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Abstract:
This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66% respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, a novel double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. Interestingly, the abnormal performance of the double-sort portfolios cannot be explained by a lack of liquidity or data mining and is robust to transaction costs and to different specifications of the risk-return trade-off.

Commodity Futures, Momentum, Term Structure, Backwardation, Contango, Double-sort strategy

Abstract:
The paper examines the role of non-normality risks in explaining the momentum puzzle of equity returns. It shows that momentum profits are not normally distributed and, relatedly, that the momentum profitability is partly a compensation for systematic negative skewness risk in line with market efficiency. This finding is pervasive across nine trading strategies that combine different holding and ranking periods and is reinforced when time dependencies in abnormal returns and risks are explicitly modeled. The analysis also reveals that the market and skewness risks of momentum portfolios evolve over the business cycle in a manner that is consistent with market timing and risk aversion. While non-normality risks matter, a large proportion of the momentum profits remains unexplained which may provide comfort to behavioural theorists.

Momentum strategy, Abnormal returns, Skewness, Conditional asset pricing

Abstract:
We employ a two-regime, nonlinear model and more than a century of data to investigate the time series behavior of the S&P Composite price-dividends and price-earnings ratios. On average, the ratios display continuation fuelled by investor sentiment in bull markets but they adjust toward their long run equilibrium levels in bear markets. Impulse response functions that simulate the effect of a shock on the future evolution of the ratios exhibit the typical underreaction-overreaction time profile postulated in behavioral theories of stock returns. Our results indicate that market sentiment plays an important role in the short run but fundamentals dominate in the long run ensuring overall mean-reversion.

Behavioral finance, underreaction-overreaction, threshold autoregression

Abstract:
Monte Carlo simulations are used to explore the small sample properties of a mean group and two pooled panel estimators of a regression coefficient when the regressor is I(1). We compare and contrast the effect of I(0) and I(1) errors and homogeneous and heterogeneous coefficients in a design based on two typical PPP panels. The results confirm that the asymptotic theory is relevant to practical applications. With I(0) errors and homogeneous coefficients, the estimators are unbiased, dispersion depends on the signal-noise ratio and falls at rate T(root-N) as expected. With I(1) errors and no cointegration, the estimators are unbiased and dispersion falls at rate root-N. When heterogeneity with I(0) errors is introduced, the dispersion of the pooled estimators falls at rate root-N but that of the mean group continues to fall at rate T(root-N). Finally, the pooled estimators are likely to lead to distorted inference both in the case of I(1) errors and of I(0) errors with heterogeneous coefficients. The mean group estimators, however, are generally correctly sized. An application to a panel of OECD economies suggests that the PPP hypothesis-nominal exchange rates and price differentials move one-for-one in the long run-seems to hold even if real exchange rates are subject to permanent shocks.

Monte Carlo, response surface, spurious regression, PPP

Abstract:
This paper investigates the short-term behaviour of closed-end funds following large price shocks for a panel of 63 UK-traded funds. Our findings suggest that for the eight market-wide shocks, significant overreaction occurs. The level of overreaction is unrelated to the size of the funds. Both the small and difficult-to-arbitrage fund groups take longer to absorb the shocks. This is in contrast with the large and easy-arbitrage groups. However, the small funds group shows less overreaction and faster reversals after filtering out the difficult-to-arbitrage funds. The speed of reversal thus appears to be determined principally by ease-of-arbitrage.

Overreaction, Reversal, Closed-end funds, Discount, Net asset value

Abstract:
Recently, the large T panel literature has emphasized unobserved, time-varying heterogeneity that may stem from omitted common variables or global shocks that affect each individual unit differently. These latent common factors induce cross-section dependence and may lead to inconsistent regression coefficient estimates if they are correlated with the explanatory variables. Moreover, if the process underlying these factors is nonstationary, the individual regressions will be spurious but pooling or averaging across individual estimates still permits consistent estimation of a long-run coefficient. The need to tackle both error cross-section dependence and persistent autocorrelation is motivated by the evidence of their pervasiveness found in three well-known, international finance and macroeconomic examples. A range of estimators is surveyed and their finite-sample properties are examined by means of Monte Carlo experiments. These reveal that a mean group version of the common-correlated-effects estimator stands out as the most robust since it is the preferred choice in rather general (non) stationary settings where regressors and errors share common factors and their factor loadings are possibly dependent. Other approaches which perform reasonably well include the two-way fixed effects, demeaned mean group and between estimators but they are less efficient than the common-correlated-effects estimator.

Factor analysis, global shocks, latent variables, Feldstein-Horioka, PPP

Abstract:
Several recent studies advocate the use of nonparametric estimators of daily price variability that exploit intraday information. This paper compares four such estimators, realised volatility, realised range, realised power variation and realised bipower variation, by examining their in-sample distributional properties and out-of-sample forecast ranking when the object of interest is the conventional conditional variance. The analysis is based on a 7-year sample of transaction prices for 14 NYSE stocks. The forecast race is conducted in a GARCH framework and relies on several loss functions. The realized range fares relatively well in the in-sample fit analysis, for instance, regarding the extent to which it brings normality in returns. However, overall the realised power variation provides the most accurate 1-day-ahead forecasts. Forecast combination of all four intraday measures produces the smallest forecast errors in about half of the sampled stocks. A market conditions analysis reveals that the additional use of intraday data on day t-1 to forecast volatility on day t is most advantageous when day t is a low volume or an up-market day. The results have implications for value-at-risk analysis.

Conditional variance, Quadratic variation, Nonparametric estimators, Intraday prices, Superior predictive ability

Abstract:
This paper assesses empirically two competing unemployment theories. It identifies one structural break in U.K. and German unemployment around 1980 that is more severe in both absolute and relative terms than that for the United States in 1973. This offers support for the structuralist theory. A nonlinear (TAR) model is used to capture fast-up, slow-down unemployment dynamics. Impulse response functions suggest that the half-lives of shocks are longer in the postbreak subsamples, especially in Europe, which places the persistence theory closer to the mark. We conclude that elements from both theories are needed for an adequate account of unemployment dynamics.

Asymmetries, structural breaks, hysteresis, threshold autoregression

Abstract:
This paper assesses empirically two competing accounts of high unemployment, the structuralist and persistence theories. It identifies one structural break in UK and German unemployment around 1980 which is more severe in both absolute and relative terms than that for the US in 1973. This offers support for the structuralist theory. A nonlinear, momentum-TAR model is used to capture fast-up, slow-down unemployment dynamics. Impulse response functions suggest that the half-lives of shocks are longer in the post-break subsamples, especially in Europe, which places the persistence theory closer to the mark. We conclude that elements from both theories are needed for an adequate account of unemployment dynamics.

Business cycle asymmetries, structural break, hysteresis

Abstract:
This paper differentiates itself from the existing literature by testing for heterogeneities in the interest rate transmission mechanism using a large sample of 662 monthly retail rate histories (1993-2004) on seven key deposit and loan products. Error correction models are estimated to analyze long run pass-through, long-run mark up and the short run speed of adjustment. The prediction that the official and retail rates move together in the long run is supported by the data. The evidence suggests weak between-product heterogeneity but notable differences were found between financial firms in the way they adjust their rates which could hinder the achievement of monetary policy objectives. Consumer responses to official rate changes could therefore be more phased and intricate than hitherto believed. Heterogeneity in adjustment is found to be linked to menu costs and key financial ratios under managerial control.

Error correction model, Long run equilibrium rate, Adjustment speed, Mark up, Pass through, Heterogeneity, Menu costs

Abstract:
This paper compares rival sovereign default models that differ in how country-, region- and time-specific effects are treated. The quality of the models is gauged using inference-based criteria and the plausibility of estimates. An out-of-sample forecast evaluation framework is deployed based on statistical- and economic-loss functions, naive benchmarks and equal-predictive-ability tests. The inference metrics overwhelmingly favor more complex models that allow for time-varying country heterogeneity. However, simplicity beats complexity in terms of forecasting. Pooled logit models that simply control either for regional heterogeneity or for time effects produce the most accurate forecasts and outperform the naive models.

Panel logit, unobserved heterogeneity, economic loss, predictive performance

Abstract:
We investigate the role of intraday prices and volume in enhancing daily volatility forecasts for individual trading of 14 S&P500 stocks. The benchmark is a GARCH equation fitted to daily returns and augmented with several realised volatility measures or volume. We find very low correlation between statistical accuracy and profitability. Financial loss functions indicate that intraday prices do not yield gains over standard GARCH forecasts. If any intraday information is worthwhile, it comes in the form of trading volume. The best performing strategy involves buying the stock at extreme levels of volatility, suggesting a stronger volatility-return relationship in turbulent periods.

Conditional variance forecasting, Trading rules, Realised Volatility, Directional change

Abstract:
This paper explores the interest rate transmission mechanism on the basis of a large disaggregated sample of British monthly deposit and loan rates 1993-2005 for seven key products. The focus is on the adjustment speed towards the long run equilibrium rate. A sizeable proportion of UK deposits and credit products are found to have a time-varying adjustment speed, driven by the change in the policy rate. Tests based on regime-switching models indicate that the adjustment speed has four states defined by the sign of the policy rate change and the sign of the gap. The magnitude of changes in the policy rate also influences the adjustment speed in a regime-switching manner, but this nonlinear aspect is less pervasive across products than the sign asymmetry. Furthermore, mainly for deposit products there is curvature in the catch-up effect towards equilibrium - the error correction is disproportionately larger for big gaps. The marked heterogeneity found across financial institutions and products in the adjustment process raises important questions about the monetary transmission and the effectiveness of monetary policy.

Error Correction Model, Adjustment Speed, Time-variation, Regime-Switching, Curvature

Abstract:
We divide the time series of aggregate valuation into bull and bear market phases to test for momentum and reversal, respectively. Our results are consistent with price-earnings and price-dividends displaying continuation by drifting upwards in bull markets irrespective of fundamentals. Such persistence can be explained by market sentiment but not within a classical framework. However the link to fundamentals is restored in bear markets where valuation ratios exhibit mean reversion toward their long run equilibrium levels and thus overall stationarity. Finally, impulse response functions indicate that shocks to the ratios typically follow an underreaction-overreaction time profile that is more pronounced in bull rather than bear markets.

Behavioral finance, underreaction-overreaction, threshold autoregression

Abstract:
This paper explores the interest rate transmission mechanism using a broad disaggregated sample of UK deposit and credit products. For a large proportion of rates the adjustment speed is time-varying, switching among four regimes according to the direction of the policy rate and its effect on the disequilibrium gap. In general, this sign asymmetry implies faster adjustment to the long run path when the policy rate revision widens the gap. There is evidence of curvature in the catch-up effect towards equilibrium, namely, large gaps entail a disproportionately faster correction although mainly for deposits. The size of the policy rate change also impacts the adjustment speed. The notable heterogeneity found across financial institutions/products regarding the presence of these nonlinear patterns raises important questions on how to assess the effectiveness of monetary policy. The cross-section heterogeneity uncovered can be explained to some extent by diversification, profit volatility, product range, market concentration and menu costs.

Error Correction Model, Adjustment Speed, Time-variation, Regime-Switching, Curvature

Abstract:
A country's intertemporal budget constraint implies current account stationarity or that its saving and investment rates should cointegrate. However, such behaviour may not pertain in finite sample spans where the current account could be subject to persistent shocks. Accordingly, this paper reconsiders the Feldstein-Horioka puzzle for a panel of 12 OECD economies 1980I-2000IV using a mean group regression approach that is robust to persistent innovations and accounts for country heterogeneity and cross-sectional dependence. The mean group estimates are notably smaller than that from the conventional cross-section estimator and are statistically insignificant. Our findings support the view that capital is highly mobile in the long run for OECD economies despite persistence in the current account.

Abstract:
This paper uses threshold autoregressions to characterize asymmetries in adjustment dynamics and develops likelihood ratio tests to detect them. A robust bootstrap technique is proposed to circumvent the problem that the asymptotic distribution of the test statistics is non-standard. Monte Carlo simulations show that the bootstrap tests are correctly sized and are robust to near-unit roots and non-Gaussian errors. Their power is reasonable, improves sharply with the time series length and remains satisfactory for smooth transition autoregressions. Our approach combined with nonparametric tests can discriminate between asymmetries in adjustment dynamics and in innovations. An application to four monthly US dollar spot returns provides evidence of amplitude asymmetry.

Regime-switching, LR test, Bootstrap, Subsampling, Monte Carlo

Abstract:
This paper sheds light on US stock price deviations from fundamentals by analyzing the time-series dynamics of post-1870 S&P valuation ratios. It employs a non-linear, two-regime framework that allows for different behavior over phases of the stock market cycle. Persistence in the ratios implies prolonged price deviations from fundamentals stemming from short run continuation fueled by investor sentiment during bull markets. However, the pull from fundamentals ensures that valuation ratios and prices move toward their equilibrium levels in bear markets. Impulse response functions highlight sluggish adjustment and indicate that the effects of positive shocks are more pronounced and long-lasting in bull markets. The main conclusion is that, while market sentiment plays an important transitory role, valuation ratios do mean revert and so prices reflect fundamentals in the long run.

Fundamentals, Behavioral finance, Investor sentiment, Threshold autoregression

Abstract:
This paper considers three different approaches - K-means clustering and logit regressions based on macrovariables or credit ratings - to develop an Early Warning System for sovereign default. The data pertain to 75 emerging and developing countries. The optimal choice of key elements, such as the logit cut-off probability and the number of clusters, is shown to depend on the decision-maker's preferences. The latter are encapsulated in a loss function and a degree of risk aversion parameter. The out-of-sample forecast evaluation suggests that the classifiers have different strengths in terms of missed defaults and false alarms and that their forecast ranking is unstable. We show that forecast combining pays and that the weighting scheme for this purpose should also be chosen optimally to account for the decision-maker's preferences.

Debt crises, K-means clustering, logistic regression, bank internal ratings, loss function, forecast combination

Abstract:
This paper analyses the contribution of various numerical approaches to making the estimation of threshold autoregressive time series more efficient. It relies on the computational advantages of QR factorizations and proposes Givens transformations to update these factors for sequential LS problems. By showing that the residual sum of squares is a continuous rational function over threshold intervals it develops a new fitting method based on rational interpolation and the standard necessary optimality condition. Taking as benchmark a simple grid search, the paper illustrates via Monte Carlo simulations the efficiency gains of the proposed tools.

Band-TAR, QR factorization, Givens rotations, Rational interpolation

Abstract:
This paper explores the long run behaviour and short run dynamics of quarterly UK real interest rates, 1950-1999, in a threshold autoregressive framework. Using bootstrap LR extensions of the Enders and Granger (1998) threshold unit root and asymmetry tests, it finds support for sign and amplitude asymmetric mean reversion. These findings provide one explanation for the apparent persistence in real interest rates and are consistent with asymmetric feedback rules for inflation targeting.

Fisher effect, inflation targeting, persistence, threshold autoregression

Abstract:
The short-run dynamics of German mark and US dollar real exchange rates are investigated for a panel of 19 OECD economies in a vector error correction framework for the 1973-96 period. The novel persistence profiles approach of Pesaran and Shin ("Cointegration and Speed of Convergence to Equilibrium", Journal of Econometrics, Vol. 71, (1996), pp. 117-143) indicates that the effect of system-wide shocks declines rapidly initially but decays slowly thereafter. It yields an average of just one year for the half-life of such shocks but some seven years before they fully dissipate. These half-life estimates are just one-quarter of the consensus estimates. Our results are consistent with non-linear adjustment and with monetary factors being the main source of real exchange rate volatility.

Abstract:
The base currency effect in the PPP literature refers to the stylised fact that tests on real exchange rates denominated in German marks are more likely to support mean reversion than analogous tests on US dollar rates. Using a panel of 19 OECD currencies and monthly data, 1973-97, three panel unit root approaches are employed to investigate this issue - the Im, Pesaran and Shin (1995) mean group ADF estimator in its standard and demeaned versions, a SUR-FGLS panel test procedure, and the Taylor and Sarno (1998) likelihood ratio approach. In particular we explore the view that the base currency effect can be attributed to neglected cross sectional dependence and/or heterogeneous serial correlation. The tests provide qualitatively similar verdicts for both dollar and mark real exchange rates. The conclusion is that evidence for a base currency effect disappears once one allows for cross sectional dependence. Finally the panel test results generally support long run PPP which may be explained by the fact that such tests retain most of their power in the presence of potential nonlinearities as shown by Taylor, Peel and Sarno (2000).

real exchange rates, panel unit root tests, cross sectional dependence, nonlinearities

Abstract:
Using threshold autoregressive specifications, this paper extends the Enders and Granger (1998) framework for parametric tests of level asymmetry. In particular it develops bootstrap likelihood ratio statistics to test the symmetry null against sign and amplitude asymmetries or a combination of both. Monte Carlo simulations show that the proposed tests have good size properties and reasonable power. Their use is illustrated by means of an application to nominal exchange rate changes, 1973M2-2000M2.

threshold autoregression, level asymmetries, Monte Carlo