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Abstract:
The monthly return distributions of many hedge fund indices exhibit highly unusual skewness and kurtosis properties as well as first-order serial correlation. This has important consequences for investors. We demonstrate that although hedge fund indices are highly attractive in mean-variance terms, this is much less the case when skewness, kurtosis and autocorrelation are taken into account. Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds. Similarly, mean-variance portfolio analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio. We also find substantial differences between indices that aim to cover the same type of strategy. Investors' perceptions of hedge fund performance and value added will therefore strongly depend on the indices used.

hedge fund, hedge fund index, Sharpe Ratio, Mean-Variance analysis, skewness, kurtosis

Abstract:
The price-earnings effect has been thoroughly documented and is the subject of numerous academic studies. However, in existing research it has almost exclusively been calculated on the basis of the previous year's earnings. We show that the power of the effect has until now been seriously underestimated due to taking too short-term a view of earnings. Looking at all UK companies since 1975, using the traditional P/E ratio we find the difference in average annual returns between the value and glamour deciles to be 6%. This is similar to other authors' findings. We are able to almost double the value premium by calculating the P/E ratio using earnings averaged over the previous eight years.

Abstract:
The price-earnings effect has been thoroughly documented and widely studied around the world. However, in existing research it has almost exclusively been calculated on the basis of the previous year's earnings. We show that the power of the effect has until now been seriously underestimated, due to taking too short-term a view of earnings. We look at all UK companies since 1975, and using the traditional P/E ratio we find the difference in average annual returns between the value and glamour deciles to be 6%, similar to other authors' findings. We are able to almost double the value premium by calculating P/E ratios using earnings averaged over the last eight years. Averaging, however, implies equal weights for each past year. We further enhance the premium by optimising the weights of the past years of earnings in constructing the P/E ratio.

price-earning ratios, value investing, arbitrage strategy, UK stock market, value premium

Abstract:
Following early failures, more recent empirical evidence has suggested that timing entries to and exits from equity markets may be feasible. A number of approaches to this most basic form of dynamic asset allocation are available, but which works best? This study investigates the relative profitability of several different methodologies using a very long dataset on the S&P 500. In order to overcome the accusations of data snooping and arbitrary parameter choice that beset much previous work in this area, we carefully consider whether the rule performance is sensitive to the specified user-adjustable parameters. We find that all but one of the approaches are able to beat a buy-and-hold equities strategy in risk-adjusted terms, although a strategy based on the difference between the earnings-price ratio and short term Treasury yields works best.

market timing rules, speculative bubbles, dynamic asset allocation, S&P500, stock index returns

Abstract:
Factor models are frequently applied to hedge fund returns in an attempt to separate the return from identified risk factors (beta) and from manager skill (alpha). More recently, these same techniques have been used to replicate the returns from hedge fund strategies with varying degrees of success. In this paper, we show that due to the particular nature of hedge fund incentive contracts, the use of net of fee returns can lead to considerably biased estimates of factor exposures which can distort the picture of fund manager performance. The solution we propose is to model the gross returns of hedge funds and the incentive fees independently, which gives a truer representation of the underlying return generating process. Using a large sample of hedge funds, we quantify the effect of this bias on both performance attribution and replication. We find that using net of fee returns understates the return attributable to beta by up to 58 basis points per annum. Following from this we find that some of the additional beta exposure can be captured by basing replication on gross rather than net returns. We also investigate the risk taking behaviour of fund managers conditional upon the delta of their incentive option and find that contrary to previous studies, there does appear to be evidence of increased risk taking for those managers who find themselves significantly below their high water mark.

hedge fund, returns, alpha, beta, fees, performance

Abstract:
The price-earnings ratio is a widely used measure of the expected performance of companies, and it has almost invariably been calculated as the ratio of the current share price to the previous year's earnings. However, the P/E of a particular stock is partly determined by outside influences such as the year in which it is measured, the size of the company, and the sector in which the company operates. Examining all UK companies since 1975, we propose a modified price-earnings ratio that decomposes these influences. We then use a regression to weight the factors according to their power in predicting returns. The decomposed price-earnings ratio is able to double the gap in annual returns between the value and glamour deciles, and thus constitutes a useful tool for value fund managers and hedge funds.

Price-earnings ratio, value investing, the value premium, trading strategy, UK stock returns

Abstract:
This paper compares a number of different extreme value models for determining the value at risk of three LIFFE futures contracts. A semi-nonparametric approach is also proposed where the tail events are modeled using the Generalised Pareto Distribution and normal market conditions are captured by the empirical distribution function. The value at risk estimates from this approach are compared with those of standard nonparametric extreme value tail estimation approaches, with a small sample bias-corrected extreme value approach, and with those calculated from bootstrapping the unconditional density and bootstrapping from a GARCH(1,1) model. The results indicate that for a hold-out sample, the proposed semi-nonparametric extreme value approach yields superior results to other methods, but the small sample tail index technique is also accurate.

Bootstrap, Value at Risk (VaR), Generalised Pareto Distribution, Parametric, Semi-nonparametric and Small Sample Bias Corrected Tail Index Estimators, GARCH models

Abstract:
Investigations into value-based 'anomalies' such as the P/E effect typically sort shares into quintiles, or at most deciles. These are blunt instruments. We test whether most of the extra value to be found in the lower end of the P/E spectrum is to be found in the very lowest P/E shares, and whether the worst investments are in the few shares with the highest P/E. Using a long-term definition of earnings, and attributing influences on the P/E to company size and sector, we find that small portfolios of value shares give returns of 40%+ per annum, while small portfolios of glamour shares give returns less than the risk-free rate. We thus show that by a more judicious use of the P/E ratio, we can considerably enhance the value premium.

Value premium, price-earnings ratio, price-earnings ratio, UK stock returns

Abstract:
This study evaluates the efficiency of cross hedging with single stock futures (SSF) contracts. We propose a new technique for hedging exposure to an individual stock that does not have options or exchange-traded SSF contracts written on it. Our method selects as a hedging instrument a portfolio of SSF contracts which are selected based on how closely matched their underlying firm characteristics are with the characteristics of the individual stock we are attempting to hedge. We investigate whether using cross-sectional characteristics to construct our hedge can provide hedging efficiency gains over that of constructing the hedge based on return correlations alone. Overall, we find that the best hedging performance is achieved through a portfolio that is hedged with market index futures and a SSF matched by both historical return correlation and cross-sectional matching characteristics. We also find it preferable to retain the chosen SSF contracts for the whole out-of-sample period while re-estimating the optimal hedge ratio at each rolling window.

Single stock futures, hedging, Universal Stock Futures, OneChicago

Abstract:
This study evaluates the efficiency of cross hedging with single stock futures (SSF) contracts. We propose a new technique for hedging exposure to an individual stock that does not have options or exchange-traded SSF contracts written on it. Our method selects as a hedging instrument a portfolio of SSF contracts which are selected based on how closely matched their underlying firm characteristics are with the characteristics of the individual stock we are attempting to hedge. We investigate whether using cross-sectional characteristics to construct our hedge can provide hedging efficiency gains over that of constructing the hedge based on return correlations alone. Overall, we find that the best hedging performance is achieved through a portfolio that is hedged with market index futures and a SSF matched by both historical return correlation and cross-sectional matching characteristics. We also find it preferable to retain the chosen SSF contracts for the whole out-of-sample period while re-estimating the optimal hedge ratio at each rolling window.

Basis risk, single stock futures, hedging, universal stock futures

Abstract:
This study examines the relation between corporate social performance and stock returns in the UK. We closely evaluate the interactions between social and financial performance with a set of disaggregated social performance indicators for environment, employment, and community activities instead of using an aggregate measure. While scores on a composite social performance indicator are negatively related to stock returns, we find the poor financial reward offered by such firms is attributable to their good social performance on the environment and, to a lesser extent, the community aspects. Considerable abnormal returns are available from holding a portfolio of the socially least desirable stocks. These relationships between social and financial performance can be rationalized by multi-factor models for explaining the cross-sectional variation in returns, but not by industry effects.

Abstract:
This study examines the relationship between corporate social performance and stock returns in the UK. Using a set of disaggregated social performance indicators for environment, employment and community activities, we are able to more closely evaluate the interactions between social and financial performance than would be the case for an aggregate measure. While scores on a composite social performance indicator are significantly negatively related to stock returns, we find that the poor financial reward offered by such firms is attributable to their good social performance on the employment and to a lesser extent the environmental aspects. Interestingly, we find that considerable abnormal returns are available from holding a portfolio of the socially least desirable stocks. These relationships between social and financial performance cannot be rationalised by multi-factor models for explaining the cross-sectional variation in returns or by industry effects.

Corporate social responsibility, ethical investing, stock returns, trading rule performance

Abstract:
The article analyses the impact of trading costs on the profitability of momentum strategies in the UK and concludes that losers are more expensive to trade than winners. The observed asymmetry in the costs of trading winners and losers crucially relates to the high cost of selling loser stocks with small size and low trading volume. Since transaction costs severely impact net momentum profits, the paper defines a new low-cost relative-strength strategy by shortlisting from all winner and loser stocks those with the lowest total transaction costs. While the study severely questions the profitability of standard momentum strategies, it concludes that there is still room for momentum-based return enhancement, should asset managers decide to adopt low-cost relative-strength strategies.

Momentum profits, Transaction costs, Low-cost strategy

Abstract:
This study proposes a utility-based framework for the determination of optimal hedge ratios that can allow for the impact of higher moments on the hedging decision. The approach is applied to a set of 20 commodities that are hedged with futures contracts. We examine the entire hyperbolic absolute risk aversion (HARA) family of utilities which include quadratic, logarithmic, power and exponential utility functions. We find that for small to moderate commodity exposure, the performance of hedges constructed allowing for non-zero higher moments is only very slightly better than the performance of the much simpler OLS hedge ratio. For high commodity exposures, higher moments do matter and their relative weights in the utility function affect the optimal decision in-sample but not out of sample. We support our empirical findings by theoretical analysis of optimal hedging decisions and we uncover a novel link between optimal hedge ratios and the minimax hedge ratio, that is the ratio which minimizes the largest loss of the hedged position.

utility-based hedging, OLS, non-normality risk, commodity futures, skewness, kurtosis

Abstract:
This paper examines the relationship between a firm's reputation and the returns on its shares. We employ a unique dataset from the UK based on ten years of surveys conducted for Management Today, where company directors and analysts at leading investment firms are asked to rate each company in their sector. We consider whether there may be a short-term effect around the time of the announcement and whether longer-term returns are superior for highly ranked firms. We find that while there is little evidence for short-term price pressure around the time of the event, investors who purchase stocks with reputation scores that have risen significantly can make abnormal returns. Consistent with the notion that there is no such thing as bad publicity, we find that firm's whose scores have fallen substantially still exhibit positive abnormal returns in both the short and long run when the market index is employed as a benchmark. However, when a more appropriate comparator is used, evidence of out-performance entirely disappears.

Corporate reputation, Management Today Most Admired Firms, stock returns, trading rule performance

Abstract:
Numerous studies have documented the failure of the static and conditional capital asset pricing models to explain the difference in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. Our results show that the time-series of value premia is strongly and positively correlated with its volatility. This conclusion is robust to the criterion used to sort stocks into value and growth portfolios and to the country under review (U.S. and U.K.). Our paper therefore adds to the weight of evidence on the possible role of idiosyncratic risk in explaining equity returns.

Value premium, CAPM, GJR-GARCH(1,1)-M, Conditional unsystematic risk

Abstract:
Using UK equity index data, this paper considers the impact of news on time varying measures of beta, the usual measure of undiversifable risk. The empirical model implies that beta depends on news about the market and news about the sector. The asymmetric response of beta to news about the market is consistent across all sectors considered. Recent research is divided as to whether abnormalities in equity returns arise from changes in expected returns in an efficient market or over-reactions to new information. The evidence in this paper suggests that such abnormalities may be due to changes in expected returns caused by time-variation and asymmetry in beta.

Abstract:
Using UK equity index data, this paper considers the impact of news on time varying measures of beta, the usual measure of undiversifiable risk. The results suggest that beta depends on two sources of news - news about the market and news about the sector. The asymmetric effect in beta is consistent across all sectors considered. Recent research provides conflicting evidence as to whether abnormalities in equity returns are a result of changes in expected returns in an efficient market or an over-reaction to new information. The evidence in this paper suggests that such abnormalities may occur as a result of changes in expected return caused by time-variation and symmetry in beta.

Stock Index, Multivariate Asymmetric GARCH, News Impact Surfaces, Conditional Beta Surfaces

Abstract:
This study considers the stock performance of America's 100 Best Corporate Citizens following the annual survey by Business Ethics. We examine both possible short-term announcement effects around the time of the survey's publication, and whether longer-term returns are higher for firms that are listed as good citizens. We find some evidence of a positive market reaction to a firm's presence in the top 100 firms that are made public, and that holders of the stock of such firms earn small abnormal returns during an announcement window. Over the year following the announcement, companies in the top 100 yield negative abnormal returns of around 3%. However, such companies tend to be large and with high price-to-book values, which existing studies suggest will tend to perform poorly. Once we allow for these firm characteristics, the poor performance of the highly rated firms largely disappears. We also find companies that are newly listed as good citizens and companies in the top 100 but outside the S&P 500 can provide considerable positive abnormal returns to investors.

corporate citizenship, Business Ethics 100 Best Corporate Citizens, corporate social responsibility, stock returns, trading rule performance

Abstract:
This study tests for the presence of periodically, partially collapsing speculative bubbles in the sector indices of the S&P 500 using a regime-switching approach. We also employ an augmented model that includes trading volume as a technical indicator to improve the ability of the model to time bubble collapses and to better capture the temporal variations in returns. We find that over 70% of the S&P 500 index by market capitalization, and seven of its ten sector component indices exhibited bubble-like behaviour over our sample period. Thus the speculative bubble that grew in the 1990's and subsequently collapsed was pervasive in the US equity market. The bubble affected numerous sectors including energy and industrials, rather than being confined to information technology, telecommunications and the media.

Stock market bubbles, fundamental values, dividends, regime switching, speculative bubble tests

Abstract:
This study assesses whether the widely documented momentum profits can be attributed to time-varying risk as described by a GJR-GARCH(1,1)-M model. We reveal that momentum profits are a compensation for time-varying unsystematic risks, which are common to the winner and loser stocks but affect the former more than the latter. In addition, we find that, perhaps because losers have a higher propensity than winners to disclose bad news, negative return shocks increase their volatility more than it increases those of the winners. The volatility of the losers is also found to respond to news more slowly, but eventually to a greater extent, than that of the winners.

Momentum profits, Unsystematic risk, GJR-GARCH(1,1)-M model

Abstract:
This study assesses whether the widely documented momentum profits can be ascribed to time-varying risk as described by a GJR-GARCH(1,1)-M model. Consistent with rational pricing in efficient markets, we reveal that momentum profits are a compensation for time-varying unsystematic risks, common to the winner and loser stocks. We also find that, because losers have a higher propensity than winners of disclose bad news, negative return shocks increase their volatility more than it increases that of the winners. The volatility of the losers is also found to respond to news more slowly, but eventually to a greater extent, than that of the winners. Following Hong et al. (2000), we interpret this as a sign that managers of loser firms are reluctant to disclosing bad news, while managers of winner firms are eager to releasing good news.

Momentum profits, Common unsystematic risk, GJR-GARCH(1,1)-M

Abstract:
The advent of index tracking early in the 1970s and the continuous growth of assets tied to the S&P 500 index have enforced perceptions of the importance of becoming an index-member, due to increased demand by index fund participants for the stocks involved in index composition changes. This study focuses on S&P 500 inclusions and examines the impact of potential overnight price adjustment after the announcement of an S&P 500 index change. We find evidence of a significant overnight price change that diminishes the profits available to speculators although there are still profits available from the first day after announcement until a few days after the actual event. More importantly observing the tick-by-tick stock price performance of the key days of the event window for the first time, we find evidence of consistent trading patterns during trading hours over inclusion event. A separate analysis of two different sub-periods as well as of NASDAQ and NYSE listed stocks allows for a detailed examination of the price and volume effect in continuous time.

Index effect, S&P 500, market efficiency, price pressure

Abstract:
In this paper we test for the presence of periodically partially collapsing, positive and negative speculative bubbles in the S&P 500 Composite Index for the period 1888-2003. We extend existing regime - Switching models of speculative behavior by including abnormal volume as an indicator of the probable time of the bubble collapse. Abnormal volume is included as both a classifying variable that helps predict the probability of the bubble surviving, and as a factor of risk in the surviving state equation. Increased volume is considered a signal that market beliefs concerning the future of the bubble are changing. We show that the deviation of actual prices from fundamental values and abnormal volume are significant predictors and classifiers of returns.

Stock market bubbles, fundamental values, dividends, regime switching, speculative bubble tests

Abstract:
Research into medieval interest rates has been hampered by the diversity of terms and methods used by historians, creating serious misconceptions in the reporting of medieval interest rates, which have then been taken at face value by later scholars. This has had important repercussions on the wider debate on the credit risk of different forms of medieval governments and the costs of borrowing as a bar to investment. This paper seeks to establish a standardised methodology to accurately calculate interest rates from historical sources, which will provide a firmer foundation for comparisons between regions and periods. It also supports other recent literature suggesting that medieval economic and financial development was more advanced than previously portrayed. The paper is illustrated with case studies drawn from the credit arrangements of the English kings between 1272 and c.1340, and argues that the variations over time in interest rates charged reflect the contemporary notion of credit worthiness as it applied to the medieval English Crown.

medieval finance, interest rates, government debt, Italian merchant banks

Abstract:
This study examines the abnormal returns, trading activity and long term performance of stocks that were added to the S&P 500 Index during the period 1990 to 2002. By using a three-factor pricing model that allows for firm size and value characteristics as well as market risk, we are able to shed new light on the widely observed index effect. We argue that for the years 1990-1997 in particular, firm size mattered in the long-run and firm size effects cannot be captured by a single factor model for abnormal returns. We also find a transitory increase in trading volume between the announcement and a few days after the effective date. The seal of S&P 500 Index membership has very long term effects and inclusion is not an information-free event.

Index effect, S&P 500, market efficiency, price pressure, three-factor model

Abstract:
This study considers the relationship between trading volumes, transactions costs, and the profitability of momentum strategies using data from the UK. We demonstrate that round-trip transactions costs for selling loser firms are around double those of buying winners, and in particular, the costs of selling low volume losers is more than twice as high as the cost of selling low volume winners. By contrast, there are only modest differences between the costs of buying winners and losers, irrespective of their volume levels. Yet we observe that, even in net terms, momentum strategies based on low volume stocks are more profitable than those using high volume stocks. We also note important differences between transactions costs measured using quoted versus effective spreads. Altogether, our findings should sound a word of caution for any study attempting to evaluate the impact of transactions costs on momentum profitability that such costs are very heterogeneous across firms and trade types, implying that they require careful calculation.

Momentum profits, Transaction costs, bid-ask spreads, trading volume

Abstract:
While it is commonly believed that derivative instruments are a recent invention, we document the existence of forward contracts for the sale of wool in medieval England around 700 years ago. The contracts were generally entered into by English monasteries, who frequently sold their wool for up to twenty years in advance to mostly foreign and particularly Italian merchants. Employing a unique source of data collected by hand from the historical records, we determine the interest rates implied in these transactions and we also examine the efficiency of the forward and spot markets. The calculated interest rates average around 20%, in accordance with available information concerning the interest rates used in other types of transactions at that time. Perhaps surprisingly, we also find little evidence of informational inefficiencies in these markets.

Wool market, forward contracts, market efficiency, Medieval England, interest rates

Abstract:
This paper considers the impact of match results on the stock returns of English football clubs. We propose that the magnitude of the response to a given result depends on the importance of the game, which is measured in two ways. First, we consider the extent to which the clubs are close rivals vying for similar league positions, as winning such games is particularly significant. Second, we argue that each individual game becomes more important for those clubs likely to be promoted or relegated as the season draws to a close, since a given match will have increasing information content concerning the final league position of the club. Using a fairly large panel comprising data for 19 clubs, we find that the unexpected parts of both the points and the number of goals ahead from the match do affect stock prices. There is also some limited support for the notion that stock prices are more affected by the results of important matches.

soccer results, football clubs, stock returns, efficient markets hypothesis

Abstract:
A vast literature has documented the value premium and the small firm effect as pervasive stylized facts in empirical asset pricing and yet research has been largely unable to provide entirely convincing explanations of why these phenomena exist. This paper demonstrates that the cross-sectional variation in returns between portfolios sorted by size and book-to-market value is significantly and positively related to the conditional volatility of those portfolios. We show that the explanatory power of the portfolios' sensitivities to conditional volatility for the cross-section of returns is in addition to that embodied in the sensitivities to market risk, macroeconomic, book-to-market and market capitalization factors.

cross-sectional variation in stock returns, CAPM, GARCH-M, conditional volatility, risk premium

Abstract:
In recent years, a sharp divergence of London Stock Exchange equity prices from dividends has been noted. In this paper, we examine whether this divergence can be explained by reference to the existence of a speculative bubble. Three different empirical methodologies are used: variance bounds tests, bubble specification tests, and cointegration tests based on both and data. We find that, stock prices diverged significantly from their fundamental values during the late 1990's, and that this divergence has all the characteristics of a bubble.

Abstract:
This article proposes a new model for autoregressive conditional heteroscedasticity and kurtosis. Via a time-varying degrees of freedom parameter, the conditional variance and conditional kurtosis are permitted to evolve separately. The model uses only the standard Student`s t-density and consequently can be estimated simply using maximum likelihood. The method is applied to a set of four daily financial asset return series comprising U.S. and U.K. stocks and bonds, and significant evidence in favor of the presence of autoregressive conditional kurtosis is observed. Various extensions to the basic model are proposed, and we show that the response of kurtosis to good and bad news is not significantly asymmetric.

conditional kurtosis, fat tails, fourth moment, GARCH, Student`s t-distribution

Abstract:
Internal risk management models of the kind popularized by J.P. Morgan are now used widely by the world's most sophisticated financial institutions as a means of measuring risk. Using the returns on three of the most popular futures contracts on the London International Financial Futures Exchange, in this paper we investigate the possibility of using multivariate generalized autoregressive conditional heteroscedasticity (GARCH) models for the calculation of minimum capital risk requirements (MCRRs). We propose a method for the estimation of the value at risk of a portfolio based on a multivariate GARCH model. We find that the consideration of the correlation between the contracts can lead to more accurate, and therefore more appropriate, MCRRs compared with the values obtained from a univariate approach to the problem.

Abstract:
We examine whether a three-regime model that allows for dormant, explosive and collapsing speculative behaviour can explain the dynamics of the S&P 500. We extend existing models of speculative behaviour by including a third regime that allows a bubble to grow at a steady rate, and propose abnormal volume as an indicator of the probable time of bubble collapse. We also examine the financial usefulness of the three-regime model by studying a trading rule formed using inferences from it, whose use leads to higher Sharpe ratios and end of period wealth than from employing existing models or a buy-and-hold strategy.

Abstract:
We consider the finite sample properties of model selection by information criteria in conditionally heteroscedastic models. Recent theoretical results show that certain popular criteria are consistent in that they will select the true model asymptotically with probability 1. To examine the empirical relevance of this property, Monte Carlo simulations are conducted for a set of non-nested data generating processes (DGPs) with the set of candidate models consisting of all types of model used as DGPs. In addition, not only is the best model considered but also those with similar values of the information criterion, called close competitors, thus forming a portfolio of eligible models. To supplement the simulations, the criteria are applied to a set of economic and financial series. In the simulations, the criteria are largely ineffective at identifying the correct model, either as best or a close competitor, the parsimonious GARCH (1, 1) model being preferred for most DGPs. In contrast, asymmetric models are generally selected to represent actual data. This leads to the conjecture that the properties of parameterizations of processes commonly used to model heteroscedastic data are more similar than may be imagined and that more attention needs to be paid to the behaviour of the standardized disturbances of such models, both in simulation exercises and in empirical modeling.

Abstract:
This paper investigates the properties of implied volatility series calculated from options on Treasury bond futures, traded on LIFFE. We demonstrate that the use of near-maturity at the money options to calculate implied volatilities causes less mispricing and is therefore superior to, a weighted average measure encompassing all relevant options. We demonstrate that, whilst a set of macroeconomic variables has some predictive power for implied volatilities, we are not able to earn excess returns by trading on the basis of these predictions once we allow for typical investor transactions costs.

Abstract:
This paper is the first to utilize a direct test for periodic, partially collapsing speculative bubbles in US REIT prices. A long history of data is employed for the All, Mortgage and Equity REIT categories. This approach is more powerful than existing tests and is based on the formulation of a switching model that has a surviving regime where the bubble continues to grow and a collapsing regime where the bubble implodes. There is some evidence for the presence of speculative bubbles, most notably in the Mortgage REITs series. There is also visual evidence of a negative bubble in all three series in the early 1970s and of a positive bubble after 2000 which subsequently burst. We are able to compute the time-varying probabilities of being in the surviving and collapsing regimes, and through this to estimate a probability that the bubble will burst during the following period. We show how this information may be used in developing a signal to inform investors’ decisions on timing an exit from the market, thereby shielding their portfolios from the effects of periodically bursting bubbles or indeed taking advantage of such bubbles.

REITs, periodic partially collapsing speculative bubbles, direct bubble tests, probability of collapse, trading signals

Abstract:
Numerous studies have documented the failure of the static and conditional capital asset pricing models to explain the difference in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. Our results show that the time-series of value premia is strongly and positively correlated with its volatility. This conclusion is robust to the criterion used to sort stocks into value and growth portfolios and to the country under review (the US and the UK). Our paper is consistent with evidence on the possible role of idiosyncratic risk in explaining equity returns, and also with a separate strand of literature concerning the relative lack of reversibility of value firms' investment decisions.

Abstract:
Although financial theory rests heavily upon the assumption that asset returns are normally distributed, value indices of commercial real estate display significant departures from normality. In this paper, we apply and compare the properties of two recently proposed regime switching models for value indices of commercial real estate in the US and the UK, both of which relax the assumption that observations are drawn from a single distribution with constant mean and variance. Statistical tests of the models' specification indicate that the Markov switching model is better able to capture the non-stationary features of the data than the threshold autoregressive model, although both represent superior descriptions of the data than models that allow for only one state. Our results have several implications for theoretical models and empirical research in finance.

Regime switching models, value indices of commercial real estate, non-stationary time series, normality, real estate

Abstract:
This paper employs a vector autoregressive model to investigate the impact of macroeconomic and financial variables on a UK real estate return series. Our results indicate that unexpected inflation, and the interest rate term spread have explanatory power for the property market. However the most significant influence on the real estate series are the lagged values of the real estate series themselves. We conclude that identifying the factors that have determined UK property returns over the past twelve years remains a difficult task.

Property returns, macroeconomy, vector autoregressions

Abstract:
This study models retail rents in the UK using a vector autoregressive and time series models. Two retail rent series are used, compiled by LaSalle Investment Management and CB Hillier Parker, and the emphasis is on forecasting. The results suggest that the use of the vector autoregression and time series models in this study can pick up important features of the data that are useful for forecasting purposes. The relative forecasting performance of the models appears to be subject to the length of the forecast time horizon. The results also show that the variables which were appropriate for inclusion in the vector autoregression systems differ between the two rents series, suggesting that the structure of optimal models for predicting retail rents could be specific to the rent index used. Ex ante forecasts from our time series suggest that both LaSalle Investment Management and CB Hillier Parker real retail rents will exhibit an annual growth rate above their long-term mean.

Abstract:
This paper examines the predictability of real estate asset returns using a number of time series techniques. A vector autoregressive model, which incorporates financial spreads, is able to improve upon the out of sample forecasting performance of univariate time series models at a short forecasting horizon. However, as the forecasting horizon increases, the explanatory power of such models is reduced, so that returns on real estate assets are best forecast using the long term mean of the series. In the case of indirect property returns, such short-term forecasts can be turned into a trading rule that can generate excess returns over a buy-and-hold strategy gross of transactions costs, although none of the trading rules we develop could cover the associated transactions costs. We therefore conclude that such forecastability is entirely consistent with stock market efficiency.

Real estate returns, spreads, forecasting, time series models, vector autoregressions

Abstract:
This paper investigates whether the prices of UK equity-traded property stocks over the past fifteen years contain evidence of a speculative bubble. Speculative bubbles are generated when investors include the expectation of the future price in their information set. In the presence of speculative bubbles, positive expected bubble returns will lead to increased demand and will thus force prices to diverge from their fundamental value. The present analysis draws upon the methodologies adopted in various studies examining price bubbles in the general stock market. Fundamental values are generated using two models: the dividend discount and the Gordon growth. Variance bounds tests are then applied to test for bubbles in UK property asset prices. Finally, cointegration analysis is conducted to provide further evidence on the presence of bubbles. Evidence of the existence of bubbles is found but these appear to be transitory and concentrated in the mid-to-late 1990s. Investors in property stocks should be aware that in periods when bubbles are present the market does not move on the basis of the fundamentals and abrupt price corrections can occur.

Abstract:
This paper examines the performance of various statistical models and commonly used financial indicators for forecasting securitised real estate returns for five European countries: the UK, Belgium, the Netherlands, France and Italy. Within a VAR framework, it is demonstrated that the gilt-equity yield ratio is in most cases a better predictor of securitised returns than the term structure or the dividend yield. In particular, investors should consider in their real estate return models the predictability of the gilt-equity yield ratio in Belgium, the Netherlands and France, and the term structure of interest rates in France. Predictions obtained from the VAR and univariate time-series models are compared with the predictions of an artificial neural network model. We find that, whilst no single model is universally superior across all series, accuracy measures and horizons considered, the neural network model is generally able to offer the most accurate predictions for 1-month horizons. For quarterly and half-yearly forecasts, the random walk with a drift is the most successful for the UK, Belgian and Dutch returns and the neural network for French and Italian returns. Although this study underscores market context and forecast horizon as parameters relevant to the choice of the forecast model, it strongly indicates that analysts should exploit the potential of neural networks and assess more fully their forecast performance against more traditional models.

Real estate returns, vector autoregressive models, neural networks, forecasting

Abstract:
This paper proposes two new tests for linear and nonlinear lead/lag relationships between time series based on the concepts of cross-correlations and cross-bicorrelations respectively. The tests are then applied to a set of Sterling-denominated exchange rates. Our analysis indicates that there existed periods during the post-Bretton Woods era where the temporal relationship between different exchange rates was strong, although these periods have become less frequent over the past twenty years. In particular, our results demonstrate the episodic nature of the nonlinearity, and have implications for the speed of flow of information between financial series. The method generalises recently proposed tests for nonlinearity to the multivariate context.

Cross-correlations, cross-bicorrelations, exchange rates, nonlinearity

Abstract:
This paper examines the lead-lag relationship between the FTSE 100 index and index futures price employing a number of time series models. Using ten-minutely observations from June 1996-1997, it is found that lagged changes in the futures price can help to predict changes in the spot price. The best forecasting model is of the error correction type, allowing for the theoretical difference between spot and futures prices according to the cost of carry relationship. This predictive ability is in turn utilised to derive a trading strategy which is tested under real-world conditions to search for systematic profitable trading opportunities. It is revealed that although the model forecasts produce significantly higher returns than a passive benchmark, the model was unable to outperform the benchmark after allowing for transaction costs.

Stock index futures, FTSE 100, Error correction model, Trading rules, Forecasting accuracy, Cost of carry model

Abstract:
A glance along the finance shelves at any bookshop reveals a large number of books that seek to show readers how to "make a million" or "beat the market" with allegedly highly profitable equity trading strategies. This paper investigates whether useful trading strategies can be derived from popular books of investment strategy, with "What Works on Wall Street" by James P. O'Shaughnessy, used as an example. Specifically, we test whether this strategy would have produced a similarly spectacular performance in the UK context as was demonstrated by the author for the US market. As part of our investigation, we highlight a general methodology for determining whether the observed superior performance of a trading rule could be attributed in part or in entirety to data mining. Overall, we find that the O'Shaughnessy rule performs reasonably well in the UK equity market, yielding higher returns than the FTSE All-Share Index, but lower returns than an equally weighted benchmark.

Abstract:
There is much evidence in the literature that the volatilities of equity returns show evidence of asymmetric responses to good and bad news. At the same time, there is evidence that the unconditional distribution of stock returns is asymmetric as well. This paper examines the effects of asymmetries of various forms on the accuracy of value at risk models. We compare the value at risk estimates derived from models which assume both a symmetric unconditional distribution of returns and a symmetric response of volatility to good and bad news, with models which explicitly allow for each class of asymmetries. We find that, between the two types of asymmetry considered, the asymmetry in the unconditional distribution is the more important feature. Use of the semi-variance, which allows for this feature, is shown to provide more stable and more reliable value at risk estimates than simple and more complex models that do not.

Stock index, Minimum Capital Risk Requirements, Internal Risk Management Models, Value at risk, asymmetries, multivariate GARCH, semi-variance

Abstract:
This paper investigates the frequency of extreme events for three LIFFE futures contracts for the calculation of minimum capital risk requirements (MCRRs). We propose a semi-parametric approach where the tails are modelled by the Generalized Pareto Distribution and smaller risks are captured by the empirical distribution function. We compare the capital requirements form this approach with those calculated from the unconditional density and from a conditional density - a GARCH(1,1) model. Our primary finding is that both in-sample and for a hold-out sample, our extreme value approach yields superior results than either of the other two models which do not explicitly model the tails of the return distribution. Since the use of these internal models will be permitted under the EC-CAD II, they could be widely adopted in the near future for determining capital adequacies. Hence, close scrutiny of competing models is required to avoid a potentially costly misallocation capital resources while at the same time ensuring the safety of the financial system.

Minimum Capital Risk Requirements, Generalized Pareto Distribution, GARCH models

Abstract:
Research has highlighted the usefulness of the Gilt-Equity Yield Ratio (GEYR) as a predictor of UK stock returns. This paper extends recent studies by endogenising the threshold at which GEYR switches from being low to being high or vice versa, thus improving the arbitrary nature of the determination of the threshold employed in the extant literature. It is observed that a decision rule for investing in equities or bonds, based on the forecasts from a regime switching model, yields higher average returns with lower variability than a static portfolio containing any combinations of equities and bonds. A closer inspection of the results reveals that the model has power to forecast when investors should steer clear of equities, although the trading profits generated are insufficient to outweigh the associated transactions costs.

GEYR, Markov switching, regime model, forecasting, equity & bond returns, trading rule

Abstract:
This paper demonstrates that the use of GARCH-type models for the calculation of minimum capital risk requirements (MCRRs) may lead to the production of inaccurate and therefore inefficient capital requirements. We show that this inaccuracy stems from the fact that GARCH models typically overstate the degree of persistence in return volatility. A simple modification to the model is found to improve the accuracy of MCRR estimates in both back- and out-of-sample tests. Given that internal risk management models are currently in widespread usage in some parts of the world (most notably the USA), and will soon be permitted for EC banks and investment firms, we believe that our paper should serve as a valuable caution to risk management practitioners who are using, or intend to use this popular class of models.

Minimum capital risk requirements, internal risk management models, volatility persistence

Abstract:
Many popular techniques for determining a securities firm's value at risk are based upon the calculation of the historical volatility of returns to the assets that comprise the portfolio, and of the correlations between them. One such approach is the J.P. Morgan RiskMetrics methodology using Markowitz portfolio theory. An implicit assumption underlying this methodology is that the volatilities and correlations are constant throughout the sample period, and in particular that they are not systematically related to one another. However, it has been suggested in a number of studies that the correlation between markets increases when the individual volatilities are high. This paper demonstrates that this type of relationship between correlation and volatility can lead to a downward bias in the estimated value at risk, and proposes a number of pragmatic approaches that risk managers might adopt for dealing with this issue.

Internal risk management models, stock market volatility, value at risk models, extreme market movements, correlation matrices, multivariate GARCH model

Abstract:
Many recent studies have documented the presence of speculative bubbles, defined as systematic and increasing deviations of actual prices from fundamentals, in asset prices. However, thus far the usefulness of such models has been examined in the literature only from a statistical perspective. In this paper we employ two regime switching models of periodically partially collapsing speculative bubbles and examine the risk-adjusted profits of trading rules formed using inferences from them. Use of trading rules derived from an augmented model incorporating market volume leads to higher risk adjusted returns than those obtained from employing existing models or from a buy and hold strategy.

Stock market bubbles, regime switching, speculative bubble tests, fundamental values, trading rules

Abstract:
Broad agreement exists among both the investment banking and regulatory communities that the use of internal risk management models is an efficient means for calculating capital risk requirements. The determination of model parameters laid down by the Basle Committee on Banking Supervision as necessary for estimating and evaluating the capital adequacies, however, has received little academic scrutiny. We investigate a number of issues of statistical modeling in the context of determining market-based capital risk requirements. We highlight several potentially serious pitfalls in commonly applied methodologies and conclude that simple methods for calculating value at risk often provide superior performance to complex procedures. Our results thus have important implications for risk managers and market regulators.

Risk Measurement and Management: firm/enterprise risk

Abstract:
There is widespread evidence that the volatility of stock returns displays an asymmetric response to good and bad news. This article considers the impact of asymmetry on time-varying hedges for financial futures. An asymmetric model that allows forecasts of cash and futures return volatility to respond differently to positive and negative return innovations gives super in-sample hedging performance. However, the simpler symmetric model is not inferior in a hold-out sample. A method for evaluating the models in a modern risk-management framework is presented, highlighting the importance of allowing the optimal hedge ratios to be both time-varying and asymmetric.

Abstract:
In this paper we test for the presence of periodically partially collapsing, positive and negative speculative bubbles in the S&P 500 Composite Index for the period 1888-2001. We extend existing regime-switching models of speculative behaviour by including abnormal volume as an indicator of the probable time of the bubble collapse. Abnormal volume is included as both a classifying variable that helps predict the probability of the bubble surviving, and as a factor of risk in the surviving state equation. Increased volume is considered a signal that market beliefs concerning the future of the bubble are changing. We show that abnormal volume is a significant predictor and classifier of returns.

Stock market bubbles, fundamental values, dividends, regime switching, speculative bubble tests

Abstract:
In this paper we test for the presence of periodically partially collapsing, positive and negative speculative bubbles in the S&P 500 Composite Index for the period 1888-2003. We extend existing regime-switching models of speculative behavior by including abnormal volume as an indicator of the probable time of the bubble collapse. Abnormal volume is included as both a classifying variable that helps predict the probability of the bubble surviving, and as a factor of risk in the surviving state equation. Increased volume is considered a signal that market beliefs concerning the future of the bubble are changing. We show that the deviation of actual prices from fundamental values and abnormal volume are significant predictors and classifiers of returns.

Stock market bubbles, fundamental values, dividends, regime switching, speculative bubble tests

Abstract:
We examine whether a three-regime model that allows for dormant, explosive and collapsing speculative behaviour can explain the dynamics of the S&P500 index. We extend existing models of speculative behaviour by including a third regime that allows for a bubble to grow at a steady rate, and we propose abnormal volume as an indicator of the probable time of bubble collapse. We also examine the financial usefulness of the three-regime model by studying a trading rule formed using inferences from it. Use of this trading rule leads to higher Sharpe ratios and end of period wealth than those obtained from employing existing models or a buy-and-hold strategy.

Speculative behaviour models, fundamental values, dividends, regime switching, speculative bubble tests, trading rules