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Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types of companies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types of companies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types ofcompanies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities andcompetition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types of companies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types ofcompanies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types ofcompanies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five plus percent per annum relative to the aggregate public equity market. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the cash flow, return, and risk characteristics of private equity. Unlike previous studies, we have detailed cash flow data for each fund, rather than aggregate or accounting returns. We also know the exact timing of investments and capital returns to investors and the number and types of companies each fund invested in. We document the draw down and capital return schedules for the typical private equity fund, and show that it takes several years for capital to be invested, and over ten years for capital to be returned to generate excess returns. We provide several determining factors for these schedules, including existing investment opportunities and competition amongst private equity funds. In terms of performance, we document that private equity generates excess returns on the order of five to eight percent per annum relative to the aggregate public equity market. Moreover, while we estimate the betas of the private equity funds' portfolios to be greater than one, we show that on a risk-adjusted basis the excess value of the typical private equity fund is on the order of 24 percent relative to the present value of the invested capital. One interpretation of this magnitude is that it represents compensation for holding a 10-year illiquid investment.

Venture capital, Private equity, Liquidity

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is sticky in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private equity, Venture capital, Alternative investments, Fund management

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is sticky in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private equity, Venture capital, Alternative investments, Fund management

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is sticky in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private equity, Venture capital, Alternative investments, Fund management

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is sticky in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private equity, Venture capital, Alternative investments, Fund management

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds' investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is 'sticky' in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private equity, Venture capital, Alternative investments, Fund management

Abstract:
The hybrid approach combines the two most popular approach to VaR estimation: RiskMetrics and Historical Simulation. It estimates the VaR of a portfolio by applying exponentially declining weights to past returns and then finding the appropriate percentile of this time-weighted empirical distribution. This new approach is very simple to implement. Empirical tests show a significant improvement in the precision of VaR forecasts using the hybrid approach relative to RiskMetrics and Historical Simulation. It is especially appropriate for calculating the VaR of fat-tailed and highly skewed data, with rapidly changing moments. As an aside, we also introduce a new method for testing the perfomance of various VaR forecasts.

Abstract:
This paper provides a survey of some existing as well as new evidence of the relation between market prices and fundamentals in the internet sector over the period January 1998 to February 2000. Appealing to results across a broad class of outcomes, we demonstrate a strong, circumstantial case against market rationality. In particular, we investigate (i) the level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to information-based events, (iii) internet-related anomalies, and (iv) the volatility of internet prices. As a potential explanation, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that "optimistic" investors overwhelm "pessimistic" ones, leading to prices not reflecting fundamental values. Empirical support for this model is provided using data from the stock shorting market.

Market efficiency, investments, event study, Internet

Abstract:
This paper analyzes the determinants of buyout funds investment decisions. In a model in which the supply of capital is sticky in the short run, we link the timing of funds investment decisions, their risk-taking behavior, and the returns they subsequently earn on their buyouts tochanges in the demand for private equity, conditions in the credit market, and funds ability to influence their perceived talent in the market. Using a proprietary dataset of 207 buyout funds that invested in 2,274 buyout targets over the last two decades, we then investigate the implications of the model. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is freefrom reporting and survivor biases. Thus, we are able to characterize every buyout fund s precise investment choices. Our empirical findings are consistent with the model. First, established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen. Second, the investment behavior of first-time funds is less sensitive to market conditions. Third, younger funds invest in riskier buyouts, in an effort to establish a track record. Fourth, following periods of good performance, funds become more conservative, and this effect is stronger for youngerfunds.

Private equity, Buyout funds, Alternative investments, Fund management

Abstract:
This paper analyzes the determinants of buyout funds' investment decisions. In a model in which the supply of capital is sticky in the short run, we link the timing of funds' investment decisions, their risk-taking behavior, and the returns they subsequently earn on their buyouts to changes in the demand for private equity, conditions in the credit market, and funds' ability to influence their perceived talent in the market. Using a proprietary dataset of 207 buyout funds that invested in 2,274 buyout targets over the last two decades, we then investigate the implications of the model. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is free from reporting and survivor biases. Thus, we are able to characterize every buyout fund's precise investment choices. Our empirical findings are consistent with the model. First, established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen. Second, the investment behavior of first-time funds is less sensitive to market conditions. Third, younger funds invest in riskier buyouts, in an effort to establish a track record. Fourth, following periods of good performance, funds become more conservative, and this effect is stronger for younger funds.

Abstract:
This paper analyzes the determinants of buyout funds' investment decisions. In a model in which the supply of capital is 'sticky' in the short run, we link the timing of funds' investment decisions, their risk-taking behavior, and the returns they subsequently earn on their buyouts to changes in the demand for private equity, conditions in the credit market, and funds' ability to influence their perceived talent in the market. Using a proprietary dataset of 207 buyout funds that invested in 2,274 buyout targets over the last two decades, we then investigate the implications of the model. Our dataset contains precisely dated cash inflows and outflows in every portfolio company, links every buyout target to an identifiable buyout fund, and is free from reporting and survivor biases. Thus, we are able to characterize every buyout fund's precise investment choices. Our empirical findings are consistent with the model. First, established funds accelerate their investment flows and earn higher returns when investment opportunities improve, competition for deal flow eases, and credit market conditions loosen. Second, the investment behavior of first-time funds is less sensitive to market conditions. Third, younger funds invest in riskier buyouts, in an effort to establish a track record. Fourth, following periods of good performance, funds become more conservative, and this effect is stronger for younger funds.

Private equity, Buyout funds, Alternative investments, Fund management

Abstract:
After an initial public offering, most existing shareholders are subject to a lock-up period in which they cannot sell their shares for a prespecified time. At the end of the lock-up, there is a permanent and large shift in the supply of shares. The lock-up expiration is a particularly interesting event to study because it is (i) completely known and observable, and (ii) potentially meaningful economically given the existing literature on supply shocks. This paper investigates volume and price patterns around this period, and documents several interesting results. Specifically, even though the event is totally anticipated, there is a 1% -- 3% drop in the stock price, and a 40% increase in volume, when the lock-up ends. Various explanations are considered and rejected, suggesting a new anomalous fact against market efficiency. However, convincing evidence is provided which shows that this inefficiency is not exploitable, i.e., arbitrage is not violated. This aside, the evidence points to a downward sloping demand curve for shares, with the most likely explanation pointing to a permanent, long-run effect.

Abstract:
Using a unique dataset of private equity funds over the last two decades, this paper analyzes the investment behavior of private equity fund managers. Based on recent theoretical advances, we link the timing of funds' investment and exit decisions, and the subsequent returns they earn on their portfolio companies, to changes in the demand for private equity in a setting where the supply of capital is 'sticky' in the short run. We show that existing funds accelerate their investment flows and earn higher returns when investment opportunities improve and the demand for capital increases. Increases in supply lead to tougher competition for deal flow, and private equity fund managers respond by cutting their investment spending. These findings provide complementary evidence to recent papers documenting the determinants of fund-level performance in private equity.

Private Equity, Investment decisions, Venture Capital

Abstract:
This paper investigates the relation between returns on stock indices and their corresponding futures contracts in order to evaluate potential explanations for the pervasive yet anomalous evidence of positive, short-horizon portfolio autocorrelations. Using a simple theoretical framework, we generate empirical implications for both microstructure and behavioral models. These implications are then tested using futures data on 24 contracts across 15 countries. The major findings are (i) return autocorrelations of indices tend to be positive even though their corresponding futures contracts have autocorrelations close to zero, (ii) these autocorrelation differences between spot and futures markets are maintained even under conditions favorable for spot-futures arbitrage, and (iii) these autocorrelation differences are most prevalent during low volume periods. These results point us towards a market microstructure-based explanation for short-horizon autocorrelations and away from explanations based on current popular behavioral models.

Abstract:
This paper investigates the relation between returns on stock indices and their corresponding futures contracts in order to evaluate potential explanations for the pervasive yet anomalous evidence of positive, short-horizon portfolio autocorrelations. Using a simple theoretical framework, we generate empirical implications for both microstructure and behavioral models. These implications are then tested using futures data on 24 contracts across 15 countries. The major findings are (I) return autocorrelations of indices tend to be positive even though their corresponding futures contracts have autocorrelations close to zero, (ii) these autocorrelation differences between spot and futures markets are maintained even under conditions favorable for spot-futures arbitrage, and (iii) these autocorrelation differences are most prevalent during low volume periods. These results point us towards a market microstructure-based explanation for short-horizon autocorrelations and away from explanations based on current popular behavioral models.

Abstract:
This paper investigates the relation between returns on stock indices and their corresponding futures contracts in order to evaluate potential explanations for the pervasive yet anomalous evidence of positive, short-horizon portfolio autocorrelations. Using a simple theoretical framework, we generate empirical implications for both microstructure and behavioral models. These implications are then tested using futures data on 24 contracts across 15 countries. The major findings are (I) return autocorrelations of indices tend to be positive even though their corresponding futures contracts have autocorrelations close to zero, (ii) these autocorrelation differences between spot and futures markets are maintained even under conditions favorable for spot-futures arbitrage, and (iii) these autocorrelation differences are most prevalent during low volume periods. These results point us towards a market microstructure-based explanation for short-horizon autocorrelations and away from explanations based on current popular behavioral models.

Abstract:
This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of "thin air", our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model's implications for the term structure of term premiums.

Abstract:
This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of thin air,' our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model's implications for the term structure of term premiums.

Abstract:
This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of "thin air," our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model's implications for the term structure of term premiums.

Abstract:
This paper provides one potential explanation for the rise, persistence and eventual fall of internet stock prices. Specifically, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that "optimistic" investors overwhelm "pessimistic" ones, leading to prices not reflecting fundamental values about cash flows summarized by aggregate beliefs. Empirical support for this explanation is provided by exploring the behavior of internet stock prices during the period January 1998 to November 2000. In particular, we document four important elements to our story: (i) the high level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to a shift towards potentially optimistic investors, (iii) empirical results consistent with shorting being at its maximum possible level for internet stocks, and (iv )the eventual fall, or bubble bursting, of internet stocks being tied to the increase in the number of sellers to the market via expiration of lockup agreements.

Abstract:
We investigate the empirical implications of using various measures of payout yield rather than dividend yield for asset pricing models. We find statistically and economically significant predictability in the time series when payout (dividends plus repurchases) and net payout (dividends plus repurchases minus issuances) yields are used instead of dividend yield. Similarly, we find that payout (net payout) yields contain information about the cross-section of expected stock returns exceeding that of dividend yield and that the high minus low payout yield portfolio is a priced factor.

Stock Returns, Predictability, Dividend Yield, Share Repurchases, Measurement Error

Abstract:
Previous research showed that the dividend price ratio process changed remarkably during the 1980`s and 1990`s, but that the total payout ratio (dividends plus repurchases over price) changed very little. We investigate implications of this difference for asset pricing models. In particular, the widely documented decline in the predictive power of dividends for excess stock returns in time series regressions in recent data is vastly overstated. Statistically and economically significant predictability is found at both short and long horizons when total payout yield is used instead of dividend yield. We also provide evidence that total payout yield has information in the cross-section for expected stock returns exceeding that of dividend yield and that the high minus low payout yield portfolio is a priced factor. The evidence throughout is shown to be robust to the method of measuring total payouts.

Abstract:
There is strong evidence in the literature that dividends and repurchases have been substitutes for each other throughout the 80's and 90's. Asset pricing models that try to relate cash flow distributions to asset prices need to take this into account. We find that while the dividend price ratio process has changed remarkably during the period, the total payout ratio (dividends plus repurchases normalized by price) has changed very little. More importantly, this difference has implications for asset pricing models. The widely documented decline in the predictive power of dividends for excess stock returns in recent periods is vastly overstated. Statistically and economically significant predictability is found at both short and long horizons when total payouts are used instead of dividends. In addition, we provide evidence that payouts have information in the cross-section for expected stock returns, which exceeds that of dividends.

Stock Returns, Predictability, Dividend Yield, Share Repurchases, Measurement Error

Abstract:
The standard VaR approach considers only terminal risk, completely ignoring the sample path of portfolio values. In reality interim risk may be critical in a mark-to-market environment. Sharp declines in value may generate margin calls and affect trading strategies. In this paper we introduce the notion of MaxVaR, analogous to VaR in every way except it quantifies the probability of seeing a given loss on or before the terminal date rather than at the terminal date. Under standard set of assumptions we provide a simple formula for MaxVaR and examine the ratio of MaxVaR to VaR. For reasonable parameterizations MaxVaR may exceed VaR by over 40%. MaxVaR exceeds VaR by as much as 80% or more for high Sharpe Ratio hedge-fund-like return distributions.

Value at risk, drawdown risk, long horizon risk

Abstract:
The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. Forexample, for the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons, due to the combined effects of overlapping returns and the persistence of the predictive variable. Common sampling error across equations leads to ordinary least squares coefficient estimatesand R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. The asymptotic theory is corroborated, and the analysis extended by extensive simulation evidence. We perform joint tests across horizons for a variety of explanatory variables, and provide an alternative view of the existing evidence.

Abstract:
The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. Forexample, for the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons, due to the combined effects of overlapping returns and the persistence of the predictive variable. Common sampling error across equations leads to ordinary least squares coefficient estimatesand R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. The asymptotic theory is corroborated, and the analysis extended by extensive simulation evidence. We perform joint tests across horizons for a variety of explanatory variables, and provide an alternative view of the existing evidence.

Abstract:
The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. For the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons. Common sampling error across equations leads to ordinary least squares coefficient estimates and R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. We perform joint tests across horizons for a variety of explanatory variables and provide an alternative view of the existing evidence.

G12, G14, C12

Abstract:
The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. For example, for the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons, due to the combined effects of overlapping returns and the persistence of the predictive variable. Common sampling error across equations leads to ordinary least squares coefficient estimates and R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. The asymptotic theory is corroborated, and the analysis extended by extensive simulation evidence. We perform joint tests across horizons for a variety of explanatory variables, and provide an alternative view of the existing evidence.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. For example, for the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons, due to the combined effects of overlapping returns and the persistence of the predictive variable. Common sampling error across equations leads to ordinary least squares coefficient estimates and R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. The asymptotic theory is corroborated, and the analysis extended by extensive simulation evidence. We perform joint tests across horizons for a variety of explanatory variables, and provide an alternative view of the existing evidence.

long-horizon, predictability, joint tests, persistent regressors

Abstract:
This paper investigates the relation between returns on stock indices and their corresponding futures contracts in order to evaluate potential explanations for the pervasive yet anomalous evidence of positive, short-horizon portfolio autocorrelations. Using a simple theoretical framework, we generate empirical implications for both microstructure and partial adjustment models. These implications are then tested using futures data on 24 contracts across 15 countries. The major findings are (i) return autocorrelations of indices tend to be positive even though their corresponding futures contracts have autocorrelations close to zero, (ii) these autocorrelation differences between spot and futures markets are maintained even under conditions favorable for spot-futures arbitrage, and (iii) these autocorrelation differences are most prevalent during low volume periods. These results point us towards a market microstructure-based explanation for short-horizon autocorrelations and away from explanations based on current popular behavioral models.

Abstract:
The behavioral finance literature cites the frozen concenated orange juice (FCOJ)futures market as a prominent example of the failure of prices to reflect fundamentals.This paper reexamines the relation between FCOJ futures returns and fundamentals,focusing primarily on temperature. We show that when theory clearly identifies the fundamental,i.e.,at temperatures close to or below freezing,there is a close link between FCOJ prices and that fundamental.Using a simple, theoretically-motivated,nonlinear,state dependent model of the relation between FCOJ returns and temperature,we can explain approximately 50% of the return variation.This is important because while only 4.5%of the days in winter coincide with freezing temperatures,two-thirds of the entire winter return variability occurs on these days.Moreover,when theory suggests no such relation,i.e.,at most temperature levels,we show empirically that none exists.The fact that there is no relation the majority of the time is good news for the theory and for market efficiency, not bad news.In terms of residual FCOJ return volatility,we also show that other fundamental information about supply,such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions.The fact that, even in the comparatively simple setting of the FCOJ market,it is easy to erroneously conclude that fundamentals have little explanatory power for returns serves as an important warning to researchers who attempt to interpret the evidence in markets where both fundamentals and their relation to prices are more complex.

Abstract:
The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. In contrast, we show that when theory clearly identifies the fundamental, e.g.,temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple, theoreticallymotivated, nonlinear, state dependent model, we can explain approximately 50% of the return variation on days with freezing temperatures. Moreover, while these observations represent less than 4.5% of the winter sample, they account for two-thirds of the entire winter return variability.

Abstract:
The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. This paper reexamines the relation between FCOJ futures returns and fundamentals, focusing primarily on temperature. We show that when theory clearly identifies the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple, theoretically-motivated, nonlinear, state dependent model of the relation between FCOJ returns and temperature, we can explain approximately 50% of the return variation. This is importantbecause while only 4.5% of the days in winter coincide with freezing temperatures, two-thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact thatthere is no relation the majority of the time is good news for the theory and for market efficiency, not bad news. In terms of residual FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The fact that, even in the comparatively simple setting of the FCOJ market, it is easy to erroneously conclude that fundamentals have little explanatory power for returns serves as an important warning to researchers who attempt to interpret the evidence in markets where both fundamentals and their relation to prices are more complex.

Abstract:
The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. This paper reexamines the relation between FCOJ futures returns and fundamentals, focusing primarily on temperature. We show that when theory clearly identifies the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple, theoretically-motivated, nonlinear, state dependent model of the relation between FCOJ returns and temperature, we can explain approximately 50% of the return variation. This is important because while only 4.5% of the days in winter coincide with freezing temperatures, two-thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact that there is no relation the majority of the time is good news for the theory and for market efficiency, not bad news. In terms of residual FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The fact that, even in the comparatively simple setting of the FCOJ market, it is easy to erroneously conclude that fundamentals have little explanatory power for returns serves as an important warning to researchers who attempt to interpret the evidence in markets where both fundamentals and their relation to prices are more complex.

excess volatility, nonlinear, state dependence

Abstract:
This paper investigates the conditional volatility of the firm's assets in contrast to existing studies that focus primarily on equity volatility. Using a novel dataset that allows us to map out significant portions of the capital structure, we examine the volatility properties of asset returns as calculated by a weighted average of equity, bond and loan prices. The two fundamental findings in this paper are that asset volatility is time-varying and that financial leverage matters and has a large influence on equity volatility. Within this backdrop, several new results emerge. First, leverage plays a more important role than previously thought in explaining the well-documented asymmetric volatility effect. Second, equity volatility possesses both a transitory component due primarily to asset volatility and a more permanent component due to financial leverage. Third, in terms of a breakdown of the determinants of equity volatility, we relate implied equity volatility levels and changes to different components of estimated asset volatility (i.e., both idiosyncratic and market, including lagged volatility and asymmetric return shocks) and to leverage at the firm level.

time-varying volatility, firm's assets, leverage, feedback effect

Abstract:
This paper provides one potential explanation for the rise, persistence and eventual fall of internet stock prices. Specifically, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that â¬Soptimisticâ¬? investors overwhelm â¬Spessimisticâ¬? ones, leading to prices not reflecting fundamental values about cash flows summarized by aggregate beliefs. Empirical support for this explanation is provided by exploring the behavior of internet stock prices during the period January 1998 to November 2000. In particular, we document four important elements to our story: (i) the high level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to a shift towards potentially optimistic investors, (iii) empirical results consistent with shorting being at its maximum possible level for internet stocks, and (iv) the eventual fall, or bubble bursting, of internet stocks being tied to the increase in the number of sellers to the market via expiration of lockup agreements.

Abstract:
This paper explores a model based on agents with heterogeneous beliefs facing short sales restrictions, and its explanation for the rise, persistence, and eventual fall of Internet stock prices. First, we document substantial short sale restrictions for Internet stocks. Second, using data on Internet holdings and block trades, we show a link between heterogeneity and price effects for Internet stocks. Third, arguing that lockup expirations are a loosening of the short sale constraint, we document average, long-run excess returns as low as -33 percent for Internet stocks post lockup. We link the Internet bubble burst to the unprecedented level of lockup expirations and insider selling.

Abstract:
This paper provides one potential explanation for the rise, persistence and eventual fall of internet stock prices. Specifically, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that "optimistic" investors overwhelm "pessimistic" ones, leading to prices not reflecting fundamental values about cash flows summarized by aggregate beliefs. Empirical support for this explanation is provided by exploring the behavior of internet stock prices during the period January 1998 to November 2000. In particular, we document four important elements to our story: (i) the high level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to a shift towards potentially optimistic investors, (iii) empirical results consistent with shorting being at its maximum possible level for internet stocks, and (iv) the eventual fall, or bubble bursting, of internet stocks being tied to the increase in the number of sellers to the market via expiration of lockup agreements.

Abstract:
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of shortterm interest rates, not to a breakdown of the link between fundamentals and exchange rates.

Abstract:
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of shortterm interest rates, not to a breakdown of the link between fundamentals and exchange rates.

Abstract:
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short term interest rates, not to a breakdown of the link between fundamentals and exchange rates.

Abstract:
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short term interest rates, not to a breakdown of the link between fundamentals and exchange rates.

Abstract:
The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short-term interest rates, not to a breakdown of the link between fundamentals and exchange rates.

Abstract:
This paper develops a nonparametric, model-free approach to the pricing and hedging of mortgage-backed securities (MBS), using multivariate density estimation procedures to investigate the relation between MBS prices and interest rates. While the usual methods of valuing MBSs are highly dependent on specific assumptions about interest rates and prepayment, this method will yield consistent results without requiring such assumptions. Weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level and slope of the term structure. Using this estimated relation to hedge the interest rate risk of MBS gives results that compare favorably with other commonly using hedging methods.

Abstract:
Multivariate density estimation (MDE) suggests that mortgage-backed security (MBS) prices can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons. An important finding is that the interest rate level proxies for the moneyness of the option, the expected level of prepayments, and the average life of the cash flows, while the term structure slope controls for the average rate at which these cash flows should be discounted. Though the origination and prepayment behavior of mortgages differ substantially across coupons, there remains an unexplained common factor in MBS prices. This factor does not seem to be related to the usual suspects, and therefore presents a puzzle to financial economists.

Abstract:
There have been recent, well-documented cases of financial institutions and investment groups incurring huge monetary losses on their mortgage-backed security (MBS) portfolios. This vulnerability is partly due to the complexity of MBS pricing. Homeowners have the option to prepay their mortgages and refinance the property at any time; hence, MBS investors are implicitly buying a fixed-rate bond and writing a call option on this bond. Furthermore, prepayment of mortgages (and thus the timing and magnitude of the MBS's cash flows) can occur not only when rates fall, but also for reasons not related to the interest rate option. This paper develops a nonparametric, model-free approach to the pricing of MBSs, using multivariate density estimation (MDE). Our goal is to investigate the relation between MBS prices and interest rates. While the usual methods for valuing MBSs are highly dependent on specific assumptions about interest rates and prepayments, this method yields informative results without requiring such assumptions. The MDE estimation suggests that weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons and investigate the sensitivity of prices to the two factors.

Abstract:
This paper provides an analytical solution to the problem of how an institution might optimally manage the market risk of a given exposure, under the assumption that the institution wishes to minimize its Value at Risk (VaR) using options. The solution specifies the VaR-minimizing level of moneyness of the options as a function of the underlying parameters. We show that the optimal hedge consists of a position in a single option whose strike price is independent of the level of expense the institution is willing to incur for its hedging program. The optimal strike price is increasing in the asset's drift, decreasing in its volatility for most reasonable parameter, decreasing in the risk-free interest rate, nonmonotonic in the horizon of the hedge, and increasing in the level of protection desired by the institution (i.e., the percentile of the distribution relevant for the VaR). Finally, we also show that the costs associated with a suboptimal choice of exercise price are economically significant.

Abstract:
This paper addresses the question of how an institution might optimally manage the market risk of a given exposure. We provide an analytical approach to optimal risk management under the assumption that the institution wishes to minimize its Value-at-Risk (VaR) using options follows a geometric Brownian. The optimal solution specifies the VaR-minimizing level of moneyness of the option as a function of the asset`s distribution, the risk-free rate, and the VaR hedging period. We find that the optimal strike of the put is independent of the level of expense the institution is willing to incur for its hedging program. The costs associated with a suboptimal choice of exercise price, in terms of either the increased VaR for a fixed hedging cost or the increased cost to achieve a given VaR, are economically significant. Comparative static results show that the optimal strike price of these options is increasing in the asset`s drift, decreasing in its volatility for most reasonable parameterizations, decreasing in the risk-free interest rate, nonmonotonic in the horizon of the hedge, and increasing in the level of protection desired by the institution (i.e., the percentage of the distribution relevant for the VaR). We show that the most important determinant is the conditional distribution of the underlying asset exposure; therefore, the optimal exercise price is very sensitive to the relative magnitude of the drift and diffusion of this exposure.

Abstract:
This paper addresses the question of how an institution might optimally manage the market risk of a given exposure. We provide an analytical approach to optimal risk management under the assumption that the institution wishes to minimize its Value-at-Risk (VaR) using options follows a geometric Brownian. The optimal solution specifies the VaR-minimizing level of moneyness of the option as a function of the asset's distribution, the risk-free rate, and the VaR hedging period. We find that the optimal strike of the put is independent of the level of expense the institution is willing to incur for its hedging program.

Abstract:
This paper develops a structural model of intraday price formation that embodies both public information shocks and microstructure effects. Due to its structural nature, the model's underlying parameters provide summary measures to assess trading costs, the sources of short-run price volatility, and the speed of price discovery in an internally consistent, unified setting. We estimate the model using transaction level data for a cross-section of NYSE stocks. We find, for example, that the parameter estimates jointly explain the observed U-shaped pattern in quoted bid-ask spreads and in price volatility, the magnitude of transaction price volatility due to market frictions, and the autocorrelation patterns of transaction returns and quote revisions. Further, in contrast to bid- ask spread patterns, we find that execution costs of a trade are much smaller than the spread and increase monotonically over the course of the day. This may provide an explanation for why there is concentration in trade at the open.

Abstract:
This paper demonstrates that an an institutional feature inherent in a multitude of mutual funds managing billions in assets generates fund NAVs that reflect stale prices. Since, in many cases, investors can trade at these NAVs with little or no transactions costs, there is an obvious trading opportunity. Simple, feasible strategies generate Sharpe ratios that are sometimes one hundred times greater than the Sharpe ratio of the underlying fund. These opportunities are especially prevalent in international funds that buy Japanese or European equities and in funds that invest in thinly traded securities in the U.S. When implemented, the gains from these strategies are matched by o setting losses incurred by buy-and-hold investors in these funds. In one particular example, we explore the consequences of trading between different Vanguard mutual funds, motivated via the rules inherent in University 403B plans. Compared to an equal-weighted buy-and-hold portfolio of international Vanguard funds with a 25% cumulative return, the strategy discussed in this paper produces a 139% return while being in the stock market less than 25% of the time!

Abstract:
This paper demonstrates that an an institutional feature inherent in amultitude of mutual funds managing billions in assets generates fund NAVs that reect stale prices. Since, in many cases, investors can trade at these NAVs with little or no transactions costs, there is an obvious tradingopportunity. Simple, feasible strategies generate Sharpe ratios that are sometimes one hundred times greater than the Sharpe ratio of the underlying fund. These opportunities are especially prevalent in international funds that buy Japanese or European equities and in funds that invest in thinly traded securities in the U.S. When implemented, the gains from these strategies are matchedby o setting losses incurred by buy-and-hold investors in these funds. In one particular example, we explore the consequences of trading between different Vanguard mutual funds, motivated via the rules inherent in University 403B plans. Compared to an equal-weighted buy-and-hold portfolio ofinternational Vanguard funds with a 25% cumulative return, the strategy discussed in this paper produces a 139% return while being in the stock market less than 25% of the time!

Abstract:
In this paper, we investigate empirically the well-known put-call parity no-arbitrage relation in the presence of short sale restrictions. We use a new and comprehensive sample of options on individual stocks in combination with a measure of the cost and difficulty of short selling, specifically the spread between the rate a short-seller earns on the proceeds from the sale relative to the standard rate (the rebate rate spread). We find that violations of put-call parity are asymmetric in the direction of short sales constraints, their magnitudes are strongly related to the rebate rate spread, and they are maintained even in the presence of transactions costs both in the options and equity lending market. These violations appear to be related to both the maturity of the option and the level of valuations in the stock market, consistent with a behavioral finance theory that relies on over-optimistic investors in the stock market and segmentation between the stock and options markets. Moreover, the extent of violations of put-call parity and the rebate rate spread for individual stocks are significant predictors of future stock returns. For example, cumulative abnormal returns, net of borrowing costs, over a 2ﾫ-year sample period can exceed 65%.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
In this paper, we investigate empirically the well-known put-call parity no-arbitrage relation in the presence of short sale restrictions. We use a new and comprehensive sample of options on individual stocks in combination with a measure of the cost and difficulty of short selling, specifically the spread between the rate a short-seller earns on the proceeds from the sale relative to the normal rate (the rebate rate spread). We find statistically and economically significant violations of put-call parity that are strongly related to the rebate rate spread. Stocks with negative rebate rate spreads exhibit prices in the stock market that are up to 7.5% greater than those implied in the options market (for the extreme 1% tail). Even after accounting for transaction costs in the options markets, these violations persist and their magnitude appears to be related to the general level of valuations in the stock market. Moreover, the extent of violations of put-call parity and the rebate rate spread for individual stocks are significant predictors of future stock returns. For example, cumulative abnormal returns, net of borrowing costs, over a 2½-year sample period can exceed 70%. It is difficult to reconcile these results with rational models of investor behavior, and, in fact, they are consistent with the presence of over-optimistic irrational investors in the markets for some individual securities.

Abstract:
The variance ratio test statistic, which is based on k-period differences of the data, iscommonly used in empirical finance and economics to test the random walk hypothesis. We obtain the asymptotic power function of the variance ratio test statistic when the differencing period k is increasing with the sample size n such that k/n ' ´ > 0. We show that the test is inconsistent against a variety of mean reverting alternatives, confirm the result in simulations, and then characterise the functional form of the asymptotic power in terms of ´ and these alternatives.

Abstract:
Due to a timing mismatch between fee receipts and commission payments, there is a newand growing market for securities backed by fees from back-end load and level load mutualfunds. This paper develops a contingent claims methodology for the valuation of thesesecurities. The resulting security value depends primarily on the current value of fund assets and the fee schedule. The valuation formula also provides an analytical expression for the appropriate strategy for hedging fluctuations in asset value. As a case study, we investigate the hedging performance of an institution that holds a portfolio of these securities.

Abstract:
No abstract is available for this paper.

Abstract:
This paper develops a new strategy for dynamically hedging mortgage-backed securities (MBSs). The approach involves estimating the joint distribution of returns on MBSs and T-note futures, conditional on current economic conditions. We show that our approach has a simple intuitive interpretation of forming a hedge ratio by differentially weighting past pairs of MBS and T-note futures returns. An out-of-sample hedging exercise is performed for 8%, 9% and 10% GNMAs over the 1990-1994 period for weekly and monthly return horizons. The dynamic approach is very successful at hedging out the interest rate risk inherent in all of the GNMAs. For example, in hedging weekly returns on 10% GNMAs, our dynamic method reduces the volatility of the GNMA return from 41 to 24 basis points, whereas a static method manages only 29 basis points of residual volatility. Moreover, only 1 basis point of the volatility of the dynamically hedged return can be attributed to risk associated with U.S. Treasuries, which is in contrast to 14 basis points of interest rate risk in the statically hedged return.

Abstract:
This paper develops a new strategy for dynamically hedging interest-rate contingent claims, such as mortgage-backed securities (MBSs). The approach involves estimating the joint distribution of returns on MBSs and T-note futures, conditional on current economic conditions. We show that our approach has a simple intuitive interpretation of forming a hedge ratio by differentially weighting past pairs of MBS and T-note futures returns.As an example, an out-of-sample hedging exercise is performed for 8%, 9% and 10% GNMAs over the 1990-1994 period for weekly and monthly return horizons. The dynamic approach is very successful at hedging out the interest rate risk inherent in all of the GNMAs. In hedging weekly returns on 10% GNMAs, our dynamic method reduces the volatility of the GNMA return from 41 to 24 basis points, whereas a static method manages only 29 basis points of residual volatility. Moreover, only 1 basis point of the volatility of the dynamically hedged return can be attributed to risk associated with U.S. Treasuries, which is in contrast to 14 basis points of interest rate risk in the statically hedged return.

Abstract:
In this paper, we investigate empirically the well-known put-call parity no-arbitragerelation in the presence of short sale restrictions. We use a new and comprehensivesample of options on individual stocks in combination with a measure of the cost anddifficulty of short selling, specifically the spread between the rate a short-seller earns on the proceeds from the sale relative to the normal rate (the rebate rate spread). We findstatistically and economically significant violations of put-call parity that are strongly related to the rebate rate spread. Stocks with negative rebate rate spreads exhibit prices in the stock market that are up to 7.5% greater than those implied in the options market (for the extreme 1% tail). Even after accounting for transaction costs in the options markets, these violations persist and their magnitude appears to be related to the general level of valuations in the stock market. Moreover, the extent of violations of put-call parity and the rebate rate spread for individual stocks are significant predictors of future stock returns. For example, cumulative abnormal returns, net of borrowing costs, over a 2½-year sample period can exceed 70%. It is difficult to reconcile these results with rational models of investor behavior, and, in fact, they are consistent with the presence of overoptimistic irrational investors in the markets for some individual securities.

Abstract:
This paper investigates the implications of a 2-regime model of the business cycle for term premiums and volatilities in the bond market. The model, which is estimated via maximum likelihood using GDP, consumption and production data, has two key features -- mean growth rates that vary across regimes and time-varying transition probabilities between regimes. The implied dynamics of term premiums and volatilities are complex and interesting. Business cycle turning points are characterized by high volatility and strongly time-varying term premiums. These implications are then investigated using data on bond returns. Nonparametric estimation results are broadly consistent with the model. Using the slope of the term structure as a conditioning variable, we can identify periods with negative term premiums and volatile returns.

Abstract:
This paper investigates the implications of a 2-regime model of the business cycle forterm premiums and volatilities in the bond market. The model, which is estimated viamaximum likelihood using GDP, consumption and production data, has two key features-mean growth rates that vary across regimes and time-varying transition probabilities between regimes. The implied dynamics of term premiums and volatilities are complex and interesting. Business cycle turning points are characterized by high volatility and strongly time-varying term premiums. These implications are then investigated using data on bond returns. Nonparametric estimation results are broadly consistent with the model. Using the slope of the term structure as a conditioning variable, we can identify periods with negative term premiums and volatile returns.

Abstract:
We provide a test of the liquidity preference hypothesis (i.e., the monotonicity of ex ante term premiums), conditioning on the shape of the yield curve. The approach we use is general, and does not require a structural model for conditional expected returns. Using nonparametric estimates, the evidence supports previous conclusions in the literature regarding time-varying negative term premiums. For example, in periods in which the term structure is downward sloping, we find that the premiums can be significantly negative and are often monotonically decreasing in maturity. Interestingly, in these periods the volatility of the term premium is still increasing in maturity, indicating that bond return volatility is not a priced risk.

Abstract:
Combining insights from the contingent claims and the asset-backed securities literatures, we study the economics of value creation in the asset management business. In particular, we provide a theoretical model and a closed form formula for the value of fund fees in the presence of the well known flow-performance relation, giving rise to interesting nonlinearities and volatility-related effects. The theoretical model sheds light on the role of fees, asset growth, asset and benchmark volatility, and the intensity of the flow-performance relation. To better understand the role ofchanging fund characteristics such as age and size on the fund value and fund risk, we estimate theempirical relation between returns and flows conditional on these characteristics for various assetclasses. We study these effects using Monte Carlo simulations for various economically meaningfulparameter values for specific asset classes. Measuring value as a fraction of assets under management,we find that both value and risk, systematic and idiosyncratic, decline in size and age. In addition, value is a complex, non-monotonic function of the fee charged on the fund.

Abstract:
This paper reexamines frozen concentrated orange juice (FCOJ) futures returns as they relate to fundamentals, in particular, temperature. We show that when theory clearly identities the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple theoretical nonlinear model of the relation between FCOJ returns and temperature, we can explain approximately 50%of the return variation. This is important because while only 4.5%of the days in winter coincide with freezing temperatures, two- thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact that there is no relation the majority of the time is good news for the theory and market efficiency, not bad news. In terms of other FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The evidence in this paper suggests that the literature s conclusion about irrationality drawn from the FCOJ market have more to do with econometricians lack of modeling ability than with the empirical facts.

Abstract:
The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. This paper reexamines the relation between FCOJ futures returns and fundamentals, focusing primarily on temperature. We show that when theory clearly identifies the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple, theoretically-motivated, nonlinear, state dependent model of the relation between FCOJ returns and temperature, we can explain approximately 50% of the return variation. This is important because while only 4.5% of the days in winter coincide with freezing temperatures, two-thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact that there is no relation the majority of the time is good news for the theory and for market efficiency, not bad news. In terms of residual FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The fact that, even in the comparatively simple setting of the FCOJ market, it is easy to erroneously conclude that fundamentals have little explanatory power for returns serves as an important warning to researchers who attempt to interpret the evidence in markets where both fundamentals and their relation to prices are more complex.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The standard VaR approach considers only terminal risk, completely ignoring the path of the portfolio value prior to this final horizon. This assumption is unrealistic-interim risk may be critical in a mark-to-market environment because interim values of a portfolio may generate margin calls and affect trading strategies. We provide a simple framework for adjusting standard VaR for interim risk. We introduce the notion of MaxVaR, which is analogous to VaR except that it considers the probability of seeing a given low cumulative return on or before the terminal date. Under the standard lognormality assumption and for reasonable parameterizations, MaxVaR may exceed VaR by over 40%. We show that adjusting VaR for interim mark-to-market risk is critically important for high Sharpe Ratio portfolios (e.g., for hedge funds).

Abstract:
We demonstrate that an institutional feature of numerous mutual funds - funds managing billions in assets - generates fund net asset values that reflect stale prices. Because investors can trade at these NAVs with limited transaction costs in many cases, obvious trading opportunities exist. These opportunities are especially prevalent in funds that buy Japanese or European equities. Simple, feasible strategies generate Sharpe ratios (excess return divided by standard deviation) that are many times greater than the Sharpe ratio of the underlying fund. We illustrate the potential of the strategy for three Vanguard Group mutual funds. A particular issue to keep in mind is that when implemented, the gains from these strategies are matched by offsetting losses incurred by buy-and-hold investors in these funds.

Portfolio Management: trading and execution, Portfolio Management: private client focus

Abstract:
This paper reexamines evidence on the monotonicity of the term premium. Using a recently developed approach for testing inequality constraints, we propose and conduct tests for whether the term premium is monotonic and reach different conclusions from those implied by individual "t- statistics" on term premiums, even under a Bonferroni-type adjustment. Our results generally support McCulloch's (1987) view that the liquidity preference hypothesis remains unrefuted.

Abstract:
This article provides a unified approach for testing serial correlation in stock returns. We describe a general class of statistics which are linear combinations of consistent estimators of autocorrelations. As special cases, we show that this class captures many of the statistics studied in the recent finance and macroeconomics literature. Using this result, we then provide a common perspective on the asymptotic distribution and power of these statistics.

Abstract:
This paper reexamines the autocorrelation patterns of short- horizon stock returns. We document empirical results which imply that these autocorrelations have been overstated in the existing literature. Based on several new insights, we provide support for a market efficiency-based explanation of the evidence. Our analysis suggests institutional factors are the most likely source of the autocorrelation patterns.

Abstract:
This article develops a new approach for hedging mortgage- backed securities (MBS) that involves estimating the joint distribution returns on MBS and T-note futures, conditional on economic conditions. The resulting hedge ratio is calculated by differentially weighting past pairs of MBS and T-note futures returns, where the weights depend on how close current economic variables are to their historical values.In an out-of-sample hedging exercise, using weekly and monthly returns on 8%, 9%, and 10% GNMAs over the 1990-1994 period, the dynamic approach is very successful at hedging out interest rate risk. For example, in hedging weekly returns on 10% GNMAs, the method reduces the volatility of the return from 4.1 to 2.4 basis points, while a static method achieves only 29 basis points of residual volatility. Moreover, only 1 basis point of the volatility of the dynamically hedged return can be attributed to risk associated with U.S. Treasuries, compared to 14 basis points of interest rate risk in the statically hedged return.

Abstract:
While there is significant interest in investing in Brady bonds, the source of attraction is often the exposure to sovereign risk (and its yield compensation), while the exposure to U.S. interest rate risk is a "necessary evil". This paper addresses the problem of determining the interest rate sensitivity of Brady debt. We show that the most relevant state variables in determining the duration of a Brady bond are U.S. interest rates and the bond's strip spread. Motivated by the difficulty of using structural models to price and hedge Brady debt, we provide a model-free approach to estimating the hedge ratio. Using our approach to hedge the Argentinian Par and Discount Brady bonds, we find that only a small fraction (15% or so) of the total risk is hedgeable, but our hedged portfolio exhibits little covariation with U.S. interest rates.