Carry Trades,Order Flow,and the Forward Bias Puzzle

We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time‐varying risk premium consistent with that bias. Using 10 years of data on FX order flow, we find that more than half of the forward bias is accounted for by order flow—with the rest being explained by expectational errors. We also find that carry trading increases currency‐crash risk in that order flow generates negative skewness in FX returns.     

The Delisting Bias in CRSP's Nasdaq Data and Its Implications for the Size Effect

We investigate the bias in CRSP's Nasdaq data due to missing returns for delisted stocks. We find that the missing returns are large and negative on average, and that delisted stocks experience a substantial decrease in liquidity. We estimate that using a corrected return of −55 percent for missing performance-related delisting returns corrects the bias. We revisit previous work which finds a size effect among Nasdaq stocks. After correcting for the delisting bias, there is no evidence that there ever was a size effect on Nasdaq. Our results are inconsistent with most risk-based explanations of the size effect.     

Turning local: Home-bias dynamics of relocating foreigners

Using comprehensive data from Denmark, we study private investors’ preferences for domestic stocks. We compare the equity home bias of foreigners recently relocated to Denmark to the equity home bias of other investors. We find that home bias of recently relocated foreigners is lower than home bias of other investors. Our main result is that when relocated foreigners’ duration of stay increases, their home bias also increases. After 7–8 years, home bias of relocated foreigners does not differ from home bias of other investors. Our results imply that familiarity with domestic stocks develops dynamically with the length of stay in a given country. We discuss implications for explanations of the home-bias puzzle building on information asymmetries.     

Jensen's alpha and the market‐timing puzzle

Theory predicts that market‐timing activities bias Jensen's alpha (JA). However, empirical studies have failed to find consistent evidence of this bias. We tackle this puzzle in a nested model analysis and show that the bias contains an exogenous market component that is unrelated to market‐timing skill. In a comprehensive empirical analysis of US mutual funds, we find that the timing‐induced bias in JA is mainly driven by this market component, which is uncorrelated with measured timing activities. Measures of total performance that allow for timing activities are virtually identical to JA, even if timing activities are present in the evaluated fund. Hence, we conclude that JA is a sufficient measure of total performance.     

Bias in estimating the systematic risk of extreme performers: Implications for financial analysis, the leverage effect, and long-run reversals

We show how bias can arise systematically in the beta estimates of extreme performers when long-run return reversals are present and partly, or wholly, due to sign changes in unanticipated factor realizations. Our evidence is consistent with this bias being responsible for the large shifts in the beta estimates of extreme performers, more so than the leverage effect, which has been the predominant explanation in prior literature. Bias in these contemporaneous realized betas, estimated with the same returns that are to be risk adjusted, arises due to the general problem of “overconditioning,” where betas are estimated conditional on information that is not yet known. Several methods for conditioning betas on out-of-sample returns are evaluated and found to be lacking, although some offer improvement under certain circumstances. We also show evidence of this bias in the Fama-French Three-factor loadings of extreme performers. Our findings indicate not only that previous studies of long-run reversals understate contrarian profits but that bias is prevalent in the OLS beta estimates of extreme performers, and this has implications for estimating the cost of capital and measuring long-run performance. We offer recommendations for identifying when this bias is likely present, as well as general methods to correct for it.     

An Examination of the Biases in Estimating the Benefit of Debt Insurance

This paper examines the biases in previous studies of estimating the benefit of debt insurance. We identify three possible sources of estimation biases: selection bias, marketability bias, and premium bias. Our findings indicate that both the selection bias and the marketability bias cause an underestimation of the actual benefit of bond insurance, while the premium bias results in an overestimation. Future research could benefit from this study by explicitly accounting for these estimating biases in obtaining a more accurate evaluation of the role of debt insurance in the market.     

An improved estimation method and empirical properties of the probability of informed trading

We report evidence that boundary solutions can cause a bias in the estimate of the probability of informed trading (PIN). We develop an algorithm to overcome this bias and use it to estimate PIN for nearly 80,000 stock-quarters between 1993 and 2004. We obtain two sets of PIN estimates by using the factorized likelihood functions in both [Easley et al., 2010] and [Lin and Ke, 2011], respectively. We find that the estimate based on the EHO factorization is systematically smaller than the estimate based on the LK factorization, meaning that there is a downward bias associated with the EHO factorization. In addition, we find that boundary solutions appear with a very high frequency when the LK factorization is used. Thus it is necessary to use the LK factorization together with the algorithm in this paper. At last, we document several interesting empirical properties of PIN.     

Capital Allocation Using the Bootstrap

Abstract

This paper investigates the use of the bootstrap in capital allocation. In particular, for the distortion risk measure (DRM) class, we show that the exact bootstrap estimate is available in analytic form for the allocated capital. We then theoretically justify the bootstrap bias correction for the allocated capital induced from the concave DRM when the conditional mean function is strictly monotone. A numerical example shows a tradeoff exists between the bias reduction and variance increase in bootstrapping the allocated capital. However, unlike the aggregate capital case, the variance increase of the bias-corrected allocated capital estimate substantially outweighs the benefit of bias correction, making the bootstrap bias correction at the allocated capital level not as useful. Overall, the exact bootstrap without bias correction offers an efficient method for determining allocation over the ordinary resampling bootstrap estimate and the empirical counterpart.     

International portfolio diversification and the home bias puzzle

We review the literature on equity home bias, a phenomenon stating that investors do not hold enough foreign equities for an optimally diversified portfolio. We begin by defining the home bias measurement and reviewing related evidence on the bias. Further, we consider four explanations for this puzzling phenomenon: barriers to foreign investment, country-specific risks, information asymmetry, and cultural and behavioral factors. We analyze the related theoretical arguments and empirical findings of prior studies within each explanation. Based on the discussion of previous studies, several avenues for future research are suggested. (JEL G11, G15, F41)     

Information friction and investor home bias: A perspective on the effect of global IFRS adoption on the extent of equity home bias

This paper provides a perspective on the effect of IFRS adoption on the tendency of investors to under-invest in foreign equities. We consider explanations for the equity home bias described in prior research and discuss research relevant to the informational consequences of global adoption of IFRS. Specifically, we evaluate whether IFRS adoption reduces information processing costs or decreases investor uncertainty about either the quality of financial reporting or the distribution of future cash flows. We predict that the effect of any reduction in information processing costs from the adoption of IFRS is likely to be small relative to the effects of other determinants of home bias such as the strength of investor protection mechanisms in foreign countries, behavioral biases toward familiar equities, and informational advantages related to geographical proximity. We argue that the quality of the information that investors have (or perceive they have) decreases with distance, conclude that global IFRS adoption is unlikely to affect home bias, and propose avenues for future research.     

Keeping Up with the Joneses and the Home Bias

We argue that when individuals care about their consumption relative to that of their neighbours, a home bias emerges, that is investors overweight domestic stocks in their portfolios. Domestic stocks are preferred because they also serve the objective of mimicking the economic fortunes and welfare of the investor's neighbours, countrymen, and social reference group. We also demonstrate that globalization mitigates the home bias, and derive a modified international CAPM.     

Option Trading and the Intervalling Effect Bias in Beta

Prior studies show that the beta coefficient of a security changes systematically as the length of measurement interval is varied. This phenomenon, which is called the intervalling effect bias in beta, has been attributed to the friction in the trading system that causes the delays in the price-adjustment process. This study shows that option listing is associated with a decline in the beta intervalling effect bias. The decline is most pronounced for small firms. We also find that our sample firms grow significantly after option listing. Since prior research indicates that market value is a major determinant of the magnitude of the intervalling effect, we re-examine our results using a subsample that controls for market value. The results indicate that the decline in the beta bias from the pre-listing to post-listing period is still prevalent after we control for the change in firm size. Overall, the evidence is consistent with the notion that option trading reduces the delays in the price-adjustment process, which in turn reduces the intervalling effect bias in beta.     

The existence and severity of the forward premium puzzle during tranquil and turbulent periods: Developed versus developing country currencies

In this paper we investigate the forward premium bias (FPB) puzzle for a number of developed and developing country currencies. Our main objective is to examine the possible variations in the existence and severity of the bias for different currency sets over two sample periods which can be categorized as calm and turbulent periods. We find significant evidence that the FBP tend to vary over time and across currency sets. We also find that the global financial crisis has been a turning point in the variation of the existence and severity of the bias for our currency sets. The results show that different currency sets have been affected by the crisis in different patterns. While the bias disappeared prominently for developed country currencies with the peak of the crisis, it survived and became more pronounced for some high-yielding developing country currencies. The results imply that the FPB is time-varying and its existence and severity vary across and within currency sets depending on the time period under consideration. Overall, the findings of the paper suggest that both time period-specific characteristics as well as currency-specific factors play a vital role for the existence and severity of the FPB.     

Stock market investors' use of stop losses and the disposition effect

The disposition effect is an investment bias where investors hold stocks at a loss longer than stocks at a gain. This bias is associated with poorer investment performance and exhibited to a greater extent by investors with less experience and less sophistication. A method of managing susceptibility to the bias is through use of stop losses. Using the trading records of UK stock market individual investors from 2006 to 2009, this paper shows that stop losses used as part of investment decisions are an effective tool for inoculating against the disposition effect. We also show that investors who use stop losses have less experience and that, when not using stop losses, these investors are more reluctant to realise losses than other investors.     

The home-institution bias

We document a new investor preference we call the home-institution bias. Whereas the home-asset bias is a preference for domestic assets, the home-institution bias is a preference for domestic financial institutions. Our data come from Sweden’s government-mandated retirement system. In cross-fund regressions, we find that funds offered by Swedish institutions received around 10 times more money than similar funds offered by foreign institutions. We show that this preference for home institutions is distinct from the home-asset preference, is not driven by information asymmetries, and is consistent with an underlying preference by individuals to deal with the familiar. Cross-individual regressions also support a behavioral explanation because the home-institution bias is strongest among financially-unsophisticated and provincial investors.     

Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied by Earnings Forecasts

Recent literature has used analysts' earnings forecasts, which are known to be optimistic, to estimate implied expected rates of return, yielding upwardly biased estimates. We estimate that the bias, computed as the difference between the estimates of the implied expected rate of return based on analysts' earnings forecasts and estimates based on current earnings realizations, is 2.84%. The importance of this bias is illustrated by the fact that several extant studies estimate an equity premium in the vicinity of 3%, which would be eliminated by the removal of the bias. We illustrate the point that cross‐sample differences in the bias may lead to the erroneous conclusion that cost of capital differs across these samples by showing that analysts' optimism, and hence, bias in the implied estimates of the expected rate of return, differs with firm size and with analysts' recommendation. As an important aside, we show that the bias in a value‐weighted estimate of the implied equity premium is 1.60% and that the unbiased value‐weighted estimate of this premium is 4.43%.     

Learning, price formation and the early season bias in the NBA

We test the NBA betting market for efficiency and find that totals lines are significantly biased early each season, yet sides lines do not show a similar bias. While market participants generally force line movements in the correct direction from open to close, they do not fully remove the identified bias in totals lines. This inefficiency enables a profitable technical trading strategy, as the resulting win rate of our proposed simple betting strategy against the closing totals line is 56.72%.     

Estimation of the bid - ask spread and its components: a new approach

We show that time variation in expected returns and/or partialprice adjustments lead to a downward bias in previous estimatorsof both the spread and its components. We introduce a new approachthat provides unbiased and efficient estimators of the componentsof the spread. We find that between 77 and 97 percent of thedownward bias in previous spread estimate is caused by timevariation in expected returns. More importantly, the adverse-selectioncomponent, though significant, accounts for a much smaller proportion(8 to 13 percent) of the quoted spread, at least for small trades,than the proportion (over 40 percent) previously reported inthe literature. Order processing costs are the predominant componentof quoted spreads.     

On the design of an optimal non-linear tax/pension system with habit formation

We study the optimal tax/pension design in a two-period model where individuals differ in both productivity and discount rates or projection bias and where their utility of the retirement period consumption is not independent of the earlier standard of living. We consider both welfarist and paternalistic social objectives. The paternalistic government attempts to correct the projection bias by using a higher discount factor. We derive general mathematical expressions that characterize optimal tax/pension design (marginal tax/subsidy rates). They suggest that the pattern of marginal labor income taxes depends on habit formation. Negative marginal labor income tax rates are possible. To gain a better understanding, we examine numerically the properties of an optimal lifetime redistribution policy with habit formation. We find support for non-linear tax/pension program in which some types of individuals are taxed while some are subsidized. The effect of changes in the degree of habit formation is explored in the numerical simulations as well as the implications of different degrees of correlation between skill and projection bias.     

News release and the role of different types of investors

We examine how investors react to positive and negative news in the Chinese stock market. We show that positive news is followed by a reversal in stock price, while negative news reports are accompanied by a drift. Using a unique account-level dataset, we find that institutional investors' attention bias contributes to the market's absorption process for different types of news, which is different from the conclusion that the phenomenon is driven by retail investors in the U.S. market. We explain the differences between the two markets as the short-sale constraints induce the attention bias of institutional investors in China. Individual investors are not able to correctly judge the content of news reports, and act as a liquidity provider. We highlight the market regulation plays an important role in the process of investors analyzing information.