Loss aversion, asymmetric market comovements, and the home bias
Loss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the different utility impact of wealth gains and losses leads loss-averse investors to behave similarly to investors with high risk aversion. But if so, should these agents not perceive larger gains from international diversification than standard expected-utility preference agents with plausible levels of risk aversion? They might not, because comovements in international stock markets are asymmetric: Correlations are higher in market downturns ...
Performance maximization of actively managed funds
Ratios that indicate the statistical significance of a fund's alpha typically appraise its performance. A growing literature suggests that even in the absence of any ability to predict returns, holding options positions on the benchmark assets or trading frequently can significantly enhance performance ratios. This paper derives the performance-maximizing strategy--a variant of buy-write--and the least upper bound on such performance enhancement, thereby showing that if common equity indexes are used as benchmarks, the potential performance enhancement from trading frequently is usually ...
Stock returns and volatility: pricing the short-run and long-run components of market risk
We decompose the time series of equity market risk into short- and long-run volatility components. Both components have negative and highly significant prices of risk in the cross section of equity returns. A three-factor model with the market return and the two volatility components compares favorably to benchmark models. We show that the short-run component captures market skewness risk, while the long-run component captures business cycle risk. Furthermore, short-run volatility is the more important cross-sectional risk factor, even though its average risk premium is smaller than the ...
Equity premium predictions with adaptive macro indexes
Fundamental economic conditions are crucial determinants of equity premia. However, commonly used predictors do not adequately capture the changing nature of economic conditions and hence have limited power in forecasting equity returns. To address the inadequacy, this paper constructs macro indexes from large data sets and adaptively chooses optimal indexes to predict stock returns. I find that adaptive macro indexes explain a substantial fraction of the short-term variation in future stock returns and have more forecasting power than both the historical average of stock returns and commonly ...
The pre-FOMC announcement drift
Since the Federal Open Market Committee (FOMC) began announcing its policy decisions in 1994, U.S. stock returns have on average been more than thirty times larger on announcement days than on other days. Surprisingly, these abnormal returns are accrued before the policy announcement. The excess returns earned during the twenty-four hours prior to scheduled FOMC announcements account for more than 80 percent of the equity premium over the past seventeen years. Similar results are found for major global equity indexes, but not for other asset classes or other economic news announcements. We ...
The microstructure of cross-autocorrelations
This paper examines the mechanism through which the incorporation of information into prices leads to cross-autocorrelations in stock returns. The lead-lag relation between large and small stocks increases with lagged spreads of large stocks. Further, order flows in large stocks significantly predict the returns of small stocks when large stock spreads are high. This effect is consistent with the notion that trading on common information takes place first in the large stocks and is then transmitted to smaller stocks with a lag, suggesting that price discovery takes place in the large stocks.
Jump-robust volatility estimation using nearest neighbor truncation
We propose two new jump-robust estimators of integrated variance based on high-frequency return observations. These MinRV and MedRV estimators provide an attractive alternative to the prevailing bipower and multipower variation measures. Specifically, the MedRV estimator has better theoretical efficiency properties than the tripower variation measure and displays better finite-sample robustness to both jumps and the occurrence of ?zero? returns in the sample. Unlike the bipower variation measure, the new estimators allow for the development of an asymptotic limit theory in the presence of ...
Funding liquidity risk and the cross-section of stock returns
We derive equilibrium pricing implications from an intertemporal capital asset pricing model where the tightness of financial intermediaries? funding constraints enters the pricing kernel. We test the resulting factor model in the cross-section of stock returns. Our empirical results show that stocks that hedge against adverse shocks to funding liquidity earn lower average returns. The pricing performance of our three-factor model is surprisingly strong across specifications and test assets, including portfolios sorted by industry, size, book-to-market, momentum, and long-term reversal. ...
The impact of creditor protection on stock prices in the presence of credit crunches
Data show that better creditor protection is correlated across countries with lower average stock market volatility. Moreover, countries with better creditor protection seem to have suffered lower decline in their stock market indexes during the current financial crisis. To explain this regularity, we use a Tobin q model of investment and show that stronger creditor protection increases the expected level and lowers the variance of stock prices in the presence of credit crunches. There are two main channels through which creditor protection enhances the performance of the stock market: (1) ...
Asset returns with earnings management
The paper investigates stock return dynamics in an environment where executives have an incentive to maximize their compensation by artificially inflating earnings. A principal-agent model with financial reporting and managerial effort is embedded in a Lucas asset-pricing model with periodic revelations of the firm's underlying profitability. The return process generated from the model is consistent with a range of financial anomalies observed in the return data: volatility clustering, asymmetric volatility, and increased idiosyncratic volatility. The calibration results further indicate that ...