DIVERSIFICATION AND SKEWNESS IN OPTION PORTFOLIOS

Skewness in returns is relevant to option investors. Because options possess positively skewed distributions, the traditional maxim of diversification, which can destroy positive skewness, is not necessarily consistent with investment objectives. The results indicate that the majority of skewness in option portfolios is diversified with a relatively small portfolio size, suggesting a strategy of antidiversification for option investors. Even though the investment performance of options is inferior to stocks on a risk-return basis, the data indicate the suitability of option portfolios in an environment where an investor's utility is measured by the return, risk, and skewness of the return distribution.     

Intertemporal risk-return trade-off in foreign exchange rates

We investigate the intertemporal risk-return trade-off of foreign exchange (FX) rates for ten currencies quoted against the USD. For each currency, we use three risk measures simultaneously that pertain to that currency; its realized volatility, its realized skewness, and its value-at-risk. We apply monthly FX excess returns and risk measures calculated from daily observations. We find that there is a significant contemporaneous risk-return trade-off for the currencies under investigation. There is no evidence of noncontemporaneous risk-return trade-off. We pay special attention to the risk-return trade-off during the recent financial crisis.     

The impact of risk and uncertainty on expected returns

We study asset pricing in economies featuring both risk and uncertainty. In our empirical analysis, we measure risk via return volatility and uncertainty via the degree of disagreement of professional forecasters, attributing different weights to each forecaster. We empirically model the typical risk-return trade-off and augment these models with our measure of uncertainty. We find stronger empirical evidence for an uncertainty-return trade-off than for the traditional risk-return trade-off. Finally, we investigate the performance of a two-factor model with risk and uncertainty in the cross section.     

The intertemporal risk-Return relation,investor behavior,and technical trading profits: evidence from the G-7 countries

The intertemporal risk-return relation and investor behavior are both important pricing factors that jointly determine the expected market risk premium. Using the price adjustment process as a control variable, we find that the intertemporal risk-return relation is positive conditional on bad market news, but is non-positive conditional on good market news. This implies that good (bad) market news weakens (strengthens) the positive risk-return relation. The pattern in the distortion of the risk-return relation is consistent with short-term mispricing in which investors overvalue (undervalue) the stock market in reaction to good (bad) market news. We also show that ignoring the price adjustment process in the estimation of the risk-return relation leads to model misspecification and induces an upward (downward) bias in estimates of the relative risk aversion parameter conditional on good (bad) news. Our model of the asymmetric risk-return relation along with the price adjustment process is capable of generating the return dynamics that is attributable to technical trading profits. We suggest that the profitability of technical trading rules is not a violation of market efficiency, but a consequence of trading rules exploiting the asymmetric effect of price changes on the risk-return relation, along with the persistence property of price changes.     

The shrouded business of style drift in active mutual funds

This study investigates the motivation and performance consequence of intentional style drift in an exclusively in-house fund management industry in China. With style drift, fund investors are exposed to investment portfolio outside their risk-return preference but are generally unaware that their risk and return expectations are disrupted, and the functioning of the fund market undermined. Our study provides evidence for the first time about the incentive that motivates style drift behavior. We find that style drift increases a fund's subsequent net inflows, thus affirming the maximization of AUM-linked compensation as the motivation for fund manager's style drift behavior. We also find that larger funds have greater incentive to drift. We demonstrate that style drift behavior interferes with the picking of quality stocks to deliver fund performance for fund investors. Style drift as an unobserved risk behavior harms fund investor interest and undermines market integrity.     

Investor sentiment and the risk–return relation: A two-in-one approach

Traditional finance theory posits a positive risk–return relation, but empirical evidence is inconclusive. Retail investor sentiment has long been viewed as a distorting factor, while more recently institutional investor sentiment is thought to play a role. We examine the separate and joint impacts of retail and institutional investor sentiments on the risk-return relation. We find, at both market and firm levels, the risk-return relation is more likely to be distorted by the two investor-type sentiments jointly, rather than separately. We further find a cross-sectional pattern, with the risk-return relation being more sensitive to investor sentiment for stocks with specific characteristics.     

The appropriateness of default investment options in defined contribution plans: Australian evidence

For participants in defined contribution (DC) plans who refrain from exercising investment choice, plan contributions are invested following the default investment option of their respective plans. Since default investment options of different plans vary widely in terms of their benchmark asset allocation, the most important determinant of investment performance, participants enrolled in these options face significantly different wealth outcomes at retirement. This paper simulates the terminal wealth outcomes under different static asset allocation strategies to evaluate their relative appeal as default investment choice in DC plans. We find that strategies with low or moderate allocation to stocks are consistently outperformed in terms of upside potential of exceeding the participant's wealth accumulation target at retirement as well as downside risk of falling below that target outcome by aggressive strategies whose allocation to stocks approach 100%. The risk of extremely adverse wealth outcomes for plan participants also does not appear to be very sensitive to asset allocation. Our evidence suggests the appropriateness of strategies heavily tilted towards stocks to be nominated as default investment options in DC plans unless plan providers emphasize predictability of wealth outcomes over adequacy of retirement wealth.     

Executive compensation and corporate risk-taking: Evidence from private loan contracts

We examine how management stock options affect corporate risk taking. We exploit exogenous variation in stock option grants generated by FAS 123R and use loan spreads to infer risk taking. Using a difference-in-differences approach, we find that the spreads of loans taken by firms that did not expense options before FAS 123R (treated firms) significantly decrease after FAS 123R relative to firms that either did not issue stock options or voluntarily expensed stock options before 123R (control firms). We also find that the effect is stronger for firms with high agency conflicts associated with risk-shifting. Furthermore, loans taken by the treated firms are less likely to contain collateral requirements and are less likely to have covenants restricting capital investment post FAS 123R.     

Value at risk and returns of cryptocurrencies before and after the crash: long-run relations and fractional cointegration

Cryptocurrency has become an increasingly important investment vehicle, thus the long-run relationship between risk and return of cryptocurrency is vital for both investors and policy-makers. We apply the Fractionally Cointegrated Vector Autoregression (FCVAR) model and investigate the risk-return relationship. This has not been studied previously, much less disintegrating the series into periods of pre-crash, post-crash, and the full sample. Empirical results indicate that risk series in all eight cryptocurrency markets exhibit long-memory property, and there is a long-run fractional cointegration relationship between the risk of altcoins and Bitcoin. Most importantly, though a positive risk-return tradeoff is found in the full sample, there are big differences between results of pre-crash and post-crash. The time horizon set to 14 days, all the eight currencies exhibit traditional risk-return tradeoff after the crisis, whereas the effect doesn’t exist before the crisis, with the exception of Dash and Doge. In the same vein, there is no leverage effect in all eight currencies before the crisis but this effect is present in three cryptocurrencies after the crisis. The differences indicate that investors are more cautious, increasing risk awareness and demanding higher compensation for risk after the crash. The above results are robust when time horizon is 30 days.     

Socially responsible investment portfolios: Does the optimization process matter?

This study investigates the impact of the choice of optimization technique when constructing Socially Responsible Investment (SRI) portfolios. Corporate Social Performance (CSP) scores are price sensitive information that is subject to considerable estimation risk. Therefore, uncertainty in the input parameters is greater for SRI portfolios than conventional portfolios, and this affects the selection of the appropriate optimization method. We form SRI portfolios based on six different approaches and compare their performance along the dimensions of risk, risk-return trade-off, diversification and stability. Our results for SRI portfolios contradict those of the conventional portfolio optimization literature. We find that the more “formal” optimization approaches (Black-Litterman, Markowitz and robust estimation) lead to SRI portfolios that are both less risky and have superior risk-return trade-offs than do more simplistic approaches; although they also have more unstable asset allocations and lower diversification. Our conclusions are robust to a series of tests, including the use of different estimation windows and stricter screening criteria.     

Mean–variance convergence around the world

In this paper, we show (i) that the risk-return characteristics of our sample of 17 developed stock markets of the world have converged significantly toward each other during our study period 1974–2007, and (ii) that this international convergence in risk-return characteristics is driven mainly by the declining ‘country effect’, rather than the rising ‘industry effect’, suggesting that the convergence is associated with international market integration. Specifically, we first compute the risk-return distance among international stock markets based on the Euclidean distance and find that the distance thus computed has been decreasing significantly over time, implying a mean–variance convergence. In particular, the average risk-return distance has decreased by about 50% over our sample period. We also document that the risk-return characteristics of our sample of 14 emerging markets have been converging rapidly toward those of developed markets in recent years. This development notwithstanding, emerging markets still remain as a distinct asset class. Lastly, we show that the convergence in risk-return characteristics has exerted a negative impact on the efficiency of international investment during our sample period.     

Quantile regression analysis of hedge fund strategies

Extending previous work on hedge fund pricing, this paper introduces the idea of modelling the conditional quantiles of hedge fund returns using a set of risk factors. Quantile regression analysis provides a way of understanding how the relationship between hedge fund returns and risk factors changes across the distribution of conditional returns. We propose a Bayesian approach to model comparison which provides posterior probabilities for different risk factor models that can be used for model averaging. The most relevant risk factors are identified for different quantiles and compared with those obtained for the conditional expectation model. We find differences in factor effects across quantiles of returns, which suggest that the standard conditional mean regression method may not be adequate for uncovering the risk-return characteristics of hedge funds. We explore potential economic impacts of our approach by analysing hedge fund single strategy return series and by constructing style portfolios.     

Risk-return trade-off for European stock markets

This paper adopts factor models with macro-finance predictors to test the intertemporal risk-return relation for 13 European stock markets from 1986 to 2012. We use country specific, euro area, and US macro-finance factors to determine the conditional volatility and conditional return. We find that the risk-return trade-off is generally negative. The Markov switching model documents that there is time-variation in this trade-off that is linked to the state of the economy, but not the business cycles. Quantile regressions show that the risk-return trade-off is stronger at the lowest quantile of the conditional return.     

Real Estate Fund Flows and the Flow-Performance Relationship

Convexity in the flow-performance relationship of traditional asset class mutual funds is widely documented, however it cannot be assumed to hold for alternative asset classes. This paper addresses this shortcoming in the literature by examining the flow-performance relationship for real estate funds, specifically open-end, direct-property funds. This investment vehicle is designed to provide the risk-return benefits of private market real estate and is available to retail investors in many countries across the globe. An understanding of fund flow dynamics associated with this investment vehicle is of particular interest due to the liquidity risk associated with holding an inherently illiquid asset in an open-end structure. Our analysis draws on the theoretical foundations provided in the literature on mutual fund flows, performance chasing, liquidity risk, participation costs and dynamics across market cycles. We focus on German real estate funds from 1990 to 2010 as this is the largest market globally and there is a high level of confidence in the data. The results show that real estate fund investors chase past performance at the aggregate level and the relationship between flows and relative performance is asymmetric (i.e., convex) at the individual fund level. Fund-level liquidity risk tends to weaken convexity, while sensitivity increases with higher participation costs. We find the flow-performance relationship varies across time, though our interpretation is asset and investment vehicle specific. The implications are applicable to investors and fund managers of open-end, direct-property funds and, more broadly, other alternative asset funds where the underlying asset may not be liquid.     

The impact of off-balance-sheet activities on banks returns: An application of the ARCH-M to Canadian data

This paper revisits the impact of off-balance-sheet (OBS) activities on banks risk-return trade-off. Recent studies (e.g., Stiroh and Rumble, 2006) show that increasing OBS activities does not necessarily yield straightforward diversification benefits for banks. However, introducing a risk premium in the standard banks returns models, and resorting to an ARCH-M procedure, Canadian data suggest that banks risk-return trade-off displays a structural break around 1997. In the second subperiod of our sample (1997–2007), we find that the noninterest income generated by OBS activities no longer impacts banks returns negatively. While during the first period (1988–1996) the volatility variable is not significant in any returns equations, a risk premium eventually emerges, pricing the risk associated to OBS activities.     

The role of equity compensation in reducing inefficient investment in labor

We investigate whether equity compensation incentivizes executives to make efficient labor investment decisions. In doing so, we examine the extent to which stock options and restricted stock differentially influence labor investment decisions. Consistent with theoretical predictions, we find that stock options exacerbate, while restricted stock mitigates, inefficient labor investment. The effect of stock options (restricted stock) are weaker (stronger) for financially constrained firms. Our results are robust to alternative proxies for inefficient labor investment and when addressing a range of endogeneity concerns. Our research demonstrates that stock options and restricted stock matter in executives' labor investment decisions, but in different ways. Our findings have implications for future research, suggesting that stock options and restricted stock need to be separately considered when examining the impact equity compensation has on capital or investment decision making; and for executive remuneration practice.     

Downsizing decisions: The joint influence of equity incentives and behavioral biases

Although new investment can be viewed as a decision to pursue projects from a wide number of growth opportunities with easily discernible (and presumably preferable) risk profiles, downsizing (e.g., through layoffs, plant closings, asset divestitures, etc.) is a dichotomous choice to either abandon or continue an existing project where the relative risk between these options is not clear. Our evidence suggests that vega in the pre-downsizing period is associated with risky investment that necessitates future downsizing. We further find that contemporaneous vega is associated with a greater likelihood of downsizing. On the other hand, our evidence suggests that delta is a significant impediment to downsizing. We examine the influence of behavioral factors in the decision-making process and find downsizing decisions are discouraged by managerial overconfidence but encouraged by managers’ aversion to ambiguity. Finally, we investigate whether equity incentives and behavioral factors lead to better downsizing decisions. We find that downsizing firms with high ambiguity perform better after downsizing relative to their matched pair with lower ambiguity.     

股指期货与股指期权套期保值组合的Delta中性动态模拟——基于沪深300股指期货仿真交易的分析

沪深300股指期货的推出,在为市场提供套保工具和流动性的同时,也带来新的风险。本文运用同一指数的股指期权与股指期货组成多种动态套期保值组合,分析股指期货的风险对冲策略。结果表明所构造的组合都能为股指期货提供有效的套期保值;不论多头股指期货还是空头股指期货,保护性策略的风险控制能力更强。     

Trade Credit Risk Management: The Role of Executive Risk‐Taking Incentives

In this study we investigate how executive equity incentives affect companies’ risk‐taking behavior in relationships with their customers. We hypothesize and find that executive risk‐taking incentives provided by options are positively related to the degree of trade credit riskiness measured both as the amount of total trade credit a firm extends to all its customers and as the amount of trade credit a firm extends to customers with a high probability of default. We also find that the measures of trade credit riskiness are positively related to the firm's future stock return volatility, suggesting that the customer default risk inherent in customer‐supplier trade credit relationships represents an important economic source of the overall supplier‐firm riskiness. The findings of the study provide insights into why firms facing financial difficulties are not denied trade credit.     

Value at risk and the cross-section of hedge fund returns

Using two large hedge fund databases, this paper empirically tests the presence and significance of a cross-sectional relation between hedge fund returns and value at risk (VaR). The univariate and bivariate portfolio-level analyses as well as the fund-level regression results indicate a significantly positive relation between VaR and the cross-section of expected returns on live funds. During the period of January 1995 to December 2003, the live funds with high VaR outperform those with low VaR by an annual return difference of 9%. This risk-return tradeoff holds even after controlling for age, size, and liquidity factors. Furthermore, the risk profile of defunct funds is found to be different from that of live funds. The relation between downside risk and expected return is found to be negative for defunct funds because taking high risk by these funds can wipe out fund capital, and hence they become defunct. Meanwhile, voluntary closure makes some well performed funds with large assets and low risk fall into the defunct category. Hence, the risk-return relation for defunct funds is more complicated than what implies by survival. We demonstrate how to distinguish live funds from defunct funds on an ex ante basis. A trading rule based on buying the expected to live funds and selling the expected to disappear funds provides an annual profit of 8–10% depending on the investment horizons.