Generalised Rational Bias in Financial Forecasts

Laster et al. (Q J Econ 114(1):293–318, 1999) built an economic model in which forecasters have incentives to generate forecasts that differ form the consensus. It is shown that the dispersion of the equilibrium distribution of forecasters, depends on the relative importance given on the intensive forecast users’ loss versus the publicity gain from occasional users. These results depend heavily on the assumption of symmetry for the loss and density functions. In this paper we examine the effects of generalising loss preferences and probability densities to allow for asymmetries through the LinEx loss and the Skewed Normal density, respectively. We derive the generalised equilibrium distribution of forecasts which contains the results of Laster et al. as a special case. The presence of asymmetric preferences is shown to cause a movement of the distribution away from the conditional mean, towards the optimal forecast under loss asymmetry. Furthermore, forecasts now tend to cluster around this quantity in an asymmetric way. These effects tend to be further strengthened or partially offset by the presence of skewness in the distribution of data, a result consistent with the conclusions of Christodoulakis (Finan Res Lett 2:227–233, 2005).The author is grateful to an anonymous referee for helpful comments that have improved the paper. The views expressed in the paper are those of the author and should in no part be attributed to the Bank of Greece.     

Bias in Federal Reserve inflation forecasts: Is the Federal Reserve irrational or just cautious?

Inflation forecasts of the Federal Reserve seem to have systematically under-predicted inflation from the fourth quarter of 1968 until Volcker's appointment as Chairman, and to systematically over-predict it afterwards until the second quarter of 1998. Furthermore, under quadratic loss, commercial forecasts seem to have information not contained in those forecasts. To investigate the cause of this apparent irrationality, this paper recovers the loss function implied by Federal Reserve's inflation forecasts. The results suggest that the cost of having inflation above an implicit time-varying target was larger than the cost of having inflation below it for the period since Volcker, and that the opposite was true for the pre-Volcker era. Once these asymmetries are taken into account, the Federal Reserve's inflation forecasts are found to be rational.     

On the predictive power of the surplus consumption ratio

This paper shows that the surplus consumption ratio, specified by Campbell and Cochrane [1999. Journal of Political Economy 107, 205–251], is a good predictor of excess returns at long horizons. We also provide empirical evidence that this variable captures a component of expected returns, not explained by the proxies for the consumption to wealth ratio, cay and cdy, proposed by Lettau and Ludvigson [2001a. Journal of Finance 56, 815–849; 2001b. Journal of Political Economy 109, 1238–1286; 2005. Journal of Financial Economics 76, 583–626]. Moreover, used as a conditioning information for the Consumption based Asset Pricing Model (C)CAPM, the resulting linear model helps to explain for the variation in average returns across the Fama–French (25) portfolios sorted by size and book-to-market characteristics.     

SYMMETRIC VERSUS ASYMMETRIC CONDITIONAL COVARIANCE FORECASTS: DOES IT PAY TO SWITCH?

Volatilities and correlations for equity markets rise more after negative returns shocks than after positive shocks. Allowing for these asymmetries in covariance forecasts decreases mean‐variance portfolio risk and improves investor welfare. We compute optimal weights for international equity portfolios using predictions from asymmetric covariance forecasting models and a spectrum of expected returns. Investors who are moderately risk averse, have longer rebalancing horizons, and hold U.S. equities benefit most and may be willing to pay around 100 basis points annually to switch from symmetric to asymmetric forecasts. Accounting for asymmetry in both variances and correlations significantly lowers realized portfolio risk.     

Endogenous entry/exit as an alternative explanation for the disciplining role of independent analysts

Gu and Xue [2008. The superiority and disciplining role of independent analysts. Journal of Accounting and Economics, this issue, doi:10.1016/j.jacceco.2008.02.002] study the disciplining effect of independent analysts on the accuracy and forecast relevance of the forecasts of non-independent analysts. One of the intriguing results is that while independent analysts issue inferior forecasts, their presence appears to reduce the forecast bias, improve the forecast accuracy and increase the forecast relevance of forecasts issued by non-independent analysts. We explore alternative explanations for the Gu–Xue results. Our evidence of endogenous entry and exit of independent analysts provides a more compelling explanation for the reported results.     

Does the Stock Market See a Zero or Small Positive Earnings Surprise as a Red Flag?

This study shows that firms collectively incur a cost for managing earnings and analyst expectations to meet earnings forecasts. We compare the coefficient in the regression of abnormal stock returns on earnings surprise (the earnings response coefficient [ERC]) across ranges of earnings surprises. The ERC for earnings surprises in the range [0, 1¢] is significantly lower than ERCs for earnings surprises in adjacent ranges for firm-quarters in the early and mid 2000s, but not for those in the 1990s. The results are robust to controlling for the sign of estimated discretionary accruals and the trajectory of analyst earnings forecasts. We further find that investors are right to be skeptical about earnings surprises in the range [0, 1¢]. The relation of future earnings surprise with current earnings surprise is more negative for current earnings surprises in that range than for those in any other range. Evidence also suggests analysts react negatively to earnings surprises in that range.     

Measuring convergence of National Accounting Standards with International Financial Reporting Standards

This paper analyses three methods for measuring the success achieved in effecting convergence between any two sets of accounting standards. We begin by reviewing a measurement method based on the concept of Euclidean distances. We then propose two better measures (involving Jaccard's coefficients and Spearman's coefficients) to assess the progress of National Accounting Standards setting bodies in converging their standards with International Financial Reporting Standards [IFRS]. For illustrative purposes, we measure the convergence of National Accounting Standards in Portugal with International Accounting Standards [IAS] and IFRS over the period 1977–2003.     

Stock and bond market interactions with level and asymmetry dynamics: An out-of-sample application

We model the dynamic interaction between stock and bond returns using a multivariate model with level effects and asymmetries in conditional volatility. We examine the out-of-sample performance using daily returns on the S&P 500 index and 10 year Treasury bond. We find evidence for significant (cross-) asymmetries in the conditional volatility and level effects in bond returns. The out-of-sample covariance matrix forecasts of the model imply that an investor is willing to pay between 129 and 820 basis points per year for using a dynamic trading strategy instead of a passive strategy.     

New evidence on the pecking order hypothesis: the case of French convertible bonds

Convertible bonds (CBs) are an important asset class but their analysis in function of the equity and bond components has received insufficient attention in France. This study investigates the relation between announcement effects and equity components for 141 French CB issues. We use the CB sensitivity to its underlying common stock as a proxy for the equity component. Our results indicate that CB issue announcements imply significantly negative market responses, which are negatively related to the equity component. This result supports the Myers and Majluf (1984) model [Myers, S.C., Majluf, N.S., 1984. Corporate financing and investment decisions when firms have information that investors do not have. J. Financial Econ. 13, 187–221]. A more detailed analysis reveals that the market reaction is significantly positive for the subset of ‘mixed’ CBs. Mixed CB issuers are characterized by high informational asymmetries about investment opportunities compared with informational asymmetries about assets-in-place. This finding supports the revised Myers and Majluf model, which predicts positive announcement effects under certain conditions.     

RATIONAL EXPECTATIONS AND THE DYNAMIC ADJUSTMENT OF SECURITY ANALYSTS' FORECASTS TO NEW INFORMATION

We report the results of unbiasedness tests of security analysts' earnings forecasts. By examining how analysts incorporate new information into their updated earnings forecasts we can analyze directly the effect of new information on analysts' forecast revisions and evaluate whether these revised forecasts converge to rational expectations forecasts. The forecasts made by security analysts participating in the Institutional Brokers Estimate System (IBES) database are analyzed. Using standard statistical tests, we reject the simple form of the rational expectations hypothesis. However, by extending the standard tests used in previous studies, we obtain results that suggest that analysts' earnings forecasts conform to a dynamic form of rationality. The tendency of revised forecasts to converge stochastically toward the rational expectations forecast cautions against the rejection of more complicated forms of rationality.     

Volatility Forecasting in the Hang Seng Index using the GARCH Approach

The aim of this paper is to add to the literature on volatility forecasting using data from the Hong Kong stock market to determine if forecasts from GARCH based models can outperform simple historical averaging models. Overall, unlike previous studies we find that the GARCH models with non-Normal distributions show a robust volatility forecasting performance in comparison to the historical models. The results indicate that although not all models outperform simple historical averaging, the EGARCH based models, with non-normal conditional volatility, tend to produce more accurate out-of-sample forecasts using both standard measures of forecast accuracy and financial loss functions. In addition we test for asymmetric adjustment in the Hang Seng, finding strong evidence of asymmetries due to the domination of financial and property firms in this market.     

Disagreement and Biases in Inflation Expectations

Disagreement in inflation expectations observed from survey data varies systematically over time in a way that reflects the level and variance of current inflation. This paper offers a simple explanation for these facts based on asymmetries in the forecasters' costs of over- and underpredicting inflation. Our model implies (i) biased forecasts, (ii) positive serial correlation in forecast errors, (iii) a cross-sectional dispersion that rises with the level and the variance of the inflation rate, and (iv) predictability of forecast errors at different horizons by means of the spread between the short- and long-term variance of inflation. We find empirically that these patterns are present in inflation forecasts from the Survey of Professional Forecasters. A constant bias component, not explained by asymmetric loss and rational expectations, is required to explain the shift in the sign of the bias observed for a substantial portion of forecasters around 1982.     

Staged-financing contracts with private information

This paper studies the use of incentive contracts in the Bolton–Scharfstein model when some agents in the population are technically constrained from falsifying reports and stealing cash [Bolton, P., Scharfstein, D., 1990. A theory of predation based on agency problems in financial contracting. Amer. Econ. Rev. 80, 94–106]. The original Bolton–Scharfstein contract may not be optimal for a large range of parametric values. The optimal contract may induce falsification and stealing in equilibrium and social welfare may be improved. Moreover, the optimal contract does not screen different types of agents. Empirical implications for various types of staged-contracts are discussed.     

Meanings of the term ‘sustainable development’ in Finnish corporate disclosures

There is an on-going discursive struggle over how the social and environmental problems related to modern societies should be understood and resolved. Sustainable development has become a pre-eminent concept in these discussions and businesses are increasingly employing the term in their communications. However, sustainable development means “different things to different people in different contexts” [Bebbington, J. (2001). Sustainable development: A review of the international development, business and accounting literature. Accounting Forum, 25(2), 128–157; see p. 129]. Thus, there have been recent calls in the literature to analyse what the companies are actually saying in their disclosures [Thomson, I., & Bebbington, J. (2005). Social and environmental reporting in the UK: A pedagogic evaluation. Critical Perspectives on Accounting; Kolk, A. (1999). Evaluating corporate environmental reporting. Business Strategy and the Environment, 8, 225–237]. Subscribing to the social construction of reality, this study critically assesses how the term ‘sustainable development’ is constructed in the disclosures of Finnish listed companies.

Overall, in the disclosures, sustainable development is constructed as a win-win concept, which allows society to enjoy economic growth, environmental protection and social improvements with no trade-offs or radical restructurings in the social order. However, behind the usual business rhetoric, there is very little evidence of anyone actually walking this talk. Accordingly, this research calls for further discussion on companies’ role in achieving sustainable development and on the business interpretation of sustainable development in general.     

Buffer stocks and precautionary savings with loss aversion

This paper reexamines buffer stocks and precautionary savings in the presence of loss aversion. We assume that agents are disappointment averse, as in Gul [Econometrica, 59 (1991) 667–686]. We show that the concavity of the marginal utility continues to determine precautionary saving, but its effect is of a second order magnitude (proportional to the square of the coefficient of variation) compared to the first order effect (proportional to the coefficient of variation) induced by loss aversion. We show that a stabilization fund that is rather small when agents are maximizing the conventional expected utility, turns out to be rather large with loss aversion.     

An empirical examination of the benefits of international diversification

We examine the benefits of international portfolio diversification for U.K. investors between January 1985 and December 2000 using the approach of Wang [Wang, Z., 1998. Efficiency loss and constraints on portfolio holdings. Journal of Financial Economics 48, 359–375] and Li et al. [Li, K., Sarkar, A., Wang, Z., 2003. Diversification benefits of emerging markets subject to portfolio constraints. Journal of Empirical Finance 10, 57–80]. We find significant increases in the Sharpe [Sharpe, W.F., 1966. Mutual fund performance. Journal of Business 39, 119–138] and certainty equivalent return (CER) performance in moving from a domestic strategy to an international strategy that includes either global industry or country equity portfolios, even in the presence of short selling restrictions. We also find significant diversification benefits using U.K. unit trusts with international equity objectives. However, U.K. international unit trusts do not capture all the diversification benefits provided by either global industry or country equity portfolios.     

Explaining Insurance Policy Provisions via Adverse Selection

In this article, we show that common insurance policy provisions—namely, deductibles, coinsurance, and maximum limits–can arise as a result of adverse selection in a competitive insurance market. Research on adverse selection typically builds on the assumption that different risk types suffer the same size loss and differ only in their probability of loss. In this study, we allow the severity of the insurance loss to be random and, thus, generalize the results of Rothschild and Stiglitz [1976] and Wilson [1977]. We characterize the separating equilibrium contracts in a Rothschild-Stiglitz competitive market. By further assuming a Wilson competitive market, we show that an anticipatory equilibrium might be achieved by pooling, and we characterize the optimal pooling contract.     

Continuous time and nonparametric modelling of U.S. interest rate models

In this paper we compare the forecasting performance of different models of interest rates using parametric and nonparametric estimation methods. In particular, we use three popular nonparametric methods, namely, artificial neural networks (ANN), k-nearest neighbour (k-NN), and local linear regression (LL). These are compared with forecasts obtained from two-factor continuous time interest rate models, namely, Chan, Karolyi, Longstaff, and Sanders [CKLS, J. Finance 47 (1992) 1209]; Cos, Ingersoll, and Ross [CIR, Econometrica 53 (1985) 385]; Brennan and Schwartz [BR-SC, J. Financ. Quant. Anal. 15 (1980) 907]; and Vasicek [J. Financ. Econ. 5 (1977) 177]. We find that while the parametric continuous time method, specifically Vasicek, produces the most successful forecasts, the nonparametric k-NN performed well.     

Survey evidence on forecast accuracy of U.S. term spreads

Successful portfolio management strategies partly require accurate forecasts of term spreads. Such forecasts may also be useful for policymaking since the yield curve may contain predictive information for economic growth. This study asks whether experts accurately predict term spreads. We show that the consensus forecasts from two separate panels, while superior to alternative benchmark forecasts, are free of systematic bias but unable to replicate the degree of variability in the actual change. Moreover, these forecasts are directionally accurate under symmetric loss, implying that they are of value to a market participant who assigns similar costs to incorrect upward and downward moves.     

Election predictions are arbitrage-free: response to Taleb

Taleb [Election predictions as martingales: An arbitrage approach. Quant. Finance, 2018, 18, 1–5] claimed a novel approach to evaluating the quality of probabilistic election forecasts via no-arbitrage pricing techniques and argued that popular forecasts of the 2016 U.S. Presidential election had violated arbitrage boundaries. We show that under mild assumptions all such political forecasts are arbitrage-free and that the heuristic that Taleb's argument was based on is false.