Currency risk premia and uncovered interest parity in the International CAPM

Zero-investment uncovered interest parity (UIP) portfolio positions provide perfect factor-mimicking portfolios for currency risk in the International CAPM context. Their returns are the currency risk premia. Since the UIP positions on average provide low returns, the currency risk premia must be low so that currency risk appears not to be priced in an unconditional model. However, previous research has shown that UIP returns are predictable and may be quite substantial conditionally. We use this observation to generate a specific conditional version of the International CAPM. A GMM approach shows that the conditional model performs well, while the unconditional International CAPM is (marginally) rejected. The paper thus argues that previous rejections of the International CAPM stem from the fact that currency risk premia are by nature low over extended periods of time and do not provide evidence against the International CAPM.     

Differential risk premiums and the UIP puzzle

We respecify the uncovered interest rate parity (UIP) conditions by inverting the market price of the risk (Sharpe ratio) formula. Our empirical model provides new insight indicating that violations to the UIP stem from the existence of a risk premium in the exchange rates and from observed market return differentials being a noisy statistic of the markets’ expected return differentials in our respecified model. Using an integrated macro‐micro structure framework for expected market return differentials improves our model fit and the validity of UIP.     

The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value

This paper reexamines the validity of the expectation hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to 3 months. We extend the work of Longstaff [2000b. The term structure of very short term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] in two directions: (1) we implement statistical tests designed to increase test power in this context; (2) more important, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.     

Empirical Tests for Stochastic Dominance Efficiency

We derive empirical tests for the stochastic dominance efficiency of a given portfolio with respect to all possible portfolios constructed from a set of assets. The tests can be computed using straightforward linear programming. Bootstrapping techniques and asymptotic distribution theory can approximate the sampling properties of the test results and allow for statistical inference. Our results could provide a stimulus to the further proliferation of stochastic dominance for the problem of portfolio selection and evaluation. Using our tests, the Fama and French market portfolio is significantly inefficient relative to benchmark portfolios formed on market capitalization and book‐to‐market equity ratio.     

The long-horizon returns behaviour of the Portuguese stock market1

In the last few years several research studies have challenged the traditional weak-form efficiency tests of the stock market. These studies suggested an alternative to the random walk model, containing temporary and permanent components. If stocks follow such a model then the traditional tests, using returns computed for short intervals would be unable to detect them. To investigate the evidence for such models in the Portuguese stock market ten stock indexes were created. This is a pioneer study of the Portuguese stock market, and uses nominal, real and excess returns, computed for longer horizons. Three methodologies were used: variance ratios, ordinary least squares regressions and weighted least squares regressions. The statistical significance of the results was studied using traditional parametric tests as well as non-parametric tests. The evidence is mixed, as the presence of tendencies towards mean aversion and mean reversion were detected. Results also show that the evidence is very sensitive to the methodology used and the signifcance tests performed. These results, however, do not necessarily reject the weak-form market efficiency hypothesis.     

Are Asian stock markets efficient? Evidence from new multiple variance ratio tests

This paper tests for the martingale hypothesis in the stock prices of a group of Asian markets. We use new multiple variance ratio tests based on the wild bootstrap and signs. These are non-parametric finite sample tests, which do not rely on large sample theories for statistical inference. This paper also presents Monte Carlo results that these non-parametric tests show superior small sample properties to those of the conventional Chow–Denning test. Both weekly and daily data from 1990 are considered, while moving sub-sample windows are used for the latter to control the sensitivity of the results to a particular sample period. It is found that the Hong Kong, Japanese, Korean and Taiwanese markets have been efficient in the weak-form. The markets of Indonesia, Malaysia and Philippines have shown no sign of market efficiency, despite financial liberalization measures implemented since the eighties. We have also found evidence that the Singaporean and Thai markets have become efficient after the Asian crisis. In general, the results point toward the notion that the pricing efficiency of a market depends on the level of equity market development as well as the regulatory framework conducive of transparent corporate governance.     

Testing Rationality in the Point Spread Betting Market

This paper presents empirical tests of market rationality using data from the point spread betting market on National Football League games. Data from this market avoid many common pitfalls of tests of rationality in conventional financial markets. The authors test for rationality with two types of tests, statistical and economic. Results of the tests reveal that the statistical tests cannot reject market rationality while the economic tests do reject market rationality.     

Learning and the volatility of exchange rates

This paper investigates the implications for the volatility of exchange rates of specifying market uncertainty as parameter uncertainty. Private agents learn by means of Bayes rule about a parameter of the stochastic process generating the exogenous variables. Learning is shown to magnify the reaction of exchange rates to random shocks to the ‘market fundamentals’. This magnification effect of learning can explain the rejections of the econometric tests on the variance bounds and on the absence of bubbles that have been reported in the literature.     

Dynamic Stock Markets with Multiple Assets: An Experimental Analysis

We study the performance of the rational expectations hypothesis in multiperiod experimental markets with multiple assets. We find that the markets are generally inefficient from the point of view of full information aggregation. However, arbitrage relationships hold, and it is not possible to detect the informational inefficiency by using some standard tests of market efficiency. These findings suggest that the lack of arbitrage opportunities and the failure of common tests to reject inefficiency are not sufficient to conclude that a market is informationally efficient.     

Predicting exchange rate cycles utilizing risk factors

This paper attempts to predict the cyclical behavior of exchange rates by using five risk factors, viz., violations of uncovered interest rate parity (UIP), relative purchasing power parity (RPPP) and pseudo-parity for equity returns, relative (cross-country) TED spreads and relative term spreads. These factors are found to forecast periods of depreciation or appreciation and subsequent reversals. The estimates based on a dynamic probit model reveal that violations of UIP, RPPP and equity market pseudo-parity exhibit predictive power for currency cycles albeit only at short horizons. The proposed framework can be utilized by policy makers to smoothen the resulting currency misalignment and by investors to form trading strategies and hedge their positions as well as re-balance their carry trade positions.     

Adaptive market efficiency of agricultural commodity futures contracts

In this paper we investigate the adaptive market efficiency of the agricultural commodity futures market, using a sample of eight futures contracts. Using a battery of nonlinear tests, we uncover the nonlinear serial dependence in the returns series. We run the Hinich portmanteau bicorrelation test to uncover the moments in which the nonlinear serial dependence, and therefore adaptive market efficiency, occurs for our sample.     

Testing market efficiency with the pricing kernel

Market efficiency and the pricing kernel are closely related. A non-monotonic decreasing pricing kernel implies the existence of a trading strategy in contingent claims that stochastically dominates a direct investment in the market. Moreover, a market is assumed to be efficient only if no dominating strategies exist. Empirically, many studies of the pricing kernel find non-monotonicity, apparently ruling out market efficiency. However, these results are often unreliable, because the pricing measures of the pricing kernel are estimated using differing filtration sets. We show this effect both theoretically and empirically, and we discuss recent approaches in the literature for achieving more reliable estimates of the pricing kernel, potentially leading to better tests of market efficiency.     

Nonlinear serial dependence and the weak-form efficiency of Asian emerging stock markets

The objective of this paper is to re-examine the weak-form efficiency of 10 Asian emerging stock markets. Using a battery of nonlinearity tests, the statistical results reveal that all the returns series still contain predictable nonlinearities even after removing linear serial correlation from the data. The next stage of sub-sample analysis using the Hinich [Hinich, M., 1996. Testing for dependence in the input to a linear time series model. Journal of Nonparametric Statistics 6, 205–221] bicorrelation test shows that the 10 Asian series follow a pure noise process for long periods of time, only to be interspersed with brief periods of strong nonlinear dependence. The exploratory investigation found that the cross-country differences in nonlinear departure from market efficiency can be explained by market size and trading activity, while the transient burst of nonlinear periods in each individual market can be attributed largely to the occurrence of economic and political events.     

The statistical evolution of prices on the Istanbul stock exchange

This study documents the statistical properties of the stock returns on the Istanbul Stock Exchange (ISE) for the January 1988 to December 1999 period and tries to assess the evolution of the underlying stochastic structure over this time period. It also investigates empirically the relative efficiency of the ISE to test whether the rapid development of this market over the last decade caused it to become a relatively more efficient market. This is accomplished through a number of parametric and non-parametric tests of the random walk hypothesis using daily, weekly and monthly observations of the value-weighted ISE-100 index series. The emphasis is more on the evolution of the price process than on static tests of a random walk model as such. The findings indicate that the price mechanism in the ISE has evolved into a more informationally efficient process in little more than a decade of existence.     

The Canadian treasury bill auction and the term structure of interest rates

This paper examines the efficiency of the Canadian treasury bill market as measured by the performance of the expectations model of the term structure of interest rates. In particular, market efficiency is shown to depend upon certain institutional features of the treasury bill auction process. Building on past work by B. Campbell and J.W. Galbraith [Oxford Bulletin of Economics and Statistics 59 (2) (1997) 265–284], the paper establishes links between rejections of efficiency and high absolute values of the spread between six- and three-month interest rates. The major contribution of the paper is to then show that a link exists between weeks in which spreads are large and weeks in which accepted auction yields show a large degree of dispersion. The paper discusses the implications of these findings for the term structure literature and for possible auction configurations currently under consideration in Canada and the US.     

Parity conditions and the efficiency of the Australian 90- and 180-day forward markets

Covered Interest Parity (CIP) holds in the 90 and 180 forward market for the AUD/USD spot exchange rate provided fully modified least absolute deviation model (FM-LAD) procedures are applied to daily data for the period from December 2, 1985 to December 29, 2000. CIP fails if corrected ordinary least squares (OLS) and fully modified OLS (FM-OLS) procedures are applied. However, UIP fails in both markets on early data: December 2, 1985 to December 31, 1991, but holds in the 90-day market in a later subperiod: January 2, 1992 to December 29, 2000 FM. UIP is modified (M) to accommodate a potential risk premium. The MUIP model does not provide strong evidence suggesting the presence of a time-varying risk premium (TRP).     

Empirical tests of real estate market efficiency

Recent empirical research using real estate data has supported the weak and semi-strong forms of the efficient markets hypothesis. Previous studies have not included an estimate of expected appreciation into the tests of market efficiency, thus raising a question about the reliability of the results. We first use a market model to test for market efficiency with results similar to those reported by others. We next use a dynamic multiple indicator, multiple cause (DYMIMIC) model, which extracts a vector of expected appreciation from the price data, to test market efficiency. This approach produces superior results and a stronger conclusion about the efficiency of housing markets. The results indicate limited adjustment delays which can be explained by the existence of high transactions and search costs.     

Disability Insurance: Theoretical Trade-Offs and Empirical Evidence*

Disability insurance provides protection against health shocks that limit the ability to work. In most countries, these programmes are large and growing, both in expenditure and in number of recipients. We discuss the traditional trade-off between insurance and incentives in providing this insurance, with a focus on the US and UK experiences. There is substantial evidence on the extent of the labour supply incentive costs of disability insurance, but there has been a lack of evidence on the insurance value until very recently. Further, evidence on errors in the disability insurance process suggests false rejections of genuine claimants is a substantial problem, and these are more serious than false acceptances of healthy applicants. We provide a life-cycle framework for understanding the trade-offs and to evaluate the welfare implications of policy reforms. We argue that reforms should be focused on reducing false rejections and supporting labour market attachment. The difficulty in considering reform is that the design of disability insurance has many aspects that interact and impact on outcomes.     

The Performance of Actively Managed International Mutual Funds

International mutual funds allow individual investors to diversify abroad at a reasonable cost. This paper tests whether international funds that actively engage in country and security selection outperform passive global benchmarks. We apply a mean-variance efficiency test that incorporates the practical prohibition against short sales of open-end mutual funds. Our tests reject the efficiency of the world equity market portfolio over the sample period, and our funds as a group outperform the inefficient world index. However, we find no evidence of security selectivity ability using a 12-country benchmark. We do find that active international funds provide global diversification benefits. Tests using the Positive Period Weight (PPW) measure of Grinblatt and Titman (1989), which is robust to nonlinearity in fund and benchmark returns, yield similar results.     

Regression vs. volatility tests of the efficiency of foreign exchange markets

Volatility tests are an alternative to regression tests for evaluating the joint null hypothesis of market efficiency and risk neutrality. By considering tests based on conditional volatility bounds, we show that if the alternative hypothesis is that one could ‘beat the market’ using a linear combination of observable variables, then regression tests are at least as powerful as the conditional volatility tests. If the application is to spot and forward markets for foreign exchange, then the most powerful conditional volatility test turns out to be equivalent to the analogous regression test in terms of asymptotic power.