THE POSSIBILITY OF ESTIMATING RISK PREMIA IN ASSET PRICING MODELS

The authors show that estimates of risk premia on the market based on capital asset pricing models or arbitrage pricing theories can only be estimates of the ex post or sample risk premium on the market and cannot be interpreted as better estimates of the ex ante premium than those provided by sample averages of data. The ex ante premium drops out of the generating function for the returns used in the second-pass regressions. Although previous estimates of nonmarket premia have failed to take appropriate account of the population mean, that mean can in fact be estimated and appropriate adjustments made. Various approaches to estimating the ex ante risk premium and the population mean are discussed.     

Ex post and ex ante returns and risks under different maturities of treasury bonds: evidence from developed and emerging markets

Based on asset pricing theory, reward/risk ratios vary positively with maturity of Treasury securities. We study the effect of increasing Treasury bonds' maturity on ex post and ex ante returns and risks in developed and emerging countries. As maturity increases, we show that ex post and ex ante returns are negative and they decrease while ex post and ex ante risks increase in developed countries, resulting in a sharp increase in the ex post and ex ante coefficient of variation. This indicates that investors are negatively rewarded for the risk they face for investing in Treasury bonds in developed markets. In emerging markets, as maturity increases, ex post and ex ante returns are positive for medium and long maturities and they increase while ex ante risk decreases with maturity. As maturity increases, the coefficient of variation in emerging and developed markets increases, indicating that reward to investors for facing extra risk decreases as maturity increases; however, investors are much better rewarded in emerging than developed markets.     

Reward-to-Risk Ratios in the Treasury-Bill Market

We estimate the ex‐ante reward per unit of spot‐rate volatility (the reward‐to‐risk ratio) for U.S. Treasury bills on a monthly basis and find that these ratios vary predictably over time. Reward‐to‐risk ratios are positively autocorrelated; month‐to‐month changes in these ratios are negatively autocorrelated. Variation in these ratios contributes at least as much variation to ex‐ante excess returns as does variation in interest‐rate volatility. Because ex‐ante volatility and the rewards to volatility vary independently, variation in ex‐ante premiums is greater than the variation attributable to changing volatility alone.     

Cost-based transfer pricing

This paper compares the performance of alternative cost-based transfer pricing methods. We adopt an incomplete contracting framework with asymmetric information at the trading stage. Transfer pricing guides intra-company trade and provides incentives for value-enhancing specific investments. We compare actual-cost transfer prices that include a markup over marginal costs with standard-cost transfer prices that are determined either by the central office ex ante (centralized standard-cost transfer pricing) or by the supplying division at the trading stage (reported standard-cost transfer pricing). For the actual-cost methods, we show that markups based on the joint contribution margin (contribution-margin transfer pricing) dominate purely additive markups (cost-plus transfer pricing). We obtain the following results. (1) Centralized standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face low cost uncertainty. (2) The actual-cost methods dominate the other methods if the central office and the divisions ex ante face high cost uncertainty and later, at the trading stage, the buying division receives sufficient cost information. (3) Reported standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face high cost uncertainty, and the buyer has insufficient cost information at the trading stage.     

Local and spillover shocks in implied market volatility: evidence for the U.S. and Germany

The occurrence and the transmission of large shocks in international equity markets is of essential interest to the study of market integration and financial crises. To this aim, implied market volatility allows to monitor ex ante risk expectations in different markets. We investigate the behavior of implied market volatility indices for the U.S. and Germany under a straightforward mean reversion model that allows for Poisson jumps. Our empirical findings for daily data in the period 1992 to 2002 provide evidence of significant positive jumps, i.e. situations of market stress with positive unexpected changes in ex ante risk assessments. Jump events are mostly country-specific with some evidence of volatility spillover. Analysis of public information around jump dates indicates two basic categories of events. First, crisis events occurring under spillover shocks. Second, information release events which include three subcategories, namely—worries about as well as actual—unexpected releases concerning U.S. monetary policy, macroeconomic data and corporate profits. Additionally, foreign exchange market movements may cause volatility shocks.     

Ex Ante Hedging Effectiveness of UK Stock Index Futures Contracts: Evidence for the FTSE 100 and FTSE Mid 250 Contracts

Ex ante hedging effectiveness of the FTSE 100 and FTSE Mid 250 index futures contracts is examined for a range of portfolios, consisting of stock market indexes and professionally managed portfolios (investment trust companies). Previous studies which focused on ex post hedging performance using spot portfolios that mirror market indexes are shown to overstate the risk reduction potential of index futures. Although ex ante hedge ratios are found to be characterised by intertemporal instability, ex ante hedging performance of direct hedges and cross hedges approaches that of the ex post benchmark when hedge ratios are estimated using a sufficient window size.     

Developing a Trading Rule from the FTSE-100 Stock Index Futures Contract: Evidence in Support of the EMH

An extensive literature documents the predictability of both short and long horizon returns, over a wide range of sample periods, frequencies and markets. This predictability may represent weak form inefficiency, or it may be caused by a failure to account for a time-variation in risk. We develop statistically reliable ex ante models of the returns on the FTSE-100 stock index futures contract and test a simple trading rule based on the out-of-sample predictions from these models. We interpret the failure of our ex ante model to produce abnormal returns for a risk neutral investor as evidence in favour of the EMH. Our trading rule results clearly suggest that we should be careful in interpreting such ex ante models as evidence of financial market inefficiency.     

Ex Ante Skewness and Expected Stock Returns

We use option prices to estimate ex ante higher moments of the underlying individual securities’ risk‐neutral returns distribution. We find that individual securities’ risk‐neutral volatility, skewness, and kurtosis are strongly related to future returns. Specifically, we find a negative (positive) relation between ex ante volatility (kurtosis) and subsequent returns in the cross‐section, and more ex ante negatively (positively) skewed returns yield subsequent higher (lower) returns. We analyze the extent to which these returns relations represent compensation for risk and find evidence that, even after controlling for differences in co‐moments, individual securities’ skewness matters.     

How Do Ex Ante Severance Pay Contracts Fit into Optimal Executive Incentive Schemes?

We analyze a sample of over 3,600 ex ante explicit severance pay agreements in place at 808 firms and show that firms set ex ante explicit severance pay agreements as one component in managing the optimal level of equity incentives. Younger executives are more likely to receive explicit contracts and better terms. Firms with high distress risk, high takeover probability, and high return volatility are significantly more likely to enter into new or revised severance contracts. Finally, ex post payouts to managers are largely determined by the ex ante contract terms.     

Are Real Interest Rates Equal Across Countries? An Empirical Investigation of International Parity Conditions

This paper conducts empirical tests of the equality of real interest rates across countries. The empirical evidence strongly rejects the hypothesis of real rate equality and the joint hypotheses of uncovered interest parity and ex ante relative PPP, or the unbiasedness of forward rate forecasts and ex ante relative PPP. The evidence suggests that it is worth studying open economy macroeconomic models which allow: 1) domestic real rates to differ from world rates, 2) time varying risk premiums in the forward market, or 3) deviations from ex ante relative PPP.     

Stock Options as Lotteries

We investigate the relationship between ex ante total skewness and holding returns on individual equity options. Recent theoretical developments predict a negative relationship between total skewness and average returns, in contrast to the traditional view that only coskewness is priced. We find, consistent with recent theory, that total skewness exhibits a strong negative relationship with average option returns. Differences in average returns for option portfolios sorted on ex ante skewness range from 10% to 50% per week, even after controlling for risk. Our findings suggest that these large premiums compensate intermediaries for bearing unhedgeable risk when accommodating investor demand for lottery‐like options.     

Do idiosyncratic jumps matter?

We show that idiosyncratic jumps are a key determinant of mean stock returns from both an ex post and ex ante perspective. Ex post, the entire annual average return of a typical stock accrues on the four days on which its price jumps. Ex ante, idiosyncratic jump risk earns a premium: a value-weighted weekly long-short portfolio that buys (sells) stocks with high (low) predicted jump probabilities earns annualized mean returns of 9.4% and four-factor alphas of 8.1%. This strategy’s returns are larger when there are greater limits to arbitrage. These results are consistent with investor aversion to idiosyncratic jump risk.     

THE UNDERPRICING OF INITIAL PUBLIC OFFERINGS,EX ANTE UNCERTAINTY,AND PROXY SELECTION

This paper reconsiders the prediction that the underpricing of IPOs is increasing in ex ante uncertainty by objectively establishing proxies for ex ante uncertainty on definitional grounds rather than by appealing to intuitive arguments. Based on a sample of 420 U.S. IPOs from the period 1976–1985, the results suggest that there is a hierarchy of proxies. The results also support the prediction of a positive relation between underpricing and ex ante uncertainty. Finally, the results suggest that as the effectiveness of a selected proxy as a measure of ex ante uncertainty increases, so does the strength of the relation between the degree of underpricing and ex ante uncertainty as measured by that proxy.     

The size effect on stock returns: Is it simply a risk effect not adequately reflected by the usual measures?

One of the satisfactory explanations of the size effect would seem to be in the inadequacy of the usual measure of risk as an appropriate ex ante proxy for risk. One of the ex ante measures is provided by the Standard and Poor's quality rankings for common stocks and is examined in this paper. It is shown that the quality rankings assigned by security analysts are superior over beta and variance measures of risk in explaining returns and in subsuming the size effect. These results are consistent with the hypothesis that the size effect mainly reflects a risk effect and that a significant part of the latter is not caught by the usual beta and variance measures.     

Tests of ex ante versus ex post theories of collateral using private and public information

Collateral is a widely used, but not well understood, debt contracting feature. Two broad strands of theoretical literature explain collateral as arising from the existence of either ex ante private information or ex post incentive problems between borrowers and lenders. However, the extant empirical literature has been unable to isolate each of these effects. This paper attempts to do so using a credit registry that is unique in that it allows the researcher to have access to some private information about borrower risk that is unobserved by the lender. The data also include public information about borrower risk, loan contract terms, and ex post performance for both secured and unsecured loans. The results suggest that the ex post theories of collateral are empirically dominant, although the ex ante theories are also valid for customers with short borrower–lender relations that are relatively unknown to the lender.     

On the Design of Contingent Capital with a Market Trigger

Contingent capital (CC), which aims to internalize the costs of too‐big‐to‐fail in the capital structure of large banks, has been under intense debate by policy makers and academics. We show that CC with a market trigger, in which direct stakeholders are unable to choose optimal conversion policies, does not lead to a unique competitive equilibrium unless value transfer at conversion is not expected ex ante. The “no value transfer” restriction precludes penalizing bank managers for taking excessive risk. Multiplicity or absence of equilibrium introduces the potential for price uncertainty, market manipulation, inefficient capital allocation, and frequent conversion errors.     

Bank failures and bank fundamentals: A comparative analysis of Latin America and East Asia during the nineties using bank-level data

This paper uses bank-level data from recent banking crises in East Asia and Latin America to address the following two questions: (1) To what extent did individual bank conditions explain the failures? (2) In terms of their fundamentals, was it mainly the weak banks ex ante that failed in the crisis countries? The results show that for the two regions, bank-level fundamentals significantly affect the likelihood of collapse for these banks. Systemic shocks (both macroeconomic and liquidity) that triggered the crises mainly destabilized the weak banks ex ante, particularly in East Asia, which raises questions about the role that regional differences play for the degree of banking sector resilience to systemic shocks in the financial and macroeconomic environment.     

Growth and Risk: Methodology and Micro Evidence

How exposure to risk affects economic growth is a key issuein development. This article quantifies both the ex ante andex post effects of risk using long-running panel data for ruralhouseholds in Zimbabwe. It proposes a simulation-based econometricmethodology to estimate the structural form of a micro modelof household investment decisions under risk. The key findingis that risk substantially reduces growth in this particularsetting: the mean capital stock in the sample is (in expectation)46 percent lower than in the absence of risk. About two-thirdsof the impact of risk is due to the ex ante effect (that is,the behavioral response to risk), which is usually not takeninto account in policy design. These results suggest that policyinterventions that reduce exposure to shocks or that help householdsmanage risk could be much more effective than is commonly thought.     

Short Selling and Index Arbitrage Profitability: Evidence from the SGX MSCI and TAIFEX Taiwan Index Futures Markets

There are numerous impediments to market efficiency and index arbitrage in real capital markets, including the uptick rule on short selling, execution risk, market impact costs, regulatory barriers, and capital constraints. Adopting and relaxing the uptick restriction in the Taiwan stock market facilitated a study on whether adjustments in this restriction influence the efficiency and arbitrage of the Singapore Exchange Limited (SGX) and the Taiwan Futures Exchange (TAIFEX) index futures markets. This study examines the above issues using five-minute intraday transaction data and performs an ex post test of arbitrage, ex ante test of arbitrage, and regression analysis. Empirical results indicate that relaxing the uptick rule should improve market efficiency and facilitate long arbitrage, subsequently accelerating the adjustment to no-arbitrage bounds and helping to decrease ex post and ex ante mispricing and underpricing following the relaxation.     

The ex ante real rate and inflation premium under a habit consumption model

This paper analyzes and quantifies ex ante components of bond yields – real rate of returns and risk premiums – from observed prices of nominal and indexed bonds in the United Kingdom from 1983 to 2000. The estimation uses an asset pricing framework based on a habit consumption model together with a joint formulation of consumption growth and inflation. Nominal yields carry a time-varying inflation premium that is significant throughout the period, increasing in the bond's maturity and contributing up to 25 basis points to yearly nominal yields. The analysis allows the extraction of the ex ante real rate from indexed bonds by properly taking into account both the incomplete indexation on these instruments and the inflation premium embedded in the nominal bonds.