Nonlinear mean reversion in stock prices

This paper provides new evidence on the time-series predictability of stock market returns by introducing a test of nonlinear mean reversion. The performance of extreme daily returns is evaluated in terms of their power to predict short- and long-horizon returns on various stock market indices and size portfolios. The paper shows that the speed of mean reversion is significantly higher during the large falls of the market. The parameter estimates indicate a negative and significant relation between the monthly portfolio returns and the extreme daily returns observed over the past one to eight months. Specifically, in a quarter in which the minimum daily return is −2% the expected excess return is 37 basis points higher than in a month in which the minimum return is only −1%. This result holds for the value-weighted and equal-weighted stock market indices and for each of the size decile portfolios. The findings are also robust to different sample periods, different indices, and investment horizons.     

Institutional ownership,analyst following,and share prices

We study the mutual relationships between institutional ownership, analyst following and share prices. We show that the pressure on firms to set lower share prices to attract analysts is attenuated by institutional monitoring. Our theory refutes the assumed causal relation between share price and institutional ownership, attributed to the share price–liquidity relation, and we show empirically that share prices and institutional ownership are positively related after controlling for liquidity. Our study provides a rationale for why better firms generally maintain higher share price levels, and offers new insights into the puzzling empirical linkages observed between nominal share price levels and firm fundamentals.     

Pricing options on mean reverting underliers

For mean reverting base probabilities, option pricing models are developed, using an explicit measure change induced by the selection of a terminal time and a terminal random variable. The models employed are the square root process and an OU equation driven by centred variance gamma shocks. VIX options are calibrated using the square root process. The OU equation driven by centred variance gamma shocks is applied in pricing options on the ratio of the stock price for J. P. Morgan Chase (JPM) to the Exchange Traded Fund for the financial sector with ticker XLF. For the purposes of calibrating the ratio option pricing model to market data, we indirectly infer the prices for stock options on JPM from the prices for options on the ratio, by hedging the conditional value of JPM options given XLF, using options on XLF. The implied volatilities for the options on the ratio are then indirectly observed to be fairly flat. This suggests that for JPM, the use XLF as a benchmark is a possibly good choice. It is shown to perform better than the use of the S&P 500 index. Furthermore, though the use of an unrelated stock price like Johnson and Johnson as a benchmark for JPM provides as a good fit as does the use of XLF, this comes at the cost of requiring a considerable smile for the implied volatilities on the ratio options and hence a more complex model for the implied distribution on the ratio.     

Dynamic betas for Canadian sector portfolios

The dynamic betas for ten Canadian sector portfolios using the Kalman filter approach are estimated herein and are found to be best described by a mix of the random walk (trend) and mean-reverting (cycle) processes. The relative importance of the trend and cycle components of sector betas is related to different sensitivities of the corresponding sectors to business cycles. Dynamic betas significantly increase the explanatory power of the market model, and particularly for the utilities sector. A dynamic hedging strategy using the one-step-ahead beta forecasts as the hedge ratios produces smaller hedging errors for every sector compared with the hedge ratios calculated from the alternative beta specifications.     

An interest rate model with a Markovian mean reverting level

Abstract

A two‐factor Vasicek model, where the mean reversion level changes according to a continuous time finite state Markov chain, is considered. This model could capture the behaviour of monetary authorities who normally set a reference rate which changes from time to time. We derive the term structure via the analytic expression of the bond price that involves a fundamental matrix. The validity of the bond price closed form solution is verified via the forward rate dynamics.     

Commodity prices and BRIC and G3 liquidity: A SFAVEC approach

This paper investigates the influence of liquidity in the major developed and major developing economies on commodity prices. Liquidity is taken to be M2. A novel finding is that unanticipated increases in the BRIC countries’ liquidity is associated with significant and persistent increases in commodity prices that are much larger than the effect of unanticipated increases in G3 liquidity, and the difference increases over time. Over 1999–2012 BRIC liquidity is strongly linked with global energy prices and global real activity whereas G3 liquidity is not. The impact of BRIC liquidity on mineral and metal prices is twice as large as that of G3 liquidity. Granger casualty goes from liquidity to commodity prices. BRIC and G3 liquidity and commodity prices are cointegrated. BRIC and G3 liquidity and global output and global prices are cointegrated. We construct a structural factor-augmented error correction (SFAVEC) model.     

Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.     

Optimal strike prices of stock options for effort-averse executives

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.     

Commodity prices and GDP growth

This paper explores the extent to which commodity prices can predict GDP growth rates of various countries using indices of 27 commonly traded commodity futures. Commodity returns can strongly predict the next quarter's GDP growth, while the basis shows a reasonable level of predictive power. Overall, commodity prices can be considered a leading indicator of economic growth; increasing commodity prices and basis values indicate a stronger future economy.     

Commodity and equity markets: Some stylized facts from a copula approach

In this paper, we propose to identify the dependence structure that exists between returns on equity and commodity futures and its development over the past 20 years. The key point is that we do not impose any dependence structure, but let the data select it. To do so, we model the dependence between commodity (metal, agriculture and energy) and stock markets using a flexible approach that allows us to investigate whether the co-movement is: (i) symmetrical and frequent, (ii) (a) symmetrical and mostly present during extreme events and (iii) asymmetrical and mostly present during extreme events. We also allow for this dependence to be time-varying from January 1990 to February 2012. Our analysis uncovers three major stylised facts. First, we find that the dependence between commodity and stock markets is time-varying, symmetrical and occurs most of the time (as opposed to mostly during extreme events). Second, not allowing for time-varying parameters in the dependence distribution generates a bias towards an evidence of tail dependence. Similarly, considering only tail dependence may lead to false evidence of asymmetry. Third, a growing co-movement between industrial metals and equity markets is identified as early as 2003; this co-movement spreads to all commodity classes and becomes unambiguously stronger with the global financial crisis after Fall 2008.     

Legislating stock prices

We demonstrate that legislation has a simple, yet previously undetected, impact on stock prices. Exploiting the voting record of legislators whose constituents are the affected industries, we show that the votes of these “interested” legislators capture important information seemingly ignored by the market. A long-short portfolio based on these legislators' views earns abnormal returns of over 90 basis points per month following the passage of legislation. Industries that we classify as beneficiaries of legislation experience significantly more positive earnings surprises and positive analyst revisions in the months following passage of the bill, as well as significantly higher future sales and profitability. We show that the more complex the legislation, the more difficulty the market has in assessing the impact of these bills. Further, the more concentrated the legislator's interest in the industry, the more informative are her votes for future returns.     

A tale of two prices: Liquidity and asset prices in multiple markets

This paper investigates the liquidity effect in asset pricing by studying the liquidity–premium relationship of an American depositary receipt (ADR) and its underlying share. Using the [Amihud, Yakov, 2002. Illiquidity and stock returns: cross-section and time series effects. Journal of Financial Markets 5, 31–56] measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.     

House prices,bank instability,and economic growth: Evidence from the threshold model

This paper examines the effects of house prices on bank instability when gauged at various levels of income growth. Bank stability may respond differently to house price changes or deviations from fundamental values in an economic boom environment than in a bust circumstance. A threshold estimation technique developed by Hansen (1999) is applied to a panel of 286 U.S. Metropolitan Statistical Areas (MSAs) over the period 1990Q1–2010Q4. We consider two house price indicators: the house price changes and the house price deviations from long-run equilibrium. The results suggest the existence of income growth threshold effects in the relationship between house prices and bank instability. Specifically, there are two income growth thresholds when using the house price changes and one income growth threshold when the house price deviations are applied. Robustness results using the non-MSAs sample from 1995Q1 to 2010Q4 provide further evidence of income growth threshold effects.     

Country-specific sentiment and security prices

I study the effect of country-specific sentiment on security prices. I provide evidence that a country’s popularity among Americans affects US investors’ demand for securities from that country and causes security prices to deviate from their fundamental values. Moreover, I find that country popularity is positively associated with the intensity of US cross-border mergers and acquisitions activity, suggesting that country popularity also affects firms’ investment decisions.     

Disagreement and asset prices

How do differences of opinion affect asset prices? Do investors earn a risk premium when disagreement arises in the market? Despite their fundamental importance, these questions are among the most controversial issues in finance. In this paper, we use a novel data set that allows us to directly measure the level of disagreement among Wall Street mortgage dealers about prepayment speeds. We examine how disagreement evolves over time and study its effects on expected returns, return volatility, and trading volume in the mortgage-backed security market. We find that increased disagreement is associated with higher expected returns, higher return volatility, and larger trading volume. These results imply that there is a positive risk premium for disagreement in asset prices. We also show that volatility in and of itself does not lead to higher trading volume. Instead, only when disagreement arises in the market is higher uncertainty associated with more trading. Finally, we are able to distinguish empirically between two competing hypotheses regarding how information in markets gets incorporated into asset prices. We find that sophisticated investors appear to update their beliefs through a rational expectations mechanism when disagreement arises.     

Margin requirements and equilibrium asset prices

This paper studies the effect of margin requirements on asset prices and trading volume in a general equilibrium asset pricing model where Epstein-Zin investors differ in their degree of risk aversion. Under the assumptions of unit intertemporal elasticity of substitution and zero net supply of riskless assets, I show analytically that binding margin requirements do not affect stock prices. This result stands in contrast to previous partial equilibrium analysis where fixed margin requirements increase the volatility of stock prices. In this framework, binding margin requirements induce a fall in the riskless rate, increase its volatility, and increase stock trading volume.     

The impact of portfolio diversification on mean reverting components of stock indices

Positive autocorrelations are introduced into stock index portfolios when they are formed from individual stock indices while negative autocorrelations are induced in returns by increasing the investment horizon. Using monthly data of six international stock indices, this paper examines the diversification effect with different investment horizons on autocorrelations of stock index portfolios. The results show that portfolio diversification does not alter the impact of the investment horizon on autocorrelations. Different investment horizons, however, have great impact on the diversification effect on autocorrelations. With short (long) horizons, the average autocorrelation coefficient increases (decreases) with an increase in the portfolio size, suggesting that mean-reverting component dominates the delayed adjustment effect in long horizons and vice versa in short horizons. Our results are robust across two 10-year sub-periods.The author would like to thank an anonymous referee of this Journal for the comments on an earlier version of this paper and the Research Committee of Hong Kong Baptist University for the financial support in this research.     

The stochastic behavior of commodity prices with heteroskedasticity in the convenience yield

We document a new stylized fact regarding the dynamics of the commodity convenience yield: the volatility of the convenience yield is heteroskedastic for industrial commodities; specifically, the volatility (variance) of the convenience yield depends on the convenience yield level. To explore the economic and statistical significance of the improved specification of the convenience yield process, we propose an affine model with three state variables (log spot price, interest rate, and the convenience yield). Our model captures three important features of commodity futures—the heteroskedasticity of the convenience yield, the positive relationship between spot-price volatility and the convenience yield and the dependence of futures risk premium on the convenience yield. Moreover our model predicts an upward sloping implied volatility smile, commonly observed in commodity option market.     

Psychological barriers in gold prices?

This paper examines for the first time the existence of psychological barriers in a variety of daily and intra-day gold price series. This paper uses a number of statistical procedures and presents evidence of psychological barriers in gold prices. We document that prices in round numbers act as barriers with important effects on the conditional mean and variance of the gold price series around psychological barriers.     

A generalization of reset options pricing formulae with stochastic interest rates

A generalization of reset call options with predetermined dates is derived in the case of time-dependent volatility and time-dependent interest rate by applying martingale method and change of nume?aire or change of probability measure. An analytical pricing formula for the reset call option is also obtained when the interest rate follows an extended Vasicek’s model. Numerical results show that the correlated coefficient between the stock price and interest rate is almost unacted on the price of reset call option with short maturity and Monte Carlo method is inefficient. Monte Carlo method should be only used if there is no closed-formed solution for option pricing.