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Working Paper
The effect of forecast bias on market behavior: evidence from experimental asset markets
This paper reports the results of 15 experimental asset markets designed to investigate the effect of optimistic forecast bias on market behavior. Each market is organized as a double oral auction in which participants trade a single-period asset with uncertain value. Traders are informed of the asset value distribution and, prior to trading, given the opportunity to acquire a forecast of the asset's period-end value. The degree of forecast bias is manipulated across experimental sessions so that in some sessions the forecast contains a systematic, upward (low or high) bias. We conduct sessions with inexperienced and experienced traders. The results suggest that market prices are supportive of a full revelation unbiased price in the unbiased markets and the experienced, low-bias markets. The results from the low-bias markets indicate that as long as traders have sufficient experience with such forecasts, asset prices reflect the debiased forecasts. In contrast, we find no evidence that high-bias forecasts are reflected in market prices, regardless of experience. We also find that the demand for forecasted information persists over time, but it is greater in the unbiased and low-bias conditions than in the high-bias condition. Finally, we provide little evidence that the net profit (that is, net of the information cost) of informed and uninformed traders differs, regardless of bias condition or experience level.
AUTHORS: Ackert, Lucy F.; Church, Bryan K.; Zhang, Ping
DATE: 1999

Working Paper
Consumption and asset prices with homothetic recursive preferences
When preferences are homothetic, utility can be expressed in terms of current consumption and a variable that captures all information about future opportunities. We use this observation to express the differential equation that characterizes utility as a restriction on the information variable in terms of the dynamics of consumption. We derive the supporting price system and returns process and thereby characterize optimal consumption and portfolio decisions. We provide a fast and accurate numerical solution method and illustrate its use with a number of Markovian models. In addition, we provide insight by changing the numeraire from units of consumption to units of the consumption process. In terms of the new units, the wealth-consumption ratio (which is closely related to the information variable) is the value of a coupon bond and the existence of an infinite-horizon solution depends on the positivity of the asymptotic forward rate.
AUTHORS: Fisher, Mark; Gilles, Christian
DATE: 1999

Working Paper
Pricing model performance and the two-pass cross-sectional regression methodology
Since Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973), the two-pass cross-sectional regression (CSR) methodology has become the most popular approach for estimating and testing asset pricing models. Statistical inference with this method is typically conducted under the assumption that the models are correctly specified, that is, expected returns are exactly linear in asset betas. This assumption can be a problem in practice since all models are, at best, approximations of reality and are likely to be subject to a certain degree of misspecification. We propose a general methodology for computing misspecification-robust asymptotic standard errors of the risk premia estimates. We also derive the asymptotic distribution of the sample CSR R2 and develop a test of whether two competing linear beta pricing models have the same population R2. This test provides a formal alternative to the common heuristic of simply comparing the R2 estimates in evaluating relative model performance. Finally, we provide an empirical application, which demonstrates the importance of our new results when applied to a variety of asset pricing models.
AUTHORS: Kan, Raymond; Robotti, Cesare; Shanken, Jay
DATE: 2009

Working Paper
A note on the estimation of asset pricing models using simple regression betas
Since Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973), the two-pass cross-sectional regression (CSR) methodology has become the most popular tool for estimating and testing beta asset pricing models. In this paper, we focus on the case in which simple regression betas are used as regressors in the second-pass CSR. Under general distributional assumptions, we derive asymptotic standard errors of the risk premia estimates that are robust to model misspecification. When testing whether the beta risk of a given factor is priced, our misspecification robust standard error and the Jagannathan and Wang (1998) standard error (which is derived under the correctly specified model) can lead to different conclusions.
AUTHORS: Kan, Raymond; Robotti, Cesare
DATE: 2009

Working Paper
Consumption and asset prices with recursive preferences: Continuous-time approximations to discrete-time models
This paper presents tractable and efficient numerical solutions to general equilibrium models of asset prices and consumption where the representative agent has recursive preferences. It provides a discrete-time presentation of the approach of Fisher and Gilles (1999), treating continuous-time representations as approximations to discrete-time "truth." First, exact discrete-time solutions are derived, illustrating the following ideas: (i) The price-dividend ratio (such as the wealth-consumption ratio) is a perpetuity (the canonical infinitely lived asset), the value of which is the sum of dividend-denominated bond prices, and (ii) the positivity of the dividend-denominated asymptotic forward rate is necessary and sufficient for the convergence of value function iteration for an important class of models. Next, continuous-time approximations are introduced. By assuming the size of the time step is small, first-order approximations in the step size provide the same analytical flexibility to discrete-time modeling as Ito's lemma provides in continuous time. Moreover, it is shown that differential equations provide an efficient platform for value function iteration. Last, continuous-time normalizations are adopted, providing an efficient solution method for recursive preferences.
AUTHORS: Fisher, Mark
DATE: 1999

Working Paper
Minimum-variance kernels, economic risk premia, and tests of multi-beta models
This paper uses minimum-variance (MV) admissible kernels to estimate risk premia associated with economic risk variables and to test multi-beta models. Estimating risk premia using MV kernels is appealing because it avoids the need to 1) identify all relevant sources of risk and 2) assume a linear factor model for asset returns. Testing multi-beta models in terms of restricted MV kernels has the advantage that 1) the candidate kernel has the smallest volatility and 2) test statistics are easy to interpret in terms of Sharpe ratios. The authors find that several economic variables command significant risk premia and that the signs of the premia mostly correspond to the effect that these variables have on the risk-return trade-off, consistent with the implications of the intertemporal capital asset pricing model (I-CAPM). They also find that the MV kernel implied by the I-CAPM, while formally rejected by the data, consistently outperforms a pricing kernel based on the size and book-to-market factors of Fama and French (1993).
AUTHORS: Balduzzi, Pierluigi; Robotti, Cesare
DATE: 2001

Working Paper
The price of inflation and foreign exchange risk in international equity markets
In this paper the author formulates and tests an international intertemporal capital asset pricing model in the presence of deviations from purchasing power parity (II-CAPM [PPP]). He finds evidence in favor of at least mild segmentation of international equity markets in which only global market risk appears to be priced. When using the Hansen & Jagannathan (1991, 1997) variance bounds and distance measures as testing devices, the author finds that, while all international asset pricing models are formally rejected by the data, their pricing implications are substantially different. The superior performance of the II-CAPM (PPP) is mainly attributable to significant hedging against inflation risk.
AUTHORS: Robotti, Cesare
DATE: 2001

Working Paper
Dynamic strategies, asset pricing models, and the out-of-sample performance of the tangency portfolio
In this paper, I study the behavior of an investor with unit risk aversion who maximizes a utility function defined over the mean and the variance of a portfolio's return. Conditioning information is accessible without cost and an unconditionally riskless asset is available in the market. ; The proposed approach makes it possible to compare the performance of a benchmark tangency portfolio (formed from the set of unrestricted estimates of portfolio weights) to the performance of a restricted tangency portfolio which uses single-index and multi-index asset pricing models to constrain the first moments of asset returns. ; The main findings of the paper are summarized as follows: i) The estimates of the constant and time-varying tangency portfolio weights are extremely volatile and imprecise. Using an asset pricing model to constrain mean asset returns eliminates extreme short positions in the underlying securities and improves the precision of the estimates of the weights. ii) Partially restricting mean asset returns according to single-index and multi-index asset pricing models improves the out-of-sample performance of the tangency portfolio. iii) Active investment strategies (i.e., strategies that incorporate the role played by conditioning information in investment decisions) strongly dominate passive investment strategies in-sample but do not provide any convincing pattern of improved out-of-sample performance.
AUTHORS: Robotti, Cesare
DATE: 2003

Working Paper
Rational exuberance: The fundamentals of pricing firms, from blue chip to “dot com”
The author establishes that classic firm-valuation methods based on dividends (or equivalently free cash flows or residual income) can be modified to be based on any financial variable (V), such as sales, given V is cointegrated with the fundamental value (P) of the firm. The variable V (or a fraction of V) replaces dividends in the valuation formula, through a share liquidation scheme tied to V/P. The author shows that this modified valuation formula is equivalent to the classic fundamental valuation formula based on dividends, provided the share liquidation implicit in this scheme is accounted for. The use of nondividend information V permits an estimate of the fundamental value of a firm which should be more reliable than an estimate based on dividends alone, as dividends are well-known to be smoothed and can provide a poor indicator of future cash payments to investors. This approach is shown to complement existing valuation approaches that use dividends, permitting the fundamental valuation of firms which may or may not pay out dividends, have negative earnings, negative free cash flows, or even a negative book value (of shareholder equity). This extension of the classic fundamental valuation formula also provides a new methodology for calculating the fundamental asset price of any firm, including ?dot-com? firms and privately held firms, utilizing nondividend information, such as sales, explicitly. Using dividends augmented with a cash flow from share liquidation, the author restates popular valuation methods, including the Gordon growth model, the residual income model, and the free cash flow model.
AUTHORS: Kamstra, Mark
DATE: 2001

Journal Article
What do asset prices tell us about the future?
It is fairly obvious that in market-based economies prices act as a constraint on individual behavior, providing a means by which goods and services flow to those most willing and able to pay for them. But prices play an additional role in the economy-that of signaling the present and expected future state of affairs. Having accurate forecast information is particularly important to policymakers, who are concerned with acting in advance to avoid bad economic outcomes rather than simply reacting to events. ; This article reviews the theoretical literature regarding the extent to which asset prices aggregate information and examines evidence on the ability of financial asset prices to forecast inflation, real output or consumption, and recessions. Given the available evidence, the author finds it difficult to argue that monetary policymakers should give more weight to financial market variables. What can be argued is that, according to theory, financial asset prices should aggregate at least some information about future performance of economically important variables. ; The author concludes that more work is needed along both theoretical and statistical lines for collectively figuring out what role, if any, financial asset prices or yields should play in forecasts used in conducting policy. Meanwhile, these variables will remain at most a source of information that policymakers can choose to use as a supplement to more traditional indicators.
AUTHORS: Smith, Stephen D.
DATE: 1999

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