Macroeconomic Factors Do Influence Aggregate Stock Returns

Stock market returns are significantly correlated with inflationand money growth. The impact of real macroeconomic variableson aggregate equity returns has been difficult to establish,perhaps because their effects are neither linear nor time invariant.We estimate a GARCH model of daily equity returns, where realizedreturns and their conditional volatility depend on 17 macroseries' announcements. We find six candidates for priced factors:three nominal (CPI, PPI, and a Monetary Aggregate) and threereal (Balance of Trade, Employment Report, and Housing Starts).Popular measures of overall economic activity, such as IndustrialProduction or GNP are not represented.     

Practitioners' Corner: Introduction to the Special Issue

The first 150 words of the full text of this article appear below. The material in this volume is the result of a call for papersto the participants of the "Conference on Analysis of High-FrequencyFinancial Data and Market Microstructure" held in December 2003in Taipei, Taiwan. Jeffrey Russell and Ruey Tsay have actedas guest editors for this special issue, together with the editorsRené Garcia and Eric Renault. The availability of high-frequency data has spawned considerableliterature on volatility measurement and forecasting. The materialis mathematically delicate and perhaps "Practitioners’Corner" would be well advised to let the dust settle a bit tosee what emerges at the end of the day. On the other hand, thepractically minded may well be served by a good road map ofthe issues. So with only mild apology do we take up the cartographyof some difficult terrain. To fix ideas, let S(t) denote the price process of a . . . [Full Text of this Article]     

Labor Income and Predictable Stock Returns

We propose a novel economic mechanism that generates stock returnpredictability in both the time series and the cross-section.Investors’ income has two sources, wages and dividendsthat grow stochastically over time. As a consequence the fractionof total income produced by wages fluctuates depending on economicconditions. We show that the risk premium that investors requireto hold stocks varies with these fluctuations. A regressionof stock returns on lagged values of the labor income to consumptionratio produces statistically significant coefficients and largeadjusted R²s. Tests of the model’s cross-sectional predictionson the set of 25 Fama–French portfolios sorted on sizeand book-to-market are also met with considerable support.     

Service Sector Protection: Considerations for Developing Countries

The inclusion of services in the Uruguay Round of multilateraltrade negotiations has focused attention on the protection ofdomestic service suppliers against competition from foreignsuppliers. Issues arising from these negotiations, however,may obscure another and more important issue: the case for unilateralliberalization. This article first surveys methods of protectionin the service sector, and then examines the likely cost ofprotection. Particular attention is given to developing countries.What evidence there is suggests that the costs of protectionmay be high. The article also discusses economic principlesthat could guide a review of policy toward international transactionsin the service sector. Quantitative restrictions or bans onforeign service suppliers—whether they wish to supplythrough trade or establishment—cannot easily be defendedin economic terms, and provide an obvious first target.     

Periodic Stochastic Volatility and Fat Tails

This article provides a comprehensive analysis of the size andstatistical significance of the day of the week, month of theyear, and holiday effects in daily stock index returns and volatility.We employ data from the Dow Jones Industrial Average (DJIA),the S&P 500, the S&P MidCap 400, and the S&P SmallCap600 in order to test whether the seasonal patterns of mediumand small firms are similar to those of large firms. Using formalhypothesis tests based on bootstrapping, we demonstrate thatthere are more significant calendar effects in volatility thanin expected returns, especially for the two large cap indices.More importantly, we introduce the periodic stochastic volatility(PSV) model for characterizing the observed seasonal patternsof daily financial market volatility. We analyze the interactionbetween seasonal heteroskedasticity and fat tails by comparingthe performance of Gaussian PSV and fat-tailed PSVt specificationsto the plain vanilla SV and SVt benchmarks. Consistent withour model-free results, we find strong evidence of seasonalperiodicity in volatility, which essentially eliminates theneed for a fat-tailed conditional distribution, and is robustto the exclusion of the crash of 1987 outliers.     

Transmission of Information across International Equity Markets

This article provides evidence of information transmission fromthe United States and Japan to Korean and Thai equity markets.Information is defined as important macroeconomic announcementsin the United States, Japan, Korea, and Thailand. Using high-frequencyintraday data, I find a large and significant association betweendeveloped-economy macroeconomic announcements and emerging-economyequity volatility and trading volume at short time horizons.Previous studies’ findings of at most weak evidence oftransmission from developed to emerging economies may be dueto their use of lower frequency data and their focus on developed-economyfinancial market innovations as a proxy for information. (JELE44, G14, G15)     

Household Portfolio Diversification: A Case for Rank-Dependent Preferences

The proliferation of novel preference theories in financialeconomics is hampered by a lack of non-experimental evidenceand by the theories’ additional complexity which has notbeen shown to be critical in applications. In this article Ipresent arguments in support of preferences with rank dependency.Using the Survey of Consumer Finances data, I document two widespreadpatterns inconsistent with expected utility: (i) many householdssimultaneously invest in well-deversified funds and in poorly-diversifiedportfolios of stocks; and (ii) some households with substantialsavings do not invest anything in equities. I show that portfoliochoice models with rank-dependent preferences, plausibly parameterizedand under fully rational assumptions, are quantitatively consistentwith the observed diversification. These results call for furtherefforts to integrate the models of rank-dependent preferencesin portfolio theory and asset pricing.     

Spin-offs, Divestitures, and Conglomerate Investment

We examine whether spin-offs or divestitures cause improvementsin conglomerate investment efficiency. At issue are endogeneityof these restructuring decisions and correct measurement ofinvestment efficiency. Endogeneity is a problem because thefactors that induce firms to spin off or divest divisions mayalso improve investment efficiency; measurement error is a problembecause efficiency measures employ Tobin’s q as a noisyproxy for investment opportunities. We find important differencesbetween firms that divest or spin off and a control sample.After accounting for these differences and for measurement errorin q, we find no evidence of improvements in investment efficiency.(JEL G31, G34)     

Inequality Constraints in the Fractionally Integrated GARCH Model

In this article we derive necessary and sufficient conditionsfor the nonnegativity of the conditional variance in the fractionallyintegrated generalized autoregressive conditional heteroskedastic(p, d, q) (FIGARCH) model of the order p 2 and sufficient conditionsfor the general model. These conditions can be seen as beinganalogous to those derived by Nelson and Cao (1992, Journalof Business & Economic Statistics 10, 229–235) forthe GARCH(p, q) model. However, the inequality constraints whichwe derive for the FIGARCH model illustrate two remarkable propertiesof the FIGARCH model which are in contrast to the GARCH model:(i) even if all parameters are nonnegative, the conditionalvariance can become negative and (ii) even if all parametersare negative (apart from d), the conditional variance can benonnegative almost surely. In particular, the conditions forthe (1, d, 1) model substantially enlarge the sufficient parameterset provided by Bollerslev and Mikkelsen (1996, Journal of Econometrics73, 151–184). The importance of the result is illustratedin an empirical application of the FIGARCH(1, d, 1) model toJapanese yen versus U.S. dollar exchange rate data.     

Trading volume: definitions, data analysis, and implications of portfolio theory

We examine the implications of portfolio theory for the cross-sectionalbehavior of equity trading volume. Two-fund separation theoremssuggest a natural definition for trading activity: share turnover.If two-fund separation holds, share turnover must be identicalfor all securities. If (K + 1)-fund separation holds, we showthat turnover satisfies an approximately linear K-factor structure.These implications are examined empirically using individualweekly turnover data for NYSE and AMEX securities from 1962to 1996. We find strong evidence against two-fund separation,and a principal-components decomposition suggests that turnoveris well approximated by a two-factor linear model.     

LARCH, Leverage, and Long Memory

We consider the long-memory and leverage properties of a modelfor the conditional variance of an observable stationary sequence X_t, where is the square of an inhomogeneous linear combination of X_s, s < t, withsquare summable weights b_j. This model, which we call linearautoregressive conditionally heteroskedastic (LARCH), specializes,when depends only on X_t–1, to theasymmetric ARCH model of Engle (1990, Review of Financial Studies3, 103–106), and, when depends only on finitely many X_s, to a version of the quadratic ARCH modelof Sentana (1995, Review of Economic Studies 62, 639–661),these authors having discussed leverage potential in such models.The model that we consider was suggested by Robinson (1991,Journal of Econometrics 47, 67–84), for use as a possiblylong-memory conditionally heteroskedastic alternative to i.i.d.behavior, and further studied by Giraitis, Robinson and Surgailis(2000, Annals of Applied Probability 10, 1002–1004), whoshowed that integer powers , =" BORDER="0">2 can have long-memory autocorrelations. We establish conditionsunder which the cross-autocovariance function between volatilityand levels, , decays in the manner of moving average weights of long-memory processes on suitable choiceof the b_j. We also establish the leverage property that h_t <0 for 0 < t k, where the value of k (which may be infinite)again depends on the b_j. Conditions for finiteness of thirdand higher moments of X_t are also established.     

Understanding the nature of the risks and the source of the rewards to momentum investing

Buying recent winners and shorting recent losers guaranteestime-varying factor exposures in accordance with the performanceof common risk factors during the ranking period. Adjusted forthis dynamic risk exposure, momentum profits are remarkablystable across subperiods of the entire post-1926 era. Factormodels can explain 95% of winner or loser return variability,but cannot explain their mean return components are more profitablethan those based on total returns. Neither industry effectsnor cross-sectional differences in expected returns are theprimary cause of the momentum phenomenon.     

Practitioners' Corner

The first 150 words of the full text of this article appear below. This issue of the Journal of Financial Econometrics containspapers that were presented at the (EC)² conference Econometricsof Financial and Insurance Risks held in Istanbul on December15–17, 2005. Launched in 1990, (EC)² is an annual seriesof international conferences on research in quantitative economicsand econometrics. The acronym stands for European Conferencesof the Econom[etr]ics Community. Its primary aim is to providea vibrant forum where both senior and junior European researchersin quantitative economics and econometrics can discuss the resultsand progress of their research. (EC)² conferences are of relativelysmall scale (less than 200 participants) and quite intensive.Each year a different topic is selected as the major theme ofthe conference. A few leading quantitative economists or econometriciansare invited as keynote speakers, such as Eric Ghysels, who alsoacts as co-Guest editor of this issue; the other speakers areselected . . . [Full Text of this Article]     

The Book-to-Market and Size Effects in a General Asset Pricing Model: Evidence from Seven National Markets

The positive relation of returns with Book-to-Market ratio (BE/ME)and their negative relation withMarket Value(MVE) remains strongunder a general stochastic discount function (SDF) that doesnot depend on a specific asset pricing model and avoids potentiallyserious simultaneity biases inherent in the Fama and Frenchthree-factor model. However, we find that SDF_s that includethe equivalent of the HML portfolio do not span all asset sub-spaces,even with additional conditioning information. Finally, macroand financial variables we introduce to the pricing functionsdo not offer an alternative explanation of the BE/ME effect.JEL Classification codes: G10, G12, G15, G30.     

Transparency and Liquidity: A Controlled Experiment on Corporate Bonds

This article reports the results of an experiment designed toassess the impact of last-sale trade reporting on the liquidityof BBB corporate bonds. Overall, adding transparency has eithera neutral or a positive effect on liquidity. Increased transparencyis not associated with greater trading volume. Except for verylarge trades, spreads on newly transparent bonds decline relativeto bonds that experience no transparency change. However, wefind no effect on spreads for very infrequently traded bonds.The observed decrease in transaction costs is consistent withinvestors’ ability to negotiate better terms of tradeonce they have access to broader bond-pricing data. (JEL codes:G14, G18, G23, G24, G28)     

Dynamic equilibrium and the real exchange rate in a spatially separated world

Two homogeneous stocks of physical capital are located in twodifferent countries, separated by an 'ocean.' They are consumedby local residents, invested in a random production processyielding real returns, or transferred abroad. Under proportionaltransfer costs, trade, consumption and capital imbalances areshown to be persistent. The heteroskedastic process for therelative price of capital in the two countries has a nonlinear,mean-reverting drift. Nevertheless, the conditional probabilityof the price moving from the parity value of unity is greaterthan the probability of it moving toward parity. The real interest-ratedifferential incorporates a simple risk premium.     

A closed-form GARCH option valuation model

This paper develops a closed-form option valuation formula fora spot asset whose variance follows a GARCH(p, q) process thatcan be correlated with the returns of the spot asset. It providesthe first readily computed option formula for a random volatilitymodel that can be estimated and implemented solely on the basisof observables. The single lag version of this model containsHeston's (1993) stochastic volatility model as a continuous-timelimit. Empirical analysis on S&P500 index options showsthat the out-of-sample valuation errors from the single lagversion of the GARCH model are substantially lower than thead hoc Black-Scholes model of Dumas, Fleming and Whaley (1998)that uses a separate implied volatility for each option to fitto the smirk/smile in implied volatilities. The GARCH modelremains superior even though the parameters of the GARCH modelare held constant and volatility is filtered from the historyof asset prices while the ad hoc Black-Scholes model is updatedevery period. The improvement is largely due to the abilityof the GARCH model to simultaneously capture the correlationof volatility, with spot returns and the path dependence involatility.     

State Dependence Can Explain the Risk Aversion Puzzle

Risk aversion functions extracted from observed stock and optionprices can be negative, as shown by Aït-Sahalia and Lo(2000), Journal of Econometrics 94: 9–51; and Jackwerth(2000), The Review of Financial Studies 13(2), 433–51.We rationalize this puzzle by a lack of conditioning on latentstate variables. Once properly conditioned, risk aversion functionsand pricing kernels are consistent with economic theory. Todifferentiate between the various theoretical explanations interms of heterogeneity of beliefs or preferences, market sentiment,state-dependent utility, or regimes in fundamentals, we calibrateseveral consumption-based asset pricing models to match theempirical pricing kernel and risk aversion functions at differentdates and over several years.     

Strategic Trading, Liquidity, and Information Acquisition

We study endogenous liquidity trading in a market with long-livedasymmetric information. We distinguish between public information,tractable information that can be acquired, and intractableinformation that cannot be acquired. Besides information asymmetryand noise, the adverse-selection spread depends on the diffusionof intractable information and on the interest rate. With endogenousliquidity trading, efficiency is lower than that implied bynoise-trading models. Liquidity traders benefit from the informationreleased through the insider's trades in spite of their monetarylosses. We study factors that affect the insider's informationacquisition decision, including the amount of intractable information,observability, and information acquisition costs.     

Are price limits on futures markets that cool? Evidence from the Brazilian Mercantile and Futures Exchange

This article investigates the impact of price limits on theBrazilian futures markets using high frequency data. The aimis to identify whether there is an ex ante cool-off or magneteffect. For that purpose, we examine a tick-by-tick data setthat includes all contracts on the São Paulo stock indexfutures traded on the Brazilian Mercantile and Futures Exchange(BM&F) from January 1997 to December 1999. The results indicatethat, altogether, there is a dominant cool-off effect in playand that the latter is much stronger for the floor rather thanceiling price. This explains why we observe more hits to theceiling rather than to the floor in our sample despite the factit covers one of the most turbulent periods for emerging markets.We then build a trading strategy that accounts for the cool-offeffect in the conditional mean so as to demonstrate that thelatter has not only statistical but also economic significance.The Sharpe ratio is indeed way superior to the buy-and-holdbenchmarks we consider.