The Dynamic Relations between Market Returns and Two Types of Risk with Business Cycles

We examine the dynamic relations among market returns, market (MV), and idiosyncratic (IV) around business cycles. Compared to the conventional view, which treats MV and IV separately, we first find that excess return on the market anticipates negative MV and IV, suggesting market return's role as an economic indicator, with the relation stronger in recessions. Second, IV helps predict positive MV, mainly in early part of recessions, suggesting a dynamic evolution from IV to MV. Third, MV helps predict negative IV, suggesting MV may substitute IV to some extent.     

The Role of U.S. Market on International Risk‐Return Tradeoff Relations

We study the intertemporal risk‐return tradeoff relations based on returns from 18 international markets. We find striking new empirical evidence that the inclusion of U.S. market returns significantly changes the estimated risk‐return tradeoff relations in international markets from mostly negative to predominantly positive. Our results are consistent with the lead‐lag effect between U.S. and international markets in the sense of Rapach, Strauss and Zhou.     

A High‐Frequency Investigation of the Interaction between Volatility and DAX Returns

One of the most noticeable stylised facts in finance is that stock index returns are negatively correlated with changes in volatility. The economic rationale for the effect is still controversial. The competing explanations have different implications for the origin of the relationship: Are volatility changes induced by index movements, or inversely, does volatility drive index returns? To differentiate between the alternative hypotheses, we analyse the lead‐lag relationship of option implied volatility and index return in Germany based on Granger causality tests and impulse‐response functions. Our dataset consists of all transactions in DAX options and futures over the time period from 1995 to 2005. Analyzing returns over 5‐minute intervals, we find that the relationship is return‐driven in the sense that index returns Granger cause volatility changes. This causal relationship is statistically and economically significant and can be clearly separated from the contemporaneous correlation. The largest part of the implied volatility response occurs immediately, but we also observe a smaller retarded reaction for up to one hour. A volatility feedback effect is not discernible. If it exists, the stock market appears to correctly anticipate its importance for index returns.     

Trend‐Following Trading Strategies in U.S. Stocks: A Revisit

We show that previous findings regarding the profitability of trend‐following trading rules over intermediate horizons in futures markets also extend to individual U.S. stocks. Portfolios formed using technical indicators such as moving average or channel ratios, without employing cross‐sectional rankings of any kind, tend to perform about as well as the more commonly examined momentum strategies. The profitability of these strategies appears significant, both statistically and economically, through 2007, but evidence of profitability vanishes after 2007. Market‐state dependence, while clearly present, does not explain the post‐2007 reduction in returns to these strategies.     

Volatility Risk Premium,Risk Aversion,and the Cross‐Section of Stock Returns

We test if innovations in investor risk aversion are a priced factor in the stock market. Using 25 portfolios sorted on book‐to‐market and size as test assets, our new factor together with the market factor explains 64% of the variation in average returns compared to 60% for the Fama‐French model. The new factor is generally significant with an estimated risk premium close to its time series mean also when industry portfolios and portfolios sorted on previous returns are augmented to the test assets.     

Have European Stocks become More Volatile? An Empirical Investigation of Idiosyncratic and Market Risk in the Euro Area

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the 12 euro area stock markets over the period 1974–2004. Similarly to Campbell et al. (2001) , we find a rise in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to the US, however, market risk is trended upwards in Europe and correlations are not trended downwards. Both the volatility and correlation measures are pro‐cyclical, and they rise during times of low market returns. Market and average idiosyncratic volatility jointly predict market wide returns, and the latter impact upon both market and idiosyncratic volatility. This has asset pricing and risk management implications.     

Risk‐Adjusted Long‐Term Contrarian Profits: Evidence from Non‐S&P 500 High‐Volume Stocks

Can trading volume help unravel the long‐term overreaction puzzle? With portfolios of non‐S&P 500 NYSE stocks, we show that (1) both the high‐ and low‐volume (abnormal volume) contrarian portfolios earn a much higher market‐adjusted excess return than the normal‐volume contrarian portfolio, (2) however, when leverage‐induced risk is factored in, excess returns from contrarian portfolios with normal‐ and low‐volume stocks are insignificant, (3) only excess returns from high‐volume contrarian stocks are significant and cannot be explained by the time‐varying risk and return framework, and (4) such high‐volume, risk‐adjusted excess returns arise mainly from winner (glamour) stocks.     

Incentive‐compatible contracts in merger negotiations: The role of acquirer idiosyncratic stock return volatility

We show that the acquiring firm's idiosyncratic stock return volatility (sigma) is an important determinant of the selection and perceived valuation effects of earnouts in Mergers and Acquisitions (M&As). Earnout‐based M&As are more often announced by high‐sigma acquirers (nearly 40% of all earnout‐based M&As), yet the documented higher risk‐adjusted returns accrued to acquirers in earnout‐based M&As, relative to M&As settled in cash, stock or mixed payments (the earnout effect), appear in deals announced by low‐sigma acquirers (nearly 20% of all earnout‐based M&As). High‐sigma acquirers employing earnouts appear to break even, or even experience losses, relative to their counterparts employing single up‐front payments. These results are confirmed based on a quasi‐experimental design through which the earnout effect is measured in isolation. We argue that in M&As announced by high‐sigma acquirers, the earnout effect is potentially elusive due to the presence of an acquirer‐specific information revelation effect, resulting from the heightened extent of information asymmetry between (small) acquirers’ managers and outside investors. On the contrary, the use of earnouts in M&As announced by low‐sigma (large) acquirers, whereby the acquirer‐specific information revelation effect is likely negligible, sends a strong signal for value creation that also prevents investors from inducing a size‐related discount.     

Shiller's CAPE: Market Efficiency and Risk

Robert Shiller shows that Cyclically Adjusted Price to Earnings Ratio (CAPE) is strongly associated with future long‐term stock returns. This is often interpreted as evidence of market inefficiency. We present two findings contrary to such an interpretation. First, if markets are efficient, stock returns should be higher than the risk‐free rate. We find that even when CAPE is in its ninth decile, future 10‐year stock returns, on average, are higher than future returns on 10‐year U.S. Treasurys. Thus, the results are largely consistent with market efficiency. Second, consistent with a risk–return tradeoff, we find that CAPE is negatively associated with future stock market volatility.     

Specialist Risk Attitudes and the Bid‐Ask Spread

This paper examines the relation between the bid‐ask spread and the risk of the underlying stock. It provides evidence that the specialist is not only sensitive to the absolute level of volatility, but also to changes in the level of volatility. This sensitivity arises because of increased inventory risk for the specialist when volatility is changing. For the sample of very liquid stocks in this paper, the quoted spread and the inventory cost component of the spread are shown to increase significantly during trading periods when volatility is both increasing and decreasing.     

Predicting Long‐Term Financial Returns: VAR versus DSGE Model—A Horse Race

This paper considers a U.S. institutional investor who is implementing a long‐term portfolio allocation using forecasts of financial returns. We compare the predictive performance of two competing macrofinance models—an unrestricted vector autoRegression (VAR) and a fully‐structural dynamic stochastic general equilibrium (DSGE) model—for horizons up to 15 years. Although the performances are similar for short horizons, the DSGE model outperforms the VAR at forecasting financial returns in the long term. This model also generates substantially higher Sharpe ratios. Although it contains fewer unknown parameters, it benefits from economically grounded restrictions that help anchor financial returns in the long term.     

Exchange‐Traded Fund Introductions and Closed‐End Fund Discounts and Volume

Exchange‐traded funds (ETFs), like closed‐end funds (CEFs), are managed portfolios traded like individual stocks. We hypothesize that the introduction of an ETF in an asset class similar to an existing CEF results in a substitution effect that reduces the value of the CEF's shares relative to that of its underlying assets. Our event studies show that upon the introduction of a similar ETF, CEF discounts widen significantly and relative volume declines significantly. Single‐equation and systems estimation models show that the widening in discounts and reduction in volume are related to returns‐based measures of the substitutability of ETFs for CEFs.     

Regime Shifts in Price‐Dividend Ratios and Expected Stock Returns: A Present‐Value Approach

We incorporate regime shifts in the mean of price‐dividend ratios into the present value model of van Binsbergen and Koijen (2010) who propose a latent variable approach to modeling expected returns and dividend growth rates. We find that accounting for regime shifts results in much lower persistence of expected returns and higher volatility of expected returns, and thus higher in‐sample predictability, when compared to the results from the van Binsbergen and Koijen (2010) model. We also show that the main source of the increase in the mean of price‐dividend ratios in the mid‐1990s is a decrease in the mean of expected returns.     

Return Characteristics of State‐Owned and Non‐State‐Owned Chinese A Shares

This study examines and compares stock returns and volatilities between state‐owned (SO) and non‐state‐owned (NSO) firms on the Shanghai and Shenzhen stock exchanges. Results vary significantly by exchange. Returns for both firm types, on both exchanges, exhibit negative skewness and high kurtosis inconsistent with a normal distribution. Returns display significant autocorrelation, even after the removal of lower‐order effects. Granger causality tests reveal that Shenzhen returns significantly lead Shanghai returns. Within both exchanges, SO firms lead NSO firms. Neither SO nor NSO firm shares are dominated in terms of second‐order stochastic dominance.     

Reversal of 3‐day losers and continuation of 3‐day winners on the NASDAQ

Using only the 200 large-cap securities that make up the NYSE 100 and NASDAQ 100, this study investigates 130 randomly selected formation periods from January 2000 through December 2012. During these formation periods, the three worst and three best performing stocks (based on excess return) are flagged. Once flagged, the subsequent 10-day holding period excess returns are calculated. Results indicate that NYSE securities demonstrate significant return reversal, but not return momentum. Conversely, the worst performing NASDAQ securities demonstrate return reversal, whereas the best performing NASDAQ securities demonstrate return momentum. Results are robust to the number of best and worst stocks that are flagged. Results are also robust to other combinations of formation and holding period lengths.     

Risk Measures for Hedge Funds: a Cross‐sectional Approach

This paper analyses the risk‐return trade‐off in the hedge fund industry. We compare semi‐deviation, value‐at‐risk (VaR), Expected Shortfall (ES) and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using the Fama and French (1992) methodology and the combined live and defunct hedge fund data from TASS, we find that the left‐tail risk captured by Expected Shortfall (ES) and Tail Risk (TR) explains the cross‐sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument by Artzner et al. (1999) that ES is superior to VaR as a downside risk measure. We also find the Cornish‐Fisher (1937) expansion is superior to the nonparametric method in estimating ES and TR.     

Risk Shifts Following Sarbanes‐Oxley: Influences of Disclosure and Governance

The Sarbanes‐Oxley Act of 2002 (SOX) aimed to improve financial reporting by enhancing corporate disclosure and governance. We find statistically significant increases, from before to after the passage of SOX, in total return variance, market risk and idiosyncratic risk. The risk increases are consistent with predictions that the legislation would cause firms to disclose more negative information, resulting in increased investment risk. However, in cross‐sectional tests, post‐SOX improvements in information certainty, board independence and monitoring are associated with smaller increases or greater decreases in risk. If SOX is responsible for these improvements, its effects are consistent with its purpose.     

Capital gains tax,supply‐driven trading and ownership structure: direct evidence of the lock‐in effect

This study investigates the effect of differential capital gains tax rates on investor trading and share prices in a unique market setting that facilitates the resolution of conflicting prior evidence of holding period tax incentives. In particular, we examine whether the concessionary tax treatment of long‐term capital gains increases the supply of shares that qualify for long‐term status, thereby causing downward price pressure. We find evidence of abnormal seller‐initiated trading following the 12‐month anniversary of listing for IPO firms that appreciate in price (‘winners’) and report no such evidence for firms that decline in price (‘losers’). Consistent with the tax concessions being greater for individual than institutional investors, we report that abnormal seller‐initiated trading is mitigated by higher levels of ownership by institutional investors. We also report limited evidence, for winners, of declining share prices upon qualifying for long‐term tax status.     

Real‐Time Forecasting and Political Stock Market Anomalies: Evidence for the United States

Using monthly data from 1953 to 2003, we apply a real‐time modeling approach to investigate the implications of U.S. political stock market anomalies for forecasting excess stock returns in real‐time. Our empirical findings show that political variables, chosen on the basis of widely used model‐selection criteria, are often included in real‐time forecasting models. However, political variables do not contribute systematically to improving the performance of simple trading rules. For this reason, political stock market anomalies are not necessarily an indication of market inefficiency.     

Investment Dynamics and Earnings‐Return Properties: A Structural Approach

We propose the standard neoclassical model of investment under uncertainty with short‐run adjustment frictions as a benchmark for earnings‐return patterns absent accounting influences. We show that our proposed benchmark generates a wide range of earnings‐return patterns documented in accounting research. Notably, our model generates a concave earnings‐return relation, similar to that of Basu [1997], and predicts that the earnings‐return concavity increases with the volatility of firms’ underlying shock processes and decreases with the level of firms’ investments. We find strong empirical support for these predictions. Overall, our evidence suggests that our proposed benchmark is useful for understanding the joint dynamics of variables of interest to accounting research (e.g., earnings, returns, investment, market‐to‐book) absent accounting influences, a necessary precondition for inferring the effects of accounting from these dynamics.