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Abstract:
Using an international database containing 103 German, UK and US ethical mutual funds we review and extend previous research on ethical mutual fund performance. By applying a multi-factor Carhart (1997) model we solve the benchmark problem most prior ethical studies suffered from. After controlling for investment style, we find little evidence of significant differences in risk-adjusted returns between ethical and conventional funds for the 1990-2001 period. Introducing time-variation in betas however leads to a significant under-performance of domestic US funds and a significant out-performance of UK ethical funds, relative to their conventional peers. Finally, we differentiate previous results by documenting a learning effect. After a period of strong under-performance, older ethical funds finally are catching up, while younger funds continue to under-perform both the index and conventional peers.

Mutual Funds, Performance evaluation, Style Analysis, Ethical Investments,

Abstract:
In this paper we develop an asset allocation model which allocates assets by maximising expected return subject to the constraint that the expected maximum loss should meet the Value-at-Risk limits set by the risk manager. Similar to the mean-variance approach a performance index like the Sharpe index is constructed. Furthermore it is shown that the model nests the mean-variance approach in case of normally distributed expected returns. We provide an empirical analysis using two assets: US stocks and bonds. The results highlight the influence of non-normal characteristics of the expected return distribution on the optimal asset allocation.

Abstract:
This study adds new insights to the long-running corporate environmental-financial performance debate by focusing on the concept of eco-efficiency. Using a new database of eco-efficiency ratings, we analyze the relation between eco-efficiency and financial performance from 1997 to 2004. We report that eco-efficiency relates positively to operating performance and market value. Moreover, our results suggest that the market's valuation of environmental performance has been time variant, which may indicate that the market incorporates environmental information with a drift. Although environmental leaders initially did not sell at a premium relative to laggards, the valuation differential increased significantly over time. Our results have implications for company managers, who evidently do not have to overcome a tradeoff between eco-efficiency and financial performance, and for investors, who can exploit environmental information for investment decisions.

Corporate Social Responsibility, Eco-Efficiency, Shareholder value, Firm Value, Firm Operating Performance, Management Policies, Capital Markets

Abstract:
We present the results of an international survey of 313 European CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. We find that although large firms often use present value techniques and the capital asset pricing model to assess the feasibility of an investment opportunity, CFOs of small firms still rely on the payback criterion. In capital structure policy, financial flexibility appears to be the most important factor in determining the amount of corporate debt. Corporate finance practice appears to be influenced mostly by firm size, to a lesser extent by shareholder orientation, and least by national influences.

Abstract:
In this paper we present the results of an international survey among 313 CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. We extend previous results of Graham and Harvey (2001) by broadening their sample internationally, by including corporate governance, and by applying multivariate regression analysis. We document interesting insights on how theoretical concepts are applied by professionals in the U.K., the Netherlands, Germany, and France and compare these results with the U.S. We discover compelling variations between large and small firms across all markets. While large firms frequently use present value techniques and the capital asset pricing model when assessing the financial feasibility of an investment opportunity, CFOs of small firms still rely on the payback criterion. Regarding debt policy we document more subtle disparities across firms and national samples. We also find substantial variation in corporate governance structures, which turn out to be more oriented at shareholder wealth in the Anglo-Saxon countries. Corporate finance practice appears to be influenced mostly by firm size, to a lesser extent by shareholder orientation, while national differences are weak at best.

international economics, financial economics, law and economics, corporate governance, cost of capital, capital structure

Abstract:
In this paper we empirically investigate to what extent three competing asset pricing models price an individual firm's stock differently in an internationally integrated world: (i) the multifactor ICAPM of Solnik-Sercu including both the global market portfolio and exchange rate risk premiums, (ii) the single factor ICAPM with only the global market portfolio, and (iii) the single factor domestic CAPM. We generalize the pricing error expressions of Stulz (1995b) for the domestic CAPM against the single factor ICAPM to the multifactor model with exchange rate factors included. Furthermore, we derive formal statistical tests for the existence of a pricing error of the domestic CAPM versus both the single factor ICAPM and the multifactor ICAPM. We test for the significance of these pricing errors in a sample of 2,483 firms from 10 industrialized countries using monthly data from 1980 to 1995. We find that the single factor ICAPM without exchange rate factors induces mispricing for more than 60% of all firms. The domestic CAPM leads to a substantial and statistically significant pricing error for approximately 7% of all firms.

Abstract:
There exists a widespread consensus among mainstream academics and investors that socially responsible investing (SRI) leads to inferior, rather than superior, portfolio performance. Using Innovest's well-established corporate eco-efficiency scores, we provide evidence to the contrary. We compose two equity portfolios that differ in eco-efficiency characteristics and find that our high-ranked portfolio provided substantially higher average returns compared to its low-ranked counterpart over the period 1995-2003. Using a wide range of performance attribution techniques to address common methodological concerns, we show that this performance differential cannot be explained by differences in market sensitivity, investment style, or industry-specific components. We finally investigate whether this eco-efficiency premium puzzle withstands the inclusion of transaction costs scenarios, and evaluate how excess returns can be earned in a practical setting via a best-in-class stock selection strategy. The results remain significant under all levels of transactions costs, thus suggesting that the incremental benefits of SRI can be substantial.

Socially Responsible Investing, SRI, Corporate Environmental Performance, Eco-Efficiency, Performance Measurement, Style Analysis

Abstract:
It is a well-known stylized fact that financial returns are non-normal and tend to have fat-tailed distributions. This paper presents a methodology that accurately estimates the degree of fat-tailedness, characterized by the tail-index, in small samples. We present a simple approach based on the Hill estimator. Our estimator is a weighted average of a set of Hill estimators, with weights obtained by using simple least squares techniques. The estimator produces unbiased estimates for the tail-index in small samples and we also provide appropriate standard errors. Using this estimator we produce tail-index estimates for returns on stocks and exchange rates that are close to estimates obtained from extremely large datasets. The results indicate that many documented conclusions about the tail behavior of financial series have over-estimated their fat-tailedness in small samples.

Abstract:
This paper analyzes the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross-listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1983) and Sercu (1980) including both the global market portfolio and exchange rate risk premia, and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980-1999. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12 percent of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the U.S., 80 basis points for the U.K., and 100 basis points for France.

Cross-listings, cost of equity capital, foreign exchange exposure

Abstract:
Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper, we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favor of the Student's t copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the Student's t copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant.

Financial dependence, Risk management, Copulas, Distributional tests, Tail dependence

Abstract:
Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favour of the Student's t copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the Student's t copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant.

Financial dependence, risk management, copulas, distributional tests, tail dependence

Abstract:
Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favor of the \studt copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the \studt copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant.

Financial dependence, copulas, distributional tests, tail dependence

Abstract:
In this paper we present the results of an international survey among 313 CFOs on capitalstructure choice. We document several interesting insights on how theoretical concepts arebeing applied by professionals in the U.K., the Netherlands, Germany, and France and wedirectly compare our results with previous findings from the U.S. Our results emphasize thepresence of pecking-order behavior. At the same time this behavior is not driven by asymmetricinformation considerations. The static trade-off theory is confirmed by the importance of a targetdebt ratio in general, but also specifically by tax effects and bankruptcy costs. Overall, we findremarkably low disparities across countries, despite the presence of significant institutionaldifferences. We find that private firms differ in many respects from publicly listed firms, e.g. listedfirms use their stock price for the timing of new issues. Finally, we do not find substantialevidence that agency problems are important in capital structure choice.

international economics, financial economics, capital structure, debt maturity, equity issues

Abstract:
In this paper, we present the results of an international survey among 313 CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. We extend previous results of Graham and Harvey (2001) by broadening their sample internationally, by including corporate governance, and by applying multivariate regression analysis. We document interesting insights on how theoretical concepts are applied by professionals in the U.K., the Netherlands, Germany, and France and compare these results with the U.S. We discover compelling variations between large and small firms across all markets. While large firms frequently use present value techniques and the capital asset pricing model when assessing the financial feasibility of an investment opportunity, CFOs of small firms still rely on the payback criterion. Regarding debt policy we document more subtle disparities across firms and national samples. We also find substantial variation in corporate governance structures, which turn out to be more oriented at shareholder wealth in the Anglo-Saxon countries. Corporate finance practice appears to be influenced mostly by firm size, to a lesser extent by shareholder orientation, while national differences are weak at best.

Abstract:
International financial markets are becoming integrated. Hence, globalrisk factor are increasingly important for portfolio selection andasset pricing. The recent empirical finance literature has confirmedthat both the global market portfolio and exchange rate risk factorsconstitute important determinants of asset returns. We show, however,that global risk factors do not importantly affect estimates of thecost of equity capital for a remarkably wide variety of companies. Weanalyze almost 3,300 stocks from nine industrialized countries overthe period 1980-1999. Incorporating global factors into cost ofcapital estimations leads to an adjustment of roughly 50 basis pointsper annum on average for the U.S. and 70 to 100 basis points for theother countries. Adjustments of this magnitude easily fall inside themargin of error associated with actual cost of capital computations.Specifically for U.S. companies, the amendment of the cost of capitalestimate is generally very small. This suggests that global riskfactors do not really matter for computing the cost of capital of U.S.firms.

cost of equity capital, exchange rate risk, capital budgeting, valuation

Abstract:
This Paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the 'synthetic' euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area.

European integration, real exchange rates, purchasing power parity, heterogenous SUR

Abstract:
This paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the “synthetic” euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area.

european integration, real exchange rates, purchasing power parity, heterogeneous SUR

Abstract:
In this paper we examine the effects of the amount of trade disclosure in an experimental financial market, in which nine professional traders set quotes and trade continuously. In addition to these market makers, two computerized external customers interact, representing both informed and liquidity or noise traders. The amount of transaction information is varied, whereas the level of price information is held constant at a low level. From our results it becoms clear that that uninformed traders gain from an increase in the level of transparency. This gain from transparency comes at the cost of the informed traders. In terms of spreads, we find significant wider opening spreads in transparent markets in contrast with opaque markets. The differences in spreadsize dissappear over time in such a way that the spreads in the transparent markets narrow whereas in opaque markets they remain constant. Finally, we find that transparency significantly enhances the price discovery process.

Abstract:
European banking regulation has been harmonized to a high degree over the last few decades. Nevertheless, the European banking industry remains fragmented as shown by the relatively high market shares of banks in their home countries. In this paper we concentrate on the integration process of European bank share prices. We develop a parsimonious model that is able to detect different integration (correlation) regimes. The model is applied to a set of 41 European banks that have a continuous share price listing over the period January 1990 – March 2003. Our main finding is that the correlation between larger banks in Europe has increased substantially over this period, whereas the correlation between smaller banks has become lower. A reason for this result could be that investors perceive that the activities of bigger banks get more integrated. Another reason may be that as a result of institutional and other larger investors turning their investment strategies towards a European sector-based approach, investors are tracking indices of the European banking sector. These indices are typically constructed from the stock prices of the larger banks. This would create an incentive for large banks to become more integrated with other large banks.

bank integration, equity market integration, bank risk, European banks, regime-switching

Abstract:
It is well known that returns on foreign exchange rates are not normal and tend to have fat-tailed distributions. Although the precise magnitude of the tail-fatness is crucial for applications such as risk analysis, little consensus exists in this respect due to estimation problems. In this paper, we apply a recent method to obtain unbiased inferences from the tails to re-examine the fat-tailedness of FX returns and show that the amount of fat-tailedness has been overestimated considerably. Additionally, goodness-of-fit statistics provide evidence of the appropriateness of assuming that a Student-t distribution underlies the data-generating process of FX returns. Both conclusions appear to hold more for floating than for fixed exchange rates.

Abstract:
There exists a widespread consensus among mainstream academics and investors that socially responsible investing (SRI) leads to inferior, rather than superior, portfolio performance. Using Innovest’s well-established corporate ecoefficiency scores, we provide evidence to the contrary. We compose two equity portfolios that differ in eco-efficiency characteristics and find that our highranked portfolio provided substantially higher average returns compared to its low-ranked counterpart over the period 1995-2003. Using a wide range of performance attribution techniques to address common methodological concerns, we show that this performance differential cannot be explained by differences in market sensitivity, investment style, or industry-specific components. We finally investigate whether this eco-efficiency premium puzzle withstands the inclusion of transaction costs scenarios, and evaluate how excess returns can be earned in a practical setting via a best-in-class stock selection strategy. The results remain significant under all levels of transactions costs, thus suggesting that the incremental benefits of SRI can be substantial.

corporate environmental performance, eco-efficiency, performance measurement, socially responsible investing (SRI), style analysis

Abstract:
In this study we propose the use of the Student's t dependence function to model dependence between asset returns when conducting stress tests. To properly include stress testing in a risk management system, it is important to have accurate information about the (joint) probabilities of extreme outcomes. Consequently, a model for the behavior of risk factors is necessary, specifying the marginal distributions and their dependence. Traditionally, dependence is described by a correlation matrix, implying the use of the dependence function inherent in the multivariate normal (Gaussian) distribution. Recent studies have cast serious doubt on the appropriateness of the Gaussian dependence function to model dependence between extreme negative returns. The student's t dependence function provides an attractive alternative. In this paper, we introduce four tests to analyze the empirical fit of both dependence functions. The empirical results indicate that probabilities assigned to stress tests are largely influenced by the choice of dependence function. The statistical tests reject the Gaussian dependence function, but do not reject the Student's t dependence function.

stress testing, dependence, extreme values, copulas, tail dependence

Abstract:
Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton [Merton, R.C., Lifetime Portfolio Selection under Uncertainty: The Continuous Time Case; Review of Economics and Statistics, Vol. 51, pp. 247-257, 1969] style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to the crisis prone emerging markets.

Asset allocation, Systemic risk, International finance, Regime switching models

Abstract:
Systemic crises can have grave consequences for investors in international equity markets, because it causes the risk-return trade-off to deteriorate severely for a longer period. In this paper we propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton (1969)-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises has a large impact on asset allocation decisions, while the costs of ignoring such crises are substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to emerging markets, being most prone to a crisis. An investor facing short selling constraints withdraws completely from equity markets if the likelihood of a crisis increases.

Asset allocation, systemic risk, international finance, emerging markets, regime switching

Abstract:
This paper analyzes the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross-listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1983) and Sercu (1980) including both the global market portfolio and exchange rate risk premia, and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980-1999. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12 percent of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the U.S., 80 basis points for the U.K., and 100 basis points for France.

Cross-listings, cost of equity capital, foreign exchange exposure

Abstract:
We use a controlled economic experiment to examine the implications of asymmetric information for informational linkages between a stock market and a traded call option on that stock. The setting is based on the Kyle model and Back (1993). We find that an insider trades aggressively in both the stock and the option, and that this leads to important feedback effects between the two markets: price discovery in the stock market also occurs in the option market and vice versa. The time series properties of the stock price depend directly on the intrinsic value of the option: when the intrinsic value of the option is positive, informational efficiency is higher in the market for the stock, and volatility is lower. We argue that this provides new insights into how the introduction of a traded option improves the market quality of the underlying asset.

Market microstructure, experimental economics, information asymmetry, financial derivatives

Abstract:
We use a controlled economic experiment to examine the implications of asymmetric information for informational linkages between a stock market and a traded call option on that stock. The setting is based on the Kyle model and Back (1993). We find that an insider trades aggressively in both the stock and the option, and that this leads to important feedback effects between the two markets: price discovery in the stock market also occurs in the option market and vice versa. The time series properties of the stock price depend directly on the intrinsic value of the option: when the intrinsic value of the option is positive, informational efficiency is higher in the market for the stock, and volatility is lower. We argue that this provides new insights into how the introduction of a traded option improves the market quality of the underlying asset.

information aggregation, experiments, options, price discovery, asymmetric information model

Abstract:
We examine the consequences of transparency in an experimentalmultiple-dealer market with asymmetrically informed dealers. Fiveprofessional securities traders make a market for a single security.In each trading round, one of the dealers (the "insider") is told thesecurity's true value. We vary both pre-trade and post-tradetransparency by changing the way quote and trade information ispublished. The insider's profits are greatest when price efficiency islowest. Price efficiency, in turn, is reduced by pre-tradetransparency and increased by posttrade transparency. Marketliquidity, measured by dealers' bid-ask spreads, is improved bypre-trade transparency and reduced by post-trade transparency.

financial markets, market microstructure, experimental economics, information asymmetry

Abstract:
The growing importance of SRI in the investment arena has resulted in considerable academic interest in the performance of socially responsible equity mutual funds. Remarkably, no attempts have been made to evaluate the performance of mutual funds that invest in socially responsible fixed-income securities. This study fills that gap by measuring the performance of socially responsible bond and balanced funds relative to matched samples of conventional funds, over the period 1987–2003. Using multi-index performance evaluation models, we show that the average SRI bond fund performed similar to conventional funds, while the average SRI balanced fund outperformed its conventional peers by more than 1.3% per year. The expenses charged by SRI funds, match those charged by conventional funds and, evidently, do not cause SRI funds to underperform.

Abstract:
The growing importance of SRI in the investment arena has resulted in considerable academic interest in the performance of socially responsible equity mutual funds. Remarkably, no attempts have been made to evaluate the performance of mutual funds that invest in socially responsible fixed-income securities. This study fills that gap by measuring the performance of socially responsible bond and balanced funds relative to matched samples of conventional funds, over the period 1987-2003. Using multi-index performance evaluation models, we show that the average SRI bond fund performed similar to conventional funds, while the average SRI balanced fund outperformed its conventional peers by more than 1.3% per year. The expenses charged by SRI funds, match those charged by conventional funds and, evidently, do not cause SRI funds to underperform.

Socially Responsible Investing, bonds, mutual funds, performance, SRI, ethical investing, sustainable investing

Abstract:
This paper examines trading costs in markets where dealers search for price quotes (such as multiple-dealer equity markets and foreign exchange). Using an experimental market, we compare four popular models for estimating effective spreads. The theoretical implications of 'bid-ask bounce' are borne out with remarkable accuracy in the time series of transaction prices. More important, the cost of bilateral price search is a significant component of the effective spread (roughly 40 percent using the Roll (1984) measure). These search costs are a distinct component of the spread that has not been considered in the literature.

Abstract:
An increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly then that these benefits are most needed. We investigate the robustness of recent empirical results that indicate correlation breakdown by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the empirical meltdown in diversification could be a result of assuming conditional normally distributed returns. When assuming a popular alternative distribution model - the bivariate Student-t distribution - we find significantly less support for diversification meltdown.

Exceedance correlation, Truncated correlation, Bivariate Student-t correlation

Abstract:
This paper empirically models a number of emotional assets in the optimal investment decision. Using the spanning techniques we analyze how these emotional assets add to the risk-return profile of investors. We find highly significant results for art, wine and books as a significant allocation into the emotional asset sector. Our findings firstly substantiate the current allocation of HNWI in the luxury goods sector, and secondly give rise to substantive evidence for investors choosing to maximize risk and return whilst also being prepared to give up some financial return in some sectors for emotive reasons. This gives insightful evidence that investors tend to integrate both personal and societal values into the portfolio management process and moreover helps us to separate the emotional and investment value when investing into assets in general.

Portfolio Management, Asset pricing, Consumption and Investment decisions

Abstract:
In this paper we present the results of an international survey among 313 CFOs on capitalstructure choice. We document several interesting insights on how theoretical concepts arebeing applied by professionals in the U.K., the Netherlands, Germany, and France and wedirectly compare our results with previous findings from the U.S. Our results emphasize thepresence of pecking-order behavior. At the same time this behavior is not driven by asymmetricinformation considerations. The static trade-off theory is confirmed by the importance of a targetdebt ratio in general, but also specifically by tax effects and bankruptcy costs. Overall, we findremarkably low disparities across countries, despite the presence of significant institutionaldifferences. We find that private firms differ in many respects from publicly listed firms, e.g. listedfirms use their stock price for the timing of new issues. Finally, we do not find substantialevidence that agency problems are important in capital structure choice.

international economics, financial economics, capital structure, debt maturity, equity issues

Abstract:
We examine the extent to which the consequences of insider trading for a financial market depend on the trading mechanism in an experimental multiple dealer asset market. In this market, five professional securities traders make a market in a single asset. In each trading round, one of the market makers receives inside information about the ex-post liquidation value of the asset. The insider thus competes on price directly with the other market makers. We create different trading mechanisms by varying the way quotes and trades are disclosed over the rounds. We find that efficiency is greatest, insider profits are lowest, and bid-ask spreads are smallest in the most transparent trading mechanism.

Abstract:
We investigate the building blocks for institutional investors' successful investment strategies. We focus on organizations which formulate investment beliefs and define clear views on how the capital markets work. We present the results of a world wide survey of investment beliefs. We find striking differences in how asset managers and pension funds view capital markets, and what they believe is their added value.

We link investment beliefs to performance measures and find that pension funds with beliefs on risk diversification show better return-risk performance measures, but also lower costs. Also, funds that hold clear views on risk management realize higher alpha and return/risk ratios.

Investment strategy, Pension funds, Asset managers

Abstract:
This article investigates the building blocks to successful investment strategies for institutional investors. It presents the results of a worldwide survey of investment beliefs, and finds striking differences in how pension funds and commercial asset managers view capital markets. Asset managers seem to use their investment beliefs to demonstrate their competitive advantage to current and potential clients. Pension funds, on the other hand, seem to use formulated investment beliefs as a tool for decision-making. We link investment beliefs to performance measures and find that pension funds with clear beliefs about asset pricing and risk diversification have better return/risk performance measures, as well as lower costs.

Investment Beliefs, Investment Strategy, Pension Fund, Pension Fund Governance, Performance, Rotman

Abstract:
100 years ago this year, Irving Fisher adhered to 'price movements being imperfectly foreseen' resulting in short term deviations from UIP, which in the longer term are averaged away. In this paper, we first review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation relation. Like Fisher a century ago, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. The main contribution from our paper to the literature is by observing the UIP parity condition alongside PPP we are able to observe a common component in deviations in the parity conditions, which is highly correlated. To disentangle whether the common component is the risk premia or the size of errors made in forecasting exchange rates we introduce a third parity condition, the real interest equality. We find considerable commonality in deviations from UIP and PPP suggesting that these deviations are both driven by a common factor as the forecasting errors in exchange rates. Using a dynamic latent factor model we find that deviations from UIP are almost completely due to forecasting errors in exchange rates. Using recent developments in econometric techniques we are therefore able to show that Irving Fisher's conjecture to the source of what has become known as the UIP puzzle was in fact correct. We find that our results of expectational errors being the root of the UIP puzzle, rather than any large time variation in the size of the risk premia our extremely robust across countries and using alternative specifications.

UIP, Irving Fisher, Expectations formation, Dynamic Latent Factor Model, Small-sample problems

Abstract:
Systemic crises can largely affect asset allocations due to the rapid deterioration of the risk-return trade-off. We investigate the effects of systemic crises, interpreted as global simultaneous shocks to financial markets, by introducing an investor adopting a crisis ignorant or crisis conscious strategy. Including the possibility of a systemic crisis is a substantial improvement. Investments in risky assets fall, while allocations to countries less sensitive to a crisis grow relatively. An increasing probability of a crisis exacerbates these effects. The certainty equivalent costs of ignoring systemic crises are large, ranging from 0.65% per year unconditionally, to over 5% per month conditionally on a high probability for the occurrence of a crisis.

asset allocation, systemic risk, international finance, regime switching

Abstract:
This paper analyzes the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Purchasing power parity, real exchange rates, panel models, unit root tests, heterogeneity

Abstract:
In this paper, we first review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation relation. We go on to re-examine the performance of UIP since the advent of floating exchange rates in the 1970s. Like Fisher a century ago, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. We see evidence of this behavior both in the changed coefficients estimates from rolling regressions. We also find considerable commonality in deviations from UIP and PPP suggesting that these deviations are both driven by a common factor as the forecasting errors in exchange rates. Using a dynamic latent factor model we find that deviations from UIP are almost completely due to forecasting errors in exchange rates. Once the variation in the size of the forecasting errors is taken into account we find empirical support of a unitary value for the implied beta in the Fama regression. Using a number of countries we find unanimous support that deviations from UIP are driven by errors made in forecasting exchange rates, a result which we attribute to Irving Fisher who first mentioned this a century to date.

UIP, Irving Fisher, Expectations formation, small-sample problems

Abstract:
This paper analyzes the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Purchasing Power Parity, Real Exchange Rates, Panel Models, Unit Root Tests, Heterogeneity

Abstract:
A number of studies have provided evidence of increased correlation in global financial market returns during bear markets. Others, however, have shown that some of this evidence may have been biased. We derive an alternative estimator for implied correlation based on portfolio downside risk measures that does not suffer from this bias. These unbiased quantile correlation estimates are directly applicable to portfolio optimization and to risk management techniques in general. This simple and practical approach captures the increasing correlation in extreme market conditions while providing a pragmatic approach to understanding correlation structure in multivariate return distributions. Based on data for international equity markets we find evidence of significant increased correlation in extreme returns in international equity markets. This proves the importance of providing a tail adjusted mean-variance covariance matrix.

International equity markets, correlation, extreme returns, downside risk

Abstract:
Using an international database containing 103 German, UK and US ethical mutual funds we review and extend previous research on ethical mutual fund performance. By applying a multi-factor Carhart (1997) model we overcome the benchmark problem most prior ethical studies suffered from. After controlling for investment style, we find no evidence of significant differences in risk-adjusted returns between ethical and conventional funds for the 1990-2001 period. Our results also suggest that ethical mutual funds underwent a catching up phase, before delivering financial returns similar to those of conventional mutual funds. Finally, our performance estimates are robust to the inclusion of ethical indexes, which, surprisingly, are not incrementally capable of explaining ethical mutual fund return variation.

Mutual Funds, Performance evaluation, Style Analysis, Ethical Investments

Abstract:
Using an international database containing 103 German, UK and US ethical mutual funds, we review and extend previous research on ethical mutual fund performance. By applying a multi-factor Carhart (1997) model we solve the benchmark problem most prior ethical studies suffered from. After controlling for investment style, we find little evidence of significant differences in risk-adjusted returns between ethical and conventional funds for the 1990-2001 period. Introducing time variation in betas however leads to a significant under-performance of domestic US funds and a significant out-performance of UK ethical funds, relative to their conventional peers. Finally, we differentiate previous results by documenting a learning effect. After a period of strong under-performance, older ethical funds finally are catching up, while younger funds continue to under-perform both the index and conventional peers.

Ethical mutual funds, investment style

Abstract:
We review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are connected to individual episodes in which errors surrounding exchange rate expectations are persistent, but eventually transitory. We find considerable commonality in deviations from UIP and PPP, suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model, we find that deviations from UIP are almost entirely due to expectational errors in exchange rates, rather than attributable to the risk premium; a result consistent with those reported by Fisher a century ago.

Irving Fisher, UIP, PPP, inflation, interest rates, exchange rates

Abstract:
This Paper analyses the effects of residential property holdings on optimal investment portfolios. Using a mean-variance framework, we show that residential real estate offers significant diversification benefits relative to investments in stocks and bonds for US investors. Risk averse investors that hold residential real estate for investment purposes have future wealth that is less volatile. For most geographical areas in the US, investors have the best diversification benefits from residential real estate when about 30% of their investment portfolio is residential real estate. In addition to this diversification effect, we find that stocks and bonds do not provide a good hedge for positions in real estate, implying that the relative demand for either is not significantly affected by home ownership. For less risk averse agents the price return on real estate is too low in order to justify inclusion in the investment portfolio. This implies that if agents invest a significant fraction of their wealth in their house, the non-price increase, i.e., the consumption benefits, should be significant. Our estimates suggest that the order of magnitude of these non-price increases is about 10% per year.

Portfolio choice, real estate, home ownership

Abstract:
This Paper analyses to what extent international and domestic asset pricing models lead to a different estimates of the cost of capital for an individual firm. We distinguish between (i) the multifactor ICAPM of Solnik (1983) and Sercu (1980) including both the global market portfolio and exchange rate risk premiums, and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 3,293 stocks from nine countries in the period 1980-99. We find that the domestic CAPM yields a different estimate of the cost of capital from the multifactor ICAPM for only three percent of the firms in our sample. The difference amounts to on average 50 basis points for the US, 75 basis points for Germany and Japan and similar differentials for the other countries. We attribute these findings to strong country factors in individual stock returns.

Cost of capital, ICAPM, pricing error, exchange rate exposure

Abstract:
This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for crosslisted stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980-99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France.

Abstract:
This paper analyses the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

International economics, purchasing power parity, real exchange rates, panel models, unit root tests, heterogeneity

Abstract:
We review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are connected to individual episodes in which errors surrounding exchange rate expectations are persistent, but eventually transitory. We find considerable commonality in deviations from UIP and PPP, suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model, we find that deviations from UIP are almost entirely due to forecasting errors in exchange rates, a result consistent with those reported by Fisher a century ago.

Expectations formation, Irving Fisher, small-sample problems, UIP

Abstract:
The discrete time analogue of the continuous time Krugman target zone model is developed in order to capture the typical volatility clusters and fat-tailed distributed innovations of exchange rates. It is shown that under these more general stochastic conditions the S-shaped relation between exchange rate fundamentals is preserved, but is less pronounced. The model is tested for its S-shape and stochastic properties. Two clearly distinct sets of EMS currencies are detected on the basis of curvature features. One-step-ahead realignment probabilities are used as an alternative evaluation method.

EMS currencies, fat tails, realignment probability

Abstract:
In the literature on the empirical unconditional distribution of forein exchange rate returns there is indication that the type of distribution function is related to the form of the exchange rate regime. The analysis has been hampered by the nonnestedness of the alternative distribution models. The paper investigates the issue by means of extremal analysis which allows for a unified treatment. In particular, we try to sort out whether apparent distributional differences are due to differences in techniques or regimes.

exchnage rate regime, tails, distribution

Abstract:
This paper compares foreign exchange market intervention in case there is no uncertainty about the extent of an imperfectly sustainable target zone and where there is uncertainty. A well-known example of the first case was the European Monetary System between 1979 and 1992. An example of the latter is the dirty floating of the dollar against the Dmark and yen after the so-called Louvre Accord in 1987. The analysis shows that the instantaneous effectiveness of intervention tends to be larger the more implicit the band policy is. our empirical results which use Belgian and US intervention data support this claim.

official intervention, target zones

Abstract:
For three out of five major stockmarkets it is found that those levels which are a multitude of a hundred are approached and transgressed infrequently. We explicitly test for the effect of sample bias and conduct a forecasting experiment.

psychological barriers, stock markets

Abstract:
Does socially responsible investing (SRI) lead to inferior or superior portfolio performance? This study focused on the concept of eco-efficiency, which can be thought of as the economic value a company creates relative to the waste it generates, and found that SRI produced superior performance. Based on Innovest Strategic Value Advisors' corporate eco-efficiency scores, the study constructed and evaluated two equity portfolios that differed in eco-efficiency. The high-ranked portfolio provided substantially higher average returns than its low-ranked counterpart over the 1995-2003 period. This performance differential could not be explained by differences in market sensitivity, investment style, or industry-specific factors. Moreover, the results remained significant for all levels of transaction costs, suggesting that the incremental benefits of SRI can be substantial.

Portfolio Management, Equity Strategies, Performance Measurement and Evaluation, Performance Measurement, Corporate Governance

Abstract:
Analysis of 3,300 stocks from nine industrialized countries over the 1980-99 period indicates that whether the capital asset pricing model or some form of international CAPM is used makes little difference in the cost-of-capital estimate for most companies in most countries. The international CAPM yielded an estimate of the cost of equity capital that was significantly different from that of the domestic CAPM in only 4-5 percent of the sample companies. For the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors.

Equity Investments, fundamental analysis and valuation models, Corporate Finance, capital investment decisions

Abstract:
A number of studies have provided evidence of increased correlations in global financial market returns during bear markets. Other studies, however, have shown that some of this evidence may be biased. We derive an alternative to previous estimators for implied correlation that is based on measures of portfolio downside risk and that does not suffer from bias. The unbiased quantile correlation estimates are directly applicable to portfolio optimization and to risk management techniques in general. This simple and practical method captures the increasing correlation in extreme market conditions while providing a pragmatic approach to understanding correlation structure in multivariate return distributions. Based on data for international equity markets, we found evidence of significant increased correlation in international equity returns in bear markets. This finding proves the importance of providing a tail-adjusted mean-variance covariance matrix.

Abstract:
Benefits to portfolio diversification depend crucially on correct correlation estimates, hence it is of great importance to both risk management and portfolio optimisation that the exact nature of the correlation structure between international financial assets is understood. Recent discussion on the correlation of international equity returns has focussed on the issue of whether extreme movements in international financial markets are more highly correlated than usual returns. This implies a reduction in the benefits from portfolio diversification since extreme returns are more likely to occur with greater simultaneity. Using the Value-at-Risk methodology we are able to measure the quantile correlation structure implicit in international asset returns in a simple manner without having to resort to fully parametric modelling. We illustrate that the extraction of the quantile covariance structure from this quantile correlation structure is non-trivial. Using daily data on stock market indices for a variety of countries we observe how the correlation and covariance structure changes as we move into the tails of the return distribution. We find for extreme stock market movements the benefits to international diversification are significantly curtailed even after discarding spurious correlation changes.

Abstract:
This paper compares foreign exchange market intervention in case there is no uncertainty about the extent of an imperfectly sustainable target zone and where there is uncertainty. A well-known example of the first case was the European Monetary System between 1979 and 1992. An example of the latter is the dirty floating of the dollar against the Dmark and yen after the so-called Louvre Accord in 1987. The analysis shows that the instanta- neous effectiveness of intervention tends to be larger the more implicit the band policy is. Our empirical results which use Belgian and US intervention data support this claim.

Abstract:
Using data on Asian equity markets, we observe that during periods of financial turmoil, deviations from the mean-variance framework become more severe, resulting in periods with additional downside risk to investors. Current risk management techniques failing to take this additional downside risk into account will underestimate the true Value-at-Risk with greater severity during periods of financial turnoil. We provide a conditional approach to the Value-at-Risk methodology, known as conditional VaR-x, which to capture the time variation of non-normalities allows for additional tail fatness in the distribution of expected returns. These conditional VaR-x estimates are then compared to those based on the RiskMetricsTM methodology from J.P. Morgan, where we find that the model provides improved forecasts of the Value-at-Risk. We are therefore able to show that our conditional VaR-x estimates are better able to capture the nature of downside risk, particularly crucial in times of financial crises.

Abstract:
The discrete time analogue of the continuous time Krugman target zone model is developed in order to capture the typical volatility clusters and fat tailed distributed innovations of exchange rates. It is shown that under these more general stochastic conditions the S-shaped relation between exchange rate and fundamentals is preserved. The model is tested for its S-shape and stochastic properties. To measure the degree of credibility of the EMS zone we calculate realignment probabilities and use the model to develop investment strategies which are compared with the simple random walk buy and hold strategy.

Abstract:
In this paper we present and estimate a model of short-term interest rate volatility, that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of discount bond options. Our findings indicate that the inclusion of a volatility effect in addition to a level effect in the model specification is particularly relevant for the pricing of shorter-term discount bond options.

Abstract:
In this paper, we analyze bilateral real exchange rate behavior for fifteen countries over the period May 1925 to December 1937, using a modified principal components technique that is invariant to the choice of benchmark currency. For the gold exchange rate period May 1925 - August 1931, we find that half of real exchange rate variation originates from countries on floating nominal exchange rates, stabilizing their economies, and half from price level differences between countries on the gold standard. For the managed floating period September 1931 - December 1937, we conclude that real exchange rate movements between the sterling-bloc, the European gold-bloc, and the US/Canada are dominant. Within bloc variation is secondary and, moreover, mostly due to competitive devaluations during transition periods. Our results support earlier evidence that the nominal exchange rate regime to a large extent determines real exchange rate variation.

Abstract:
For the individual, the pension is part of the investment portfolio, and should, therefore, be analyzed in the context of that portfolio. Individual asset portfolios often deviate far from the market portfolio composition. Consequently, individuals run unwanted specific risk. If pension funds were to offer investment portfolios complementary to the individual asset portfolios, the resulting portfolios would be better diversified. This reduces risk for the fund's clients.

Abstract:
Using a new survey data set of matched exchange rate and interest rate expectations for eight currencies relative to the German mark, we examine empirically the relationship between exchange rate returns, "news" and risk premia. "News" on interest differentials enters significantly in equations for the difference between the spot rate and the lagged forward rate for the British pound, Japanese yen, Spanish peseta and the U.S. dollar. An unexpected rise in the interest rate differential tends to strengthen the domestic exchange rate. For each of these currencies, we also find significant effects of our ex-ante measure of the risk premium. In addition, we investigate the effect of lagged interest rate differentials as proxy for the risk premium and find that they do not capture time-varying risk premia as is widely suggested in the literature, but probably capture a peso-problem, learning about a policy change, a market-inefficiency or a combination of these factors.

Abstract:
In this paper hedging foreign currency exposure is reconsidered. We investigate the sensitivity of hedge ratios for the well-documented existence of unconditional kurtosis in asset and exchange rate returns. We derive theoretical hedge ratios for fat-tailed asset return distributions and find that they, depending on the degree of relative risk aversion, can differ substantially from the minimum-variance case. The empirical results indicate, however, that there is no significant effect of the fat-tailed hedge ratios on the performance of the hedged portfolios. The performance of hedged portfolios is not very sensitive to the specification of the variance and higher moments.

Abstract:
To ensure a competent regulatory framework with respect to Value-at-Risk for establishing Bank's capital adequacy requirements, as promoted by the Basle Committee, then the parametrical approach to estimate VaR needs to incorporate fat tails, apparent in the return distributions of financial assets. This paper provides a simple method to obtain accurate parametric VaR measures by including a specific measure for the tail fatness of an asset's return distribution. We provide evidence for the accuracy of these VaR+ estimates by comparing different parametric VaR estimators for bi-weekly returns on US stock and bond returns.

Abstract:
We examine the effects of price disclosure on market performance in a continuous experimental multiple-dealer market in which seven professional market-makers trade a single security. The dealers trade with one another and with computerized informed and liquidity traders. Our key comparison is between fully public price queues (pre-trade transparent market) and bilateral quoting (pre-trade opaque). We find that opening spreads are wider and trading volume is lower in the opaque markets, due to higher search costs there. More importantly, however, higher search costs also induce more aggressive pricing strategies, so that price discovery is much faster in the opaque markets.

Abstract:
This paper compares the performances of centralized and decentralized communication schemes in financial markets. The results are obtained from trading sessions in an experimental financial market, in which we varied the communication structure among different sessions. We found that, in bilateral market structures, although known to be inefficient in terms of arbitrage opportunities, the pricediscovery process is more powerful than in common information communication schemes. This result suggests a rationale for a co-existence of both centralized and decentralized communication schemes in financial markets.

Abstract:
In this paper, we investigate whether real estate returns are driven by continental factors. This is especially relevant for determining the country allocation of international real estate portfolios. Strong continental factors imply that optimal diversification can only be achieved by investing inter-continentally. We find strong continental factors in Europe and North America. For the Asia/Pacific region, real estate returns were independent of continental influences. This implies that European, North American and Asian real estate investors can find the best diversification opportunities in the Asia/Pacific region.

Abstract:
The paper looks at currency hedging and international diversification of equity portfolios from a safety first perspective. We modify Arzac and Bawa's (1977) version of the Roy's safety first criterion and show how it can be successfully improved upon by exploiting the fat tail property of asset returns and the statistical theory of extremes. The latter provides a much sharper bound on the probability of disastrous returns than does the Chebyshev bound. We look at currency hedging for a portfolio of international currencies without regard for the underlying investment, and find relatively high levels of hedging. Then we look at currency hedging for a given international equity portfolio and find lower hedge ratios, showing a portfolio effect of international diversification in reducing risk of currency movements. Finally, we look at joint optimization of portfolio composition and hedging, and find further evidence of portfolio effects between equity returns in local currency and exchange rate movements.

Abstract:
In this paper we examine the impact of domestic and ERM-wide monetary conditions on national inflation rates in Belgium, France, Germany, Italy and the Netherlands for the period 1973-1994 and two sub periods using an extended open-economy version of the standard P*-model. The results show that the domestic price gaps have gradually been crowded out by the European price gap since the establishment of the ERM for the four non-anchor countries, indicating a loss of monetary autonomy. For Germany, both the domestic and the European price gap are significant after 1986. Although Germany still has a certain degree of monetary independence, the results show that monetary conditions in Germany's immediate neighbors increasingly matter for inflation in Germany. This points to the need for greater attention for the development of aggregate European monetary conditions by all countries, including Germany, and closer coordination of monetary policy.

Abstract:
Increasing capital market integration has important implications for the calculation of the cost of capital. In an integrated world the cost of capital should be determined using the International Capital Asset Pricing Model rather than the domestic Capital Asset Pricing Model. In this paper we investigate this issue with an asset pricing model that explicitly allows for deviations from Purchasing PowerParity. The pricing error when using the domestic Capital Asset Pricing Model rather than an International Capital Asset Pricing Model is zero if diversifiable domestic risk is orthogonal to the global market portfolio return and foreign currency changes. We use Hansen's (1982) Generalized Method of Moments to test for orthogonality and implement this test for more than 3000 individual stocks of 10 different countries. We cannot reject that the global market portfolio and the foreign currencies affect the cost of capital of an individual firm through the effect of the global market on the risk premium of the local market and not through the global beta of the firm.

Abstract:
Risk premia, peso-problems and market-inefficiencies have been suggested as candidate explanations for the apparent rejection of the unbiased hypothesis. If various explanations interact, a panel approach is called for. In this paper we estimate different panel models, that allow for cross-sectional dependence of exchange rates, for fifteen currencies between 1979 and 1996. We show that the deviation from uncovered interest parity is smaller than commonly presumed. Estimates of the slope coefficients of the forward premium appear to be positive but still significantly different from unity. In addition it is shown that this coefficient is close to unity if only five to ten percent of the largest changes in the forward premium are taken into account. These findings point to the importance of peso-problems and inactivity bands as explanations for the apparent rejection of the uncovered interest parity relationship.