Econometricians Have Their Moments: GMM at 32

The 2013 Nobel Prize for Economics was awarded to Eugene Fama, Lars Hansen and Robert Shiller for their work on empirical asset pricing. Hansen's primary contribution to the cited work was the development of the generalised method of moments (GMM), a statistical method that has proved such a valuable tool for testing the validity of empirical asset pricing models. The public announcement of the award also acknowledges the wider impact of GMM on empirical analysis in economics and beyond, referring to the 1982 Econometrica paper in which Hansen introduced the method as ‘one of the most influential in econometrics’. In this paper, we reflect on how the GMM‐based inference framework has evolved since 1982, reviewing developments on four main issues: model diagnostic testing, moment selection, identification and inference in misspecified models. We also illustrate the broader influence of GMM on econometrics by briefly exploring the connections between GMM and three other estimation methods: indirect inference, moment inequality based techniques, and a group of techniques that can be presented equivalently within either the generalised empirical likelihood or info‐metric frameworks.     

A Nobel Prize for the Empirical Analysis of Asset Prices

Abstract

The 2013 Nobel Memorial Prize in Economics was awarded to Eugene Fama, Robert Shiller, and Lars Peter Hansen for their empirical analysis of asset prices. The paper reviews critically the work of the three economists and highlights the differing conclusions that the three researchers reached on the relatively narrow question of the rationality of individual investors. The paper argues that there is a time inconsistency in the idea that markets reveal information about the future and concludes that, despite the sophistication of their statistical analysis, the laureates have been unable to demonstrate how a sophisticated financial economy can produce their empirical results.     

Which is the best: A comparison of asset pricing factor models in Chinese mutual fund industry

Factor models are commonly used in estimating risk-adjusted fund performance. We compare the commonly used factor models in empirical asset pricing studies and find that Fama and French (2015) five-factor model outperforms other models in the Chinese mutual fund industry and in most fund segments. The factor models we tested are more effective in explaining the return of index funds than other types. Meanwhile, we also find that the capital asset pricing model (CAPM) better controls the estimated alpha dispersion than other models. Though most multifactor models including Carhart (1997) have higher R-squared than CAPM, the cross-sectional differences between them are not statistically significant.     

Drivers of expected returns in Istanbul stock exchange: Fama–French factors and coskewness

We investigate the impact of coskewness on the variation of portfolio excess returns in Istanbul Stock Exchange (ISE) over the period July 1999 to December 2005. We form portfolios according to size, industry, size and book-to-market ratio, momentum and coskewness and compare alternative asset pricing models. The traditional capital asset pricing model (CAPM) and the three-factor model of Fama and French are tested in the multivariate testing procedure of Gibbons–Ross–Shanken (1989). Coskewness is introduced as a fourth factor and its incremental effect over CAPM and Fama–French factors is examined both in multivariate tests and in cross-sectional regressions. The findings reveal that coskewness is able to explain the size premium in ISE. Hence, the basic two-moment CAPM without the coskewness factor would underestimate the expected return of size portfolios. Multivariate test results indicate that coskewness reduces the pricing bias, albeit insignificantly. Cross-sectional analysis uncovers that coskewness has a significant additional explanatory power over CAPM, especially for size and industry portfolios. However, coskewness does not have a significant incremental explanatory power over Fama–French factors in ISE.     

Credit risk – Return puzzle: Evidence from India

Although asset pricing theories predict a positive relation between risk and returns, empirical findings on credit risk-return relationship are mixed. And, observed negative relation between the two in this regard is referred to as credit risk-return puzzle. Using credit rating as a measure of credit risk, we have investigated into the existence of this puzzle in India during July 2011 to March 2019. We have used information for the companies listed on the National Stock Exchange for this purpose. Our results validate the presence of this puzzle in the Indian stock market. Moreover, credit risk is observed to be a systematic risk, which has not been captured in the traditional asset pricing models. We have also observed partial evidence favoring both behavioural and rational pricing explanations—the two widely acknowledged explanations in the literature behind this puzzle. On our further query in this connection, we have not seen any significant change in the puzzle due to the recent enactment of the Insolvency and Bankruptcy Code.     

Asset pricing in large information networks

We study asset pricing in economies with large information networks. We focus on networks that are sparse and have power law degree distributions, in line with empirical studies of large scale social networks. Our theoretical framework yields a rich set of novel asset pricing implications. We derive closed form expressions for price, volatility, profitability and trading volume, as functions of the network topology. We also study agent welfare and show that the network that optimizes total welfare is typically a uniform one with an intermediate degree of connectedness.     

NEGATIVE CORRELATION BETWEEN STOCK AND FUTURES RETURNS: AN UNEXPLOITED HEDGING OPPORTUNITY?

The negative correlation between equity and commodity futures returns is widely perceived by investors as an unexploited hedging opportunity. A Lucas (1982) asset‐pricing model is adapted to analyse the fundamentals driving equity and commodity futures returns. Using the model we argue that such a negative correlation could arise as an equilibrium relationship which reflects traders' perceptions about the shocks driving the fundamentals such as energy and consumables, and does not necessarily indicate any hedging opportunity.     

Stochastic investor sentiment,crowdedness and deviation of asset prices from fundamentals

This study constructs a theoretical model to address how stochastic investor sentiment affects investor's crowdedness, and how stochastic investor sentiment and crowdedness affect asset prices. An asset pricing model incorporating stochastic investor sentiment and crowdedness is developed, which can provide efficient explanations for the deviations of asset prices from fundamentals and the maverick risk of investors. This model indicates that the optimistic (pessimistic) investor sentiment and the long (short) crowdedness caused by optimistic (pessimistic) sentimental investors can push asset price above (below) fundamental value. Also, the sentimental investors who are wrong and alone would take the maverick risk. Our results are consistent with the idea that investor sentiment and investor behavior matter for the asset prices and the deviations of asset prices from fundamentals.     

Luck versus skill over time: time-varying performance in the cross-section of mutual fund returns

ABSTRACT

Using returns histories spanning January 1984 to October 2014 of 5785 actively managed US closed-end equity mutual funds, we address the ‘thorny problems’ highlighted by Fama and French (The Journal of Finance, 2010, vol. 65, p. 1925) that arise due to their resampling procedure. This prevents them from capturing time variation in the parameters of equilibrium asset pricing models. These problems are addressed by combining innovative procedures which allow for testing of multiple break dates on fund-specific parameters along with cross-section bootstraps that remain valid in the presence of time-varying parameters. We find that substantial proportion – 8% – of the estimated versions of the asset pricing model have significant changes in their parameters. The effects of this time variation on the cross-section distribution of the risk-adjusted performance measure are significant and substantially increase centiles of the right tail of this distribution when compared to those produced without time-varying parameters. Our evidence regarding the lack of actively managed US equity mutual funds that generate excess returns is significantly weaker than those of Fama and French but our results do not overturn their pessimistic conclusion regarding the lack of skilled managers. We do find, unlike Fama and French, that managers generating negative returns are just unlucky but have no skill.     

The effect of environmental and social performance on the stock performance of european corporations

This paper examines the effect of sustainability performance of European corporations on their stock performance, measured as the average monthly stock return from 1996 to 2001. The econometric analysis is based on common empirical asset pricing models, particularly on the multifactor model according to Fama and French (1993, Journal of Financial Economics, 33:3–56). The consideration of sustainability performance is two-fold: The average sustainability performance of the industry in which a corporation operates and the relative sustainability performance of a corporation within a given industry. The main result is that the average environmental performance of the industry has a significantly positive influence on the stock performance. In contrast, the average social performance of the industry has a significantly negative influence. The variables of the relative environmental or social performance of a corporation within a given industry have no significant effect on the stock performance. As a by-product, the econometric analysis implies that some results of Fama and French (1993, 1996, The Journal of Finance, LI (1):55–84) regarding the risk factors of the multifactor model need not hold true for different observation periods, for different stock markets, and for the use of single stocks (instead of portfolios). An erratum to this article can be found at     

开放条件下国际资产定价模型的解析与检验

随着经济全球化的不断深入，国际资本市场的一体化程度也在不断加强，敌对国际资产定价问题的探讨显得颇为重要。尤其对开放条件下的国际资产定价理论与实证研究进行系统的梳理与分类，并对该领域现有研究中存在的问题提出未来研究的方向，更有学术价值。     

Interest rate,size and book-to-market effects in Australian financial firms

The Fama–French three-factor model (1993) has been extensively used to study the pricing of nonfinancial stocks. This study provides the first examination of the pricing of Australian financial stocks using the Fama–French framework. The four-factor model (market, size, book-to-market and momentum) augmented with the level, slope and curvature of the interest rate term structure is used to examine the pricing of Australian financial stocks. The interest rate factors have not been previously considered for pricing Australian stocks within the Fama–French framework. Consistent with US evidence, we use a system-based estimation to show that the size and book-to-market factors are not priced in the cross section of the equity returns of Australian financial stocks. Momentum and term spread are priced in the equity returns of both financial and nonfinancial stocks. These findings are robust to the inclusion of control variables such as default spread, the inflation rate and a dummy variable for the global financial crisis.     

Market equilibrium with heterogeneous recursive-utility-maximizing agents

Summary This paper considers a heterogeneous agent Lucas style exchange economy. For a class of recursive utility functions containing the standard additive expected utility functions, I demonstrate that there exist market equilibria characterized by stationary (ergodic) Markov processes for consumption, portfolio holdings, asset prices and the unobserved utilities. No assumptions about market completeness are made, and there are no restrictions on the underlying information filtration.Other contributions of this paper include: (i) an existence and uniqueness theorem of intertemporal utility for the general class of recursive generators; (ii) the optimum principle as well as its corresponding Euler equation derived for the agent's consumption and portfolio choice problem under recursive utility, and (iii) a single-agent equilibrium asset pricing formula which generalizes that of Epstein and Zin (1989).This paper is a part of my PhD dissertation at the University of Toronto. I would like to thank Larry Epstein for his enthusiastic supervision, helpful discussion and valuable comments. Thanks also to Tan Wang and especially Darrell Duffie for valuable comments.     

Equilibrium asset pricing under the Lévy process with stochastic volatility and moment risk premiums

In this paper, we extend Zhang, Zhao and Chang's (2012) production-based equilibrium asset pricing model from a jump diffusion setting to a Lévy process with stochastic volatility. This paper is a further extension of Fu and Yang (2012), which is under a Lévy process with a constant volatility. Using newly developed closed-form formulas of equity premium and pricing kernel, we are able to price Schouten's (2005) moment swaps analytically. Numerical results show that our pricing formula performs very well. Our model explains Zhao, Zhang and Chang's (2013) empirical observations on moment risk premiums.     

Generalized method of moments and present value tests of the consumption-capital asset pricing model under transactions costs: evidence from the UK stock market

In this paper we test for the inclusion of the bid–ask spread in the consumption CAPM, in the UK stock market over the time period of 1980–2000. Two econometric models are used: first, Fisher’s (in J Appl Econometrics 9:S71–S94, 1994) asset pricing model is estimated by GMM. We obtain plausible values of all the structural parameters and transactions costs. We subsequently test the robustness of our results by extending the VAR approach proposed by Campbell and Shiller (in Rev Financ Stud 1:195–228, 1988). This is achieved with the inclusion of the normalised bid–ask spread as an independent variable in the pricing equation. Overall, the statistical tests are unable to reject the bid–ask spread as an independent explanatory variable in the C-CAPM. In addition, in the VAR specification we find that both the normalised and the absolute bid–ask spread is a significant predictor of the dividend to price ratio. The paper’s main conclusion is that transaction costs should be included in asset pricing models, as they possess independent explanatory power.      

Bayesian asset pricing testing under multivariate t-distribution

The distribution of asset returns has often been proved to be heavy-tailed. In this paper, based on the Fama-French five-factor model with multivariate t-distribution, we develop a convenient and explicit Bayesian approach to test asset pricing. The developed test statistic is only by-product of the Markov Chain Monte Carlo (MCMC) outputs, and hence it is very convenient in practice. Simulation studies demonstrate the effectiveness of the finite sample performance of the proposed approach. Finally, the Fama-French data are used for testing the efficiency of financial markets, and the result shows that the market efficiency is rejected.     

Is dynamic general equilibrium a theory of everything?

Should we interpret the contributions of Edward C. Prescott and his collaborators, especially Finn Kydland and Rajnish Mehra, to dynamic general equilibrium as just a mathematical restatement of pre-Keynesian business cycle theory in the language of Arrow and Debreu? This essay advances the contrary view that Prescott has been laying the foundations for a theory of everything in macroeconomics that will stretch well beyond the frictionless environments treated in its early version. A theory of everything is an attempt to explain key empirical observations in nearly every subfield of macroeconomics from a simple, logically coherent conceptual platform with a minimum of institutional detail. After reviewing the current state of Prescott’s agenda, we examine several examples of dynamic equilibrium in economies with constant returns to scale, complete markets, idiosyncratic productivity shocks, and limited capital mobility. These examples suggest that the Solow residual controls the entire path of aggregate output if redefined more broadly to include financial, distributional and institutional variables; that the discount factor used in pricing streams of income will shift autonomously over time in response to endogenous changes in the set of unconstrained asset traders; and that a dynamic general equilibrium model with substantive frictions in financial markets goes some distance towards a joint account of well-known empirical anomalies in growth, business cycles, and asset returns.     

Alternative Perspectives on Post-Keynesian Price Theory

We present an overview of recent developments in methodological and epistemological discussion in post-Keynesian work. We use these developments as a basis for judging various contributions to the post-Keynesian literature on pricing, in particular the arguments presented by Lee in recent issues of this journal, whilst acknowledging the positive contribution of Lee's work, we argue that his critique of post-Keynesian pricing theory is flawed and that his 'empirical pricing model' is consequently ill-founded.     

ASSET RETURNS UNDER PERIODIC REVELATIONS OF EARNINGS MANAGEMENT

The article investigates stock return dynamics in an environment where executives have an incentive to maximize their compensation by artificially inflating earnings. A principal–agent model with financial reporting and managerial effort is embedded in a Lucas asset‐pricing model with periodic revelations of the firm's underlying profitability. The return process generated from the model is consistent with a range of empirical regularities observed in the return data: volatility clustering, asymmetric volatility, and high idiosyncratic volatility. The calibration results further indicate that earnings management can be quantitatively important in accounting for the dynamic patterns of stock returns.     

Rational functions: an alternative approach to asset pricing

This paper shows that asset prices are linear polynomials of various underlying explanatory factors and asset returns being ratios of these polynomials, are rational functions that do not add linearly when averaging. Hence, average returns should be modeled based on stock prices. However, continuous returns may be treated as approximately linear across time and modeled directly. Our new Rational Function (RF) models, empirically outperform the traditional asset pricing models like the Capital Asset Pricing Model (CAPM) and the Fama–French three and five-factor models for both average and continuous returns. Moreover, the RF theory also provides a model to estimate the asset volumes. The average change in asset volumes together with average returns provide the estimates for average change in market values of assets. Thus, the RF model approach can be used to select assets that provide either highest returns for profit maximization or highest change in market values for wealth maximization for given levels of risk.