnormal idiosyncratic volatility

We propose a new, price-based measure of information risk called abnormal idiosyncratic volatility (AIV) that captures information asymmetry faced by uninformed investors. AIV is the idiosyncratic volatility prior to information events in excess of normal levels. Using earnings announcements as information events, we show that AIV is positively associated with informed return run-ups, abnormal insider trading, short selling, and institutional trading during pre-earnings-announcement periods. We find that stocks with high AIV earn economically and statistically larger future returns than stocks with low AIV. Taken together, our findings support the notion that information risk is priced.     

Do relative leverage and relative distress really explain size and book-to-market anomalies?

In a capital asset pricing model (CAPM) framework, Ferguson and Shockley [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] propose two factors constructed on relative leverage and relative distress, and show that the two factors subsume Fama and French's [1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33, 3–56] factors constructed on size and book-to-market (BM) in explaining the cross-sectional average returns of the 25 size-BM portfolios. Based on tests on individual securities, we find that all factors fail to fully explain the common asset-pricing anomalies. In the spirit of Merton's [1973. An intertemporal capital asset pricing model. Econometrica 41, 867–887] intertemporal CAPM, we propose an augmented five-factor model, which incorporates Ferguson and Shockley's [2003. Equilibrium “anomalies”. Journal of Finance 58, 2549–2580] factors into the Fama–French three-factor model. The empirical results show that a simple conditional version of the augmented model is able to explain most well-known asset-pricing anomalies.     

Predicting premiums for the market, size, value, and momentum factors

This paper investigates the out-of-sample predictability of monthly market as well as size, value, and momentum premiums. We use a sample from each of the US and the Swiss stock markets between 1989 and 2007. Using the Swiss sample provides an important new perspective as the repeated evaluation of the same (US) data set leads to data mining problems. To avoid data mining in our predictability study, we test both statistical significance and robustness in the two samples. Our key results are as follows. We find no robust indication that the market premium is predictable, which is also true for the momentum and value premiums. It cannot be excluded that the results from the US may be caused by data mining in light of the results from the Swiss sample. However, the size premium seems to be somewhat predictable, due to the credit spread. We theorize that there are three possible reasons for this rare evidence for predictability. First, predictability may have disappeared over the last decade, as academic research made the respective information public. Second, predictability seems, as we demonstrate, not to be robust to the choice of methodology. Third, robustness tests in the Swiss sample reveal that many of the supposedly statistically significant interrelations from the US sample may be attributed to randomness, which, in that case, would be data mining. Therefore, we think that future discussions of predictability should address the issue of data mining by applying robustness tests.

Do risk exposures explain accounting anomalies? A new testing method

I quantitatively evaluate how much of the cross-sectional return predictive ability of a range of accounting anomalies can be attributed to firm-specific stock return covariances with market risk factors. Using a novel two-step regression-based testing method, I find robust evidence that the risk factor exposures do not explain a meaningful fraction of the time-series variations in the return predictive coefficients of the anomaly variables. Out-of-sample tests further confirm that it is the mispricing component of the accounting anomalies that is mainly responsible for the return predictability.     

Do liquidity and idiosyncratic risk matter? Evidence from the European mutual fund market

This paper examines the interaction of idiosyncratic risk, liquidity and return across time in determining fund performance, as well as across investment style portfolios of European mutual funds. This study utilizes a unique data set including returns for equity mutual funds registered in six European countries. Overall, using monthly data, we find that both liquidity and idiosyncratic risk are relevant in determining mutual fund returns. Our results are robust across different model specifications. We show that model specifications up to six factors are useful as these risk factors capture different aspects in the cross-section of mutual funds returns. The evidence regarding mutual funds subgroups is strongly in favor of the significance of liquidity, and idiosyncratic risk to a lesser extent, as risk factors. Even if liquidity and idiosyncratic risk are considered at the same time, one factor is not significantly decreasing the importance of the other factor.     

Do time-varying risk premiums explain labor market performance?

Within the standard search and matching model, time-to-build implies that high aggregate risk premiums should forecast low employment growth in the short run but high employment growth in the long run. If there is also time-to-plan, high risk premiums should forecast low net hiring rates in the short run but high net hiring rates in the long run. Our evidence indicates two-quarter time-to-build in the aggregate payroll data, no time-to-plan in the aggregate hiring data, but two-quarter time-to-plan in the job creation data for manufacturing firms. High payroll growth and high net job creation rate in manufacturing also forecast low stock market excess returns at business cycle frequencies.     

Which stocks drive the size,value, and momentum anomalies and for how long? Evidence from a statistical leverage analysis

A large number of neoclassical, behavioral, and bias-based theories try to explain the tendency of small, value, and winner stocks to outperform big, growth, and loser stocks, three well-known characteristic anomalies. Because the theories often predict similar relationships between a stock’s propensity to contribute to the anomalies and a set of correlated firm characteristics, existing studies focusing on single theories do not tell us which theory is most successful in explaining the anomalies. To fill this gap, we use a new non-parametric methodology to run a horse race between the theories. In the first step, we use statistical leverage analysis to find out which stocks are ultimately responsible for the anomalies. In the second, we use the firm characteristics suggested by the theories to forecast the identity of the anomaly drivers, with the purpose of determining which theory is most supported by the data. We find that behavioral theories are most convincing in explaining the size and book-to-market anomalies, while no theory is convincing in explaining the momentum anomaly.     

Can exchange rate volatility explain persistence in the forward premium?

The persistence of the forward premium has been cited both as evidence of the failure of the unbiasedness hypothesis and as rationale for the forward premium anomaly. This paper examines the recent proposition that forward premium persistence can be explained solely by the conditional variance of the spot rate. We provide theoretical and empirical evidence to challenge this proposition. Our empirical results are shown to be robust to the presence of structural breaks. A corollary of the results is that the ‘true’ risk premium contains a long memory component. This is non-standard and has implications for the construction of rational expectations models of the foreign exchange market.     

Can habit formation under complete market integration explain the cross-section of international equity risk premia?

In this article, we analyse whether the prominent habit formation model of Campbell and Cochrane (1999) can explain the cross-section of the G7 equity risk premia when formulated under the assumption of complete capital market integration. We test the conditional covariance representation of the model using a combined GARCH and GMM approach in the spirit of Bali (2008) and find that in comparison to the CAPM and the standard power utility CCAPM the habit model has superior explanatory power. It explains more than 90% of the cross-sectional variation in risk premia. Overall, our findings suggest that global consumption-based recession indicators and not returns of reference portfolios are key risk factors driving equity risk premia.     

Do institutional ownership and innovation influence idiosyncratic risk?

Business decisions influence the level of idiosyncratic risk. Several factors that contribute to idiosyncratic risk must be explored. Therefore, we examine the impact of innovation and institutional ownership on idiosyncratic risk for NYSE- and NASDAQ-listed firms. The sample contains 30,888 firm-year observations based on annual data from 2003 to 2016. We use a dynamic panel approach to address potential endogeneity difficulties when analyzing the results. Large-scale innovation activity, institutional investors, and innovation reduce idiosyncratic risk. Furthermore, the interactions between institutional investors and high-level ownership stakeholders considerably minimize idiosyncratic risk. Our study demonstrates that the degree to which firms adopt innovation and institutional ownership may affect firm-specific hazards.     

Return dispersion risk in FX and global equity markets: Does it explain currency momentum?

We investigate the potential link between momentum in currency returns and global economic risk as measured by currency return dispersion (RD). Initial tests contribute to the exchange rate puzzle by showing that a common macroeconomic risk component in currency markets is present in global equity markets. Subsequent tests indicate that the spread on zero-cost currency momentum strategies is larger and highly significant in high RD states compared to low RD states. Also, the relation between these momentum payoffs and global economic risk appears to increase linearly in risk. Based on this evidence, we conclude that global economic risk as proxied by RD helps to explain currency momentum profits.     

Marking‐to‐Market: Panacea or Pandora's Box?

Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark‐to‐market accounting. We show that the trade‐offs at stake in this debate are far from one‐sided. While the historical cost regime leads to some inefficiencies, marking‐to‐market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces suboptimal real decisions. We construct a framework that can weigh the pros and cons. We find that the damage done by marking‐to‐market is greatest when claims are (1) long–lived, (2) illiquid, and (3) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. Our results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking‐to‐market.     

Can salience theory explain investor behaviour? Real-world evidence from the cryptocurrency market

Research on human attention indicates that objects that stand out from their surroundings, i.e., salient objects, attract the attention of our sensory channels and receive undue weighting in the decision-making process. In the financial realm, salience theory predicts that individuals will find assets with salient upsides (downsides) appealing (unappealing). We investigate whether this theory can explain investor behaviour in the cryptocurrency market. Consistent with the theory's predictions, using a sample of 1738 cryptocurrencies, we find that cryptocurrencies that are more (less) attractive to “salient thinkers” earn lower (higher) future returns, which indicates that they tend to be overpriced (underpriced). On average, a one cross-sectional standard-deviation increase in the salience theory value of a cryptocurrency reduces its next-week return by 0.41%. However, the salience effect is confined to the micro-cap segment of the market, and its size is moderated by limits to arbitrage.     

Do the size,value, and momentum factors drive stock returns in emerging markets?

This paper investigates the size, value, and momentum effects in 18 emerging stock markets during the period 1990–2013. We find that size and momentum strategies generally fail to generate superior returns in emerging markets. The value effect exists in all markets except Brazil, and it is robust to different periods and market conditions. Value premiums tend to move positively together across different markets, and such inter-market comovements increase overtime and during the global financial crisis.     

One size fits all? High frequency trading,tick size changes and the implications for exchanges: market quality and market structure considerations

This paper offers a systematic review of the empirical literature on the implications of tick size changes for exchanges. Our focus is twofold: first, we are concerned with the market quality implications of a change in the minimum tick size. Second, we are interested in the implications of changes in the minimum tick size on market structure. We show that there is a large body of empirical literature that documents a decrease in transaction costs following a decrease in the minimum tick size. However, even though market liquidity increases, the incentive to provide market making activities decreases. We document a strong link between the minimum tick size regulations and the recent increase in high frequency trading activity. A smaller tick enhances the price discovery process. However, the question of how multiple tick size regimes affect market liquidity in a fragmented market remains to be answered. Finally, we identify topics for future research; we discuss the empirical literature on the minimum trade unit and the recent calls for a minimum resting time for quotes.     

Can trade costs explain why exchange rate volatility does not feed into consumer prices?

If countries specialize in imperfectly substitutable goods, trade costs increase the share of expenditure devoted to domestic output, reducing the exposure of consumer price inflation to exchange rate changes. I present a multi-country flexible-price model where expenditure shares are inversely related to trade costs through a gravity equation. In this setting, consumer price inflation can be approximated as an expenditure-share-weighted average of the contributions to inflation from all countries. I use data from 24 OECD countries, 1970-2003, to estimate a structural gravity model. I combine the fitted expenditure shares from the estimation with actual data on exchange rates to construct predictions of inflation. The behavior of these predictions indicates that trade costs can explain both qualitatively and quantitatively the failure of exchange rate volatility to feed into inflation.     

Can splits create market liquidity? Theory and evidence

We present a market microstructure model of stock splits in the presence of minimum tick size rules. The key feature of the model is that discretionary trading is endogenously determined. There exists a tradeoff between adverse selection costs on the one hand and discreteness related costs and opportunity costs of monitoring the market on the other hand. Under certain parameter values, there exists an optimal price. We document an inverse relation between the coefficient of variation of intraday trading volume and the stock price level. This empirical evidence and other existing evidence are consistent with the model.     

Can earnings fixated investors survive in a competitive securities market? Implications for sustained price anomalies and mark-to-market accounting

We model the dynamic survival of earnings fixated investors in a competitive securities market that allows for learning and arbitrage and that is populated by heterogeneous investors. Our model is distinct from those based on aggressive trading by overconfident investors. We prove that in the absence of noise traders, rational investors will drive out earnings fixated investors from the market in the long-run. More interestingly, we show that in a market with noise traders, some proportion of earnings fixated investors survive in long-run equilibrium for all feasible model parameter values. Furthermore, under no circumstances can the earnings fixated investors be driven out of the market completely. On the contrary, for some parameter values, the earnings fixated investors drive out the rational investors entirely. These results rationalize the long-run sustainability of common pricing anomalies. They also highlight potential benefits to society of mark-to-market accounting.