A century of equity premium predictability and the consumption–wealth ratio: An international perspective

This paper re-examines the predictive ability of the consumption–wealth ratio (cay) on the equity premium using hand-collected annual data spanning one century for four major economies. In addition to statistical tests of out-of-sample forecast accuracy, we measure the economic value of the predictive information in cay in a stylized asset allocation strategy. We find that cay does not contain predictive power prior to World War II, when a structural break occurs for all countries. In the postwar period, while statistical tests provide mixed evidence, economic criteria uncover substantial predictive power in cay, further enhanced when allowing for economically meaningful restrictions.     

Idiosyncratic consumption risk and predictability of the carry trade premium: Euro-Area evidence

The failure to empirically prove uncovered interest rate parity conditions seems to be related to the presence of risk premia on foreign currencies. Recent studies suggest that either consumption- or currency-return-based pricing factors explain the cross section of foreign currency portfolio returns. The contribution of this paper is twofold. It first shows that the return-based explanation applies to foreign currency portfolios built from the perspective of a Euro-Area investor. Second, the main results of this paper suggest that the decisive pricing factor, the so-called carry trade premium, mirrors business-cycle-related risks. Times of relatively large uninsured Euro-Area consumption growth risk are associated with an expected increase of the carry trade premium.     

Exact inference and optimal invariant estimation for the stability parameter of symmetric α-stable distributions

Hill estimation (Hill, 1975), the most widespread method for estimating tail thickness of heavy-tailed financial data, suffers from two drawbacks. One is that the optimal number of tail observations to use in the estimation is a function of the unknown tail index being estimated, which diminishes the empirical relevance of the Hill estimation. The other is that the hypothesis test of the underlying data lying in the domain of attraction of an α-stable law (α < 2) or of a normal law (α ≥ 2) for finite samples, is performed on the basis of the asymptotic distribution, which can be different from those for finite samples. In this paper, using the Monte Carlo technique, we propose an exact test method for the stability parameter of α-stable distributions which is based on the Hill estimator, yet is able to provide exact confidence intervals for finite samples. Our exact test method automatically includes an estimation procedure which does not need the assumption of a known number of observations on the distributional tail. Empirical applications demonstrate the advantages of our new method in comparison with the Hill estimation.     

Seasoned equity offerings and customer–supplier relationships

We investigate how seasoned equity offerings (SEOs) by issuers with large customers affect both trading partners’ market values and the relationship's health. We hypothesize that SEOs reveal adverse information about an issuer's major customers and find that issuers and their large customers experience negative returns on SEO announcements. These results are more pronounced when customers have higher levels of information asymmetry and when customer-supplier relationships are particularly important. Large customers of issuers experience larger declines in post-SEO sales, operating performance, and credit ratings than large customers of non-issuers. Also, SEO issuer sales to large customers and relationship duration significantly decline.     

Does the equity premium puzzle persist during financial crisis? The case of the French equity market

This paper examines the effects of the financial crisis that began in 2008 on the equity premium of 6 French sector indices. Since the systematic risk coefficient beta remains the most common explanatory element of risk premium in most asset pricing models, we investigate the impact of the crisis on the time-varying beta of the six sector indices cited. We selected daily data from January 2003 to December 2012 and we applied the bivariate MA-GARCH model (BEKK) to estimate time-varying betas for the sector indices. The crisis was marked by increased volatility of the sector indices and the market. This rise in volatility led to an increase in the systematic risk coefficient during the crisis and first post-crisis period for all the major indices. The results are intuitive and corroborate findings in the empirical literature. The increase of the time-varying beta is considered by investors as an additional risk. Therefore, as expected, investors tend to increase their equity premiums to b ear the impact of financial crisis.     

The market price of risk and the equity premium: A legacy of the Great Depression?

By positing learning and a pessimistic initial prior, we build a model that disconnects a representative consumer's subjective attitudes toward risk from the high price of risk that a rational-expectations econometrician would deduce from financial market data. We follow Friedman and Schwartz [1963. A Monetary History of the United States, 1857-1960. Princeton University Press, Princeton, NJ] in hypothesizing that the Great Depression heightened fears of economic instability. We use a robustness calculation to elicit a pessimistic prior for a representative consumer and let him update beliefs via Bayes’ law. Learning eventually erases pessimism, but while it persists, pessimism contributes a volatile multiplicative component to the stochastic discount factor that a rational-expectation econometrician would detect. With sufficient initial pessimism, the model generates substantial values for the market price of risk and equity premium and predicts high Sharpe ratios and forecastable excess stock returns.     

Contingent capital conversion under dual asset and equity jump–diffusions

We model contingent capital with market trigger under dual jump–diffusion processes in asset values and equity prices. Under the dual jump–diffusions, we show that the conversion ratio is no longer deterministic under the jump–diffusion. The conversion ratio becomes a stochastic process related to the jump process of the underlying equity and the conditional expectation of the contingent capital at the conversion time. Thus, making the implementation of contingent capital impossible. The best we can hope to practically implement this conversion design, is to give the minimal conversion ratio (at least the portion required to convert) to conform with Basel III.     

Trading activity and bid–ask spreads of individual equity options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid–ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60–90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid–ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter’s spread to narrow.     

Can ambiguity aversion solve the equity premium puzzle? Survey evidence from international data

Ambiguity aversion has been suggested as a potential explanation for the equity premium puzzle in recent theoretical models. To test this hypothesis, we measure the amount of ambiguity aversion in a large-scale international survey. A comparison to the average equity premia in these countries demonstrates that ambiguity aversion does, indeed, have a significant influence on the amount of equity risk premium, even when controlling for macroeconomic parameters. Finally, we connect differences in ambiguity aversion to differences in uncertainty avoidance, one of Hofstede’s cultural dimensions.     

CEO and board chair roles: To split or not to split?

We examine the performance and compensation implications of firms' decisions to combine the roles of CEO and board chairman (duality). We document that firms that split the CEO and chairman positions due to investor pressure have significantly lower announcement returns and subsequent performance, and lower contributions of investments to shareholder wealth. Further, these performance outcomes are more negative for firms with higher predicted probabilities of duality based on a model of economic determinants of board leadership structure. We also find that pay-performance sensitivity in CEO compensation contracts are significantly lower following a split in the CEO and chairman positions, and significantly higher following a combination in these positions. Our evidence suggests that on average, board leadership choices by firms and market responses are consistent with efficiency arguments, and recent proposals for all firms to separate the CEO and chairman roles warrant more careful consideration.     

Returns after personal tax on UK equity and gilts, 1919–1998

This paper investigates whether personal tax could help explain the size of the historic equity premium in the UK measured before personal tax. If there has been a higher tax burden on equity, some of the premium could be viewed as compensation for tax. It is estimated here that personal tax reduces the arithmetic mean nominal return on equity from 13.3% to 11.1% pa during the period 1919–1998, and the mean return on gilts from 7.1% to 5.6% pa. Thus, personal tax accounts for a slightly higher proportion of the before-tax return on gilts than on equity, implying that the equity premium is not a compensation for a higher tax burden on equity.     

Dependence structure between the equity market and the foreign exchange market–A copula approach

This paper investigates the dependence structure between the equity market and the foreign exchange market by using copulas. In particular, several copulas with different dependence structure are compared and used to directly model the underlying dependence structure. We find that there exists significant symmetric upper and lower tail dependence between the two financial markets, and the dependence remains significant but weaker after the launch of the euro. Our findings have important implications for both global investment risk management and international asset pricing by taking into account joint tail risk.     

Time-varying risk premia in foreign exchange and equity markets: evidence from Asia–Pacific countries

This paper examines the validity of the risk premia hypothesis in explaining deviations from Uncovered Interest Parity (UIP) and the role of deviations from Purchasing Power Parity (PPP) in the pricing of foreign exchange rates and equity securities in five Asia–Pacific countries and the US. Using weekly data from 1 January, 1988 to 27 February, 1998, I find that conditional variances are not related to the deviations from UIP in any statistical sense based on an univariate GARCH(1,1)-M model. As I consider both foreign exchange and equity markets together and test a conditional international CAPM (ICAPM) in the absence of PPP, I cannot reject the model based on the J-test by Hansen (Econometrica 50 (1982), 1029–1054) and find significant time-varying foreign exchange risk premia present in the data. This empirical evidence supports the notion of time-varying risk premia in explaining the deviations from UIP. It also supports the idea that the foreign exchange risk is not diversifiable and hence should be priced in both markets.     

Enter the dragon: Interactions between Chinese,US and Asia-Pacific equity markets, 1995–2010

This paper applies a variety of short-run and long-run time series techniques to data on a broad group of Asia-Pacific stock markets and the United States extending to 2010. Our empirical work confirms the importance of crises in affecting the persistence of equity returns in the Asia-Pacific region and offers some support for contagion effects. Post-Asian financial crisis quantile regressions yield substantial evidence of long-run linkages between the Shanghai market, the US market and many regional exchanges. Cointegration is particularly prevalent at the higher end of the distribution. Our results suggest that the enormous growth of the Shanghai market in the new millennium has been accompanied by a meaningful level of integration with other regional and world markets in spite of ongoing capital controls.     

Well-posedness and invariant measures for HJM models with deterministic volatility and Lévy noise

We give sufficient conditions for the existence, uniqueness and ergodicity of invariant measures for Musiela's stochastic partial differential equation with deterministic volatility and a Hilbert space valued driving Lévy noise. Conditions for the absence of arbitrage and for the existence of mild solutions are also discussed.     

What do equity issuances signal? A study of equity issuances in the UK before and during the financial crisis

The financial crisis provides an ideal setting to study how quality signalling by firms, and information asymmetries, might explain the stock price reactions around seasoned equity offerings. The heightened information asymmetry levels during the GFC should have increased the importance of issuance quality and information asymmetries in explaining announcement returns. However, we document new and, in some cases, surprising findings, using a sample of 700 UK seasoned equity offerings between 2003 and 2012: (1) Contrary to expectations, announcement returns during the crisis were driven less by signalling and asymmetric information effects and more by macroeconomic conditions and general uncertainty. (2) In constrained capital markets, firms that were able to move more quickly to raise significant amounts of capital, made the capital-raising environment more challenging for firms that followed, such that the latter had to incur additional costs. (3) Contrary to the traditional view that the low book-to-market ratios may proxy for overvaluation and thus lower announcement returns, we found a negative relationship during the crisis period. The latter is consistent with the view that book-to-market ratios may also proxy for a distressed firm effect which may have dominated the conventional ‘market timing’ effect during the GFC. (4) Announcement returns were strongly positive for many firms at the peak of the crisis, possibly because the market was relieved to see that equity issues might potentially save firms from insolvency; an equity issuance could, in such circumstances, be a positive signal, even though equity issues are conventionally seen as negative signals. Overall, our paper documents fresh and surprising results about equity capital-raising during the GFC, and also offers insights for corporate finance that are of interest beyond the current crisis.     

Australia’s equity home bias and real exchange rate volatility

The main purpose of this paper is to consider the effect of real exchange rate volatility on equity investment by Australian investors. Equity investment is of major importance to savers and investors in Australia. Also real exchange rate volatility is an important influence on Australia’s financial integration in the global economy. Analysis of the effect of real exchange rate volatility on Australia’s equity home bias is important since Australian dollar is a commodity currency. There is a close relationship between Australia’s terms of trade and real exchange rate volatility. Home bias is measured on the basis of free float-adjusted market capitalization in recognition of the fact that closely held shares are not available to ordinary investors. Real exchange rate volatility is measured by deviations from purchasing power parity on a bilateral basis between Australia and 35 countries. The cross-border equity investment data over the period 2001–2007 are from International Monetary Fund’s Coordinated Portfolio Investment Survey. Australian investors are found to invest significantly less in a country if the real exchange rate volatility of that country is relatively high (results that are robust to standard control measures and generalized method of moments).     

The cross-section of equity returns and assets’ fundamental cash-flow risk

The decomposition of consumption beta into a component driven by assets’ cash-flow news and one related to assets’ discount-rate news reveals that macroeconomic risks embodied in cash flows largely account for the cross-sectional dynamics of average stock returns. Empirically, we find that differences in expected excess returns between low book-to-market and high book-to-market portfolios are associated with differences in their cash-flow betas, and thus reflect macroeconomic, especially consumption-related risks. This result holds true for a broad set of consumption-based asset pricing models. In addition, the results indicate that the risk premium on equity markets is primarily driven by the exposure of assets’ cash-flow components to the cyclical variability of durable consumption goods.     

Assessing the FDIC's premium and examination policies using ‘Soviet’ put options

The FDIC's total liability for insuring a bank's deposits during a fixed period diminishes as the frequency of examinations increases, since a marginally solvent bank can be closed while losses are small. The paper develops a technique for pricing the insurance liability over a fixed period during which there are multiple examinations. Under current policy most banks are examined annually and reviewed every six months, at which time the fees for insurance may be adjusted. Since the current schedule of fees allows only a narrow range and a few discrete levels, the FDIC typically retains some positive or negative residual liability in each six-month period and for the entire year. We show how to estimate this net liability. The calculations of total and net liability are illustrated for a sample of large banks.     

Improvement in finite sample properties of the Hansen–Jagannathan distance test

Jagannathan and Wang [Jagannthan, R., and Wang, Z., “The conditional CAPM and the cross-section of expected returns.” Journal of Finance, 51 (1996), 3–53] derive the asymptotic distribution of the Hansen–Jagannathan distance (HJ-distance) proposed by Hansen and Jagannathan [Hansen, L.P., and Jagannathan, R., Assessing specific errors in stochastic discount factor models." Journal of Finance, 52 (1997), 557–590], and develop a specification test of asset pricing models based on the HJ-distance. While the HJ-distance has several desirable properties, Ahn and Gadarowski [Ahn, S.C., and Gadarowski, C., “Small sample properties of the GMM specification test based on the Hansen–Jagannathan distance.” Journal of Empirical Finance, 11 (2004), 109–132] find that the specification test based on the HJ-distance overrejects correct models too severely in commonly used sample size to provide a valid test. This paper proposes to improve the finite sample properties of the HJ-distance test by applying the shrinkage method [Ledoit, O., and Wolf, M., “Improved estimation of the covariance matrix of stock returns with an application to portfolio selection.” Journal of Empirical Finance, 10 (2003), 603–621] to compute its weighting matrix. The proposed method improves the finite sample performance of the HJ-distance test significantly.