• Selected
• Entire List

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:
This paper studies the strategic asset allocation for an investor with risky liabilities which are subject to inflation and real interest rate risk and who invests in stocks, government bonds, corporate bonds, T-bills, listed real estate, commodities and hedge funds. Using a vector autoregression for returns, liabilities and macro-economic state variables the paper explores the intertemporal covariance structure of assets and liabilities. We find horizon effects in time diversification, risk diversification, inflation hedge and real interest rate qualities. The covariance structures give insights into which asset classes have a term structure of risk that is different from that of stocks and bonds. The alternative assets classes add value for long-term investors. Differences in strategic portfolios for asset-only and asset-liability investors are due to differences in the global minimum variance and liability hedge portfolio. We find that the benefits of long-term investing are larger when there are liabilities.

Strategic asset allocation, asset liability management

Abstract:
This paper proposes a panel data framework for tests of affine models of the term structure of interest rates which cover equilibrium (or endogenous) models as well as extended (or exogenous, evolutionary) models. The econometric model pools yield curve data for different moments in time. Since each cross-sectional yield curve only depends on the risk neutral factor dynamics, the estimator does not involve any assumptions on the price of risk, or on actual interest rate dynamics. In the empirical application one and two factor Gaussian models are tested on US interest rate data. The main empirical results are: (i) that a two factor model cannot be rejected; (ii) that mean reversion is highly significant; and (iii) that the extended models are 'over-differenced'.

Abstract:
This paper proposes a panel data framework for tests of affine models of the term structure of interest rates which covers equilibrium (or endogenous) models as well as extended (or exogenous, evolutionary) models. The econometric model pools yield curve data for different moments in time. Since each cross sectional yield curve only depends on the risk neutral factor dynamics, the estimator does not involve any assumptions on the price of risk, or on actual interest rate dynamics. In the empirical application one- and two-factor Gaussian models are tested on U.S. interest rate data. The main empirical results are (i) that a two-factor model can not be rejected, (ii) that mean reversion is highly significant, and (iii) that the extended models are "overdifferenced."

Abstract:
This paper considers the strategic asset allocation of long-term investors who account for prior information about expected returns. We develop a vector autoregressive model where different investors have conflicting prior views on long-run expected returns. We distinguish two types of prior information: (i) direct views on the long-term mean of the equity and bond premium, and (ii) prior views on the long-run mean of predictor variables like the dividend yield and the nominal interest rate. Both priors have a pronounced effect on optimal portfolios. Even weak prior information on the unconditional mean of highly persistent time series like dividend yield and the nominal interest rate changes the estimated persistence of shocks and the predictability of excess returns.

For long-term investors we find that a portfolio that is optimal given one prior, often entails large utility costs when evaluated under an alternative prior distribution. The optimal portfolio for an optimistic investor is very costly (sub-optimal) in eyes of an investor with a more negative prior view. We define a robust portfolio as the portfolio of an investor with a prior that has minimal costs among all priors that we consider. Such a robust portfolio coincides with the optimal portfolio of a moderately optimistic investor. It contains a large proportion of equity, but far less than would be implied under both more optimistic as well as very diffuse priors.

strategic asset allocation, bayesian vector autoregression, parameter uncertainty

Abstract:
We improve both the specification and estimation of firm-specific betas. Time variation in betas is modeled by combining a parametric specification based on economic theory with a non-parametric approach based on data-driven filters. We increase the precision of individual beta estimates by setting up a hierarchical Bayesian panel data model that imposes a common structure on parameters. We show that these accurate beta estimates lead to a large increase in the cross-sectional explanatory power of the conditional CAPM. Using the betas to forecast the covariance matrix of returns also results in a significant improvement in the out-of-sample performance of minimum-variance portfolios.

asset pricing, portfolio choice, time-varying betas, Bayesian econometrics, panel data

Abstract:
In this Paper, we propose a tick time model for dealer quote interactions using ultra-high-frequency data. This model includes duration functions to measure the time dependence of volatility, as well as information asymmetry. In order to assess price discovery, we define several measures in tick time. These measures can be aggregated to calendar time, and we define a comparable measure to Hasbrouck (1995) information shares. In our empirical part, we examine the Island and Instinet Electronic Communication Networks, and three wholesale market makers for 20 actively traded stocks with varying liquidity at Nasdaq. Our results include that volatility does not increase with the duration between quote updates, and that longer quote durations lead to lower price discovery. In terms of price discovery, we find that ECNs tend to dominate the liquid stocks, whereas market makers dominate the less liquid stocks.

Price discovery, tick time models, NASDAQ, ultra-high frequency data, microstructure

Abstract:
In this paper we propose a tick time model for dealer quote interactions using ultra-high-frequency data. This model includes duration functions to measure the time dependence of volatility as well as information asymmetry. In order to assess price discovery we define several measures in tick time. These measures can be aggregated to calendar time and we define a comparable measure to Hasbrouck (1995) information shares. In our empirical part we examine the Island and Instinet Electronic Communication Networks, and three wholesale market makers for 20 actively traded stocks with varying liquidity at Nasdaq. Our results include that volatility does not increase with the duration between quote updates, and that longer quote durations lead to lower price discovery. In terms of price discovery we find that ECNs tend to dominate the liquid stocks, whereas market makers dominate the less liquid stocks.

Price Discovery, Tick Time models, Nasdaq, Ultra-high frequency data, Microstructure

Abstract:
This study provides European evidence on the ability of static and dynamic specifications of the Fama-French (1993) three-factor model to price 25 size-B/M portfolios. In contrast to US evidence, we detect a small-growth premium and find that the size effect is still present in Europe. Furthermore, we document strong time variation in factor risk loadings. Incorporating these risk fluctuations in conditional specifications of the three-factor model clearly improves its ability to explain time variation in expected returns. However, the model still fails to completely capture cross-sectional variation in returns as it is unable to explain the momentum effect.

conditional asset pricing, time-varying risk, stock market anomalies

Abstract:
Prepayment of Dutch mortgage loans is restricted to a fixed amount per calendar year. Due to path dependence the valuation of these mortgage loans is more complicated than the valuation of unrestricted prepayment options. In this paper we derive an optimal and efficient strategy to price interest-only mortgages with restricted prepayments. For tax reasons an interest-only mortgage is the most popular mortgage type in the Netherlands. The optimal strategy also provides a rational explanation why empirical prepayment models find that prepayments peak in December. Our results indicate that a restricted prepayment option still has significant value.

mortgage valuation, partial prepayments, binomial trees

Abstract:
We construct a panel data model to explain the cross-section of individual stock returns, using monthly data for 1,880 large US firms for 1985-2005. Model specification is geared towards multiple explanatory variables, poolability across industries, alternative forecast horizons, and the effects of unobserved heterogeneity among firms. We find that combining multiple firm characteristics increases the predictive power. High expected returns are mostly related to size, cashflow-to-price and turnover, and somewhat to earnings revisions and momentum. Diversified portfolios sorted on expected returns have moderate risk exposures and generate significant risk-adjusted returns over all horizons. Longer forecasting horizons drastically reduce portfolio turnover and hence lower costs.

Stock returns, Forecasting, Panel data, Industry effects, Individual effects, Time effects

Abstract:
The paper contributes to the literature on integration of stock markets by addressing the issue of non-synchronous trading. We argue that controlling for time differences in trading hours of stock markets is important and show that time-adjustment improves estimates of market integration. We also show that using weekly frequency does not sidestep the consequences of the time-match problem but leads to significant loss of information. We show that the nature of integration of stock exchanges operating in the Czech Republic, Hungary, and Poland with the stock markets of Germany, UK and US in the period 1994-2004 is very dynamic. Finally, the study shows that the autocorrelation of returns on the main market indexes of the emerging markets have declined over time.

Market integration, non-synchronous trading, emerging markets, market efficiency, Kalman filter

Abstract:
The paper contributes to the literature on integration of stock markets by addressing the issue of non-synchronous trading. We argue that controlling for time differences in trading hours of stock markets is important and show that time-adjustment improves estimates of market integration. We also show that using weekly frequency does not sidestep the consequences of the time-match problem but leads to significant loss of information. We show that the nature of integration of stock exchanges operating in the Czech Republic, Hungary, and Poland with the stock markets of Germany, UK and US in the period 1994-2004 is very dynamic. Finally, the study shows that the autocorrelation of returns on the main market indexes of the emerging markets have declined over time.

market integration, market efficiency, non-synchronous trading, emerging markets, Kalman filter

Abstract:
This paper explores the implications of asset return predictability for long-term portfolio choice when return-forecasting variables are fractionally integrated. For important predictor variables, like the dividend-price ratio, and nominal and real interest rates, we estimate orders of integration around 0.8. This leads to substantial increases of the estimated long-term risk of stocks, bonds, and cash compared to estimates obtained from a stationary VAR. Results are sensitive to the inclusion of the short-term nominal interest rate in the prediction equation of excess stock returns. Jointly with the dividend-price ratio it has significant predictive power, but contrary to the dividend-price ratio the nominal interest rate does not induce mitigating effects through mean reversion.

G11, C32, long-term portfolio choice, linear processes with fractional integration, term structure of risk

Abstract:
This paper explores the implications of asset return predictability on long-term portfolio choice when return forecasting variables exhibit long memory. We model long memory using the class of fractionally integrated time series models. Important predictor variables for U.S. data, like the dividend-price ratio and nominal and real interest rates, are non-stationary with orders of integration around 0.8. These time series properties lead to substantial increases of the estimated long-term risk of stocks, bonds and cash compared to earlier estimates obtained from a stationary VAR. Long-term risk increases because the fluctuations in the predictor variables imply that expected returns themselves become a significant source of long-term risk. We find that results are sensitive to the specification of the prediction equation of excess stock returns. The inclusion of the short-term nominal interest rate among the predictor variables has the most profound impact. Jointly with the dividend-price ratio it has significant predictive power, but contrary to the dividend-price ratio the nominal interest rate does not induce mitigating effects through mean reversion.

Long-term portfolio choice, Term structure of risk, Fractional integration, Long Memory

Abstract:
We consider mean-variance portfolio choice of a robust investor. The investor receives advice from J experts, each with a different prior for expected returns and risk. Given this advice the investor follows a min-max portfolio strategy. We study the structure of the robust mean-variance portfolio and compare its performance with a variety of alternative portfolio strategies. We find that the robust investor combines the estimates from the different experts. When experts agree on the main factors that generate returns, the robust investor relies on the advice of the expert with the strongest prior. Dispersed advice leads the investor to combine alternative estimates. The investor is likely to outperfrom alternative strategies. The theoretical analysis is supported by numerical simulations for the 25 Fama-French portfolios and for 81 European country and value portfolios.

Abstract:
We develop a term structure model that can match two stylized facts of excess returns on long-term bonds. The first stylized fact is the predictability of excess returns, which requires sufficient volatility in the price of risk. The second stylized fact is that yields are dominated by a level factor, which requires persistence in the spot interest rate or in the price of risk, or both. We calibrate a stochastic discount factor that is consistent with both stylized facts. Doing so we need time series processes that are outside the essentially affine class of term structure models. For parsimony we choose a fractionally integrated process, which leads to tractable analytical solutions. As an important implication we find that risk premiums of excess bond returns are very persistent.

term structure of interest rates, fractional integration, affine modeling

Abstract:
The high value of the implicit option to choose a retirement date at which interest rates are particularly high and life annuities relatively cheap, leads to the possibility to introduce regret aversion in the retirement investment decision of defined contribution plan participants. As a remedy for regret aversion in retirement investment decisions, this paper develops and prices a lookback option on a life annuity contract. We determine a closed-form option value under the restriction that the option holder invests risklessly during the time to maturity of the option and without the guarantee that the exact amount of retirement wealth is converted into a life annuity at retirement. Thereafter the investment restriction is relaxed and the guarantee of exact conversion is imposed and the option is priced via Monte Carlo simulations in an economic environment with a stochastic discount factor. Option price sensitivities are determined via the pricing of alternative options. We find that the price of a lookback option, with a maturity of three years, amounts to 8-9\% of the wealth at the option issuance date. The option price is highly sensitive to the exercise price of the option, i.e. pricing alternative options (e.g. Asian) substantially lowers the price. Time to maturity and interest rate volatility are other important option price drivers. Asset allocation decisions and initial interest rates hardly affect the option price.

Lookback Option, Life Annuity, Annuity Risk, Defined Contribution, Stochastic Discount Factor

Abstract:
Our main objective is to find out whether the potential gains of strategic asset allocations can be realized in an out-of-sample test. Firstly, we find that long-term investors should time the market if they use our proposed shrinkage prior. This prior downplays the predictability of asset returns and leads to superior out-of-sample results compared to a standard uniform prior. Important is the use of a utility metric to evaluate prediction models. Shrinkage limits the losses in extreme negative events and this is what risk-averse investors value the most. Secondly, we conclude that the hedge component of strategic portfolios only leads to a modest performance improvement out-of-sample. Repeated myopic strategies perform almost as well as a dynamic asset allocation strategy. Monte Carlo simulations relate this finding to estimation error, i.e. the estimated repeated myopic and dynamic portfolios approximate the true unknown optimal dynamic portfolio equally well. Next, our paper shows that incorporating parameter uncertainty leads to a small performance improvement. Finally, portfolio weight restrictions improve performance for bad models and hurt the good models.

Strategic asset allocation, out-of-sample performance evaluation

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 proposes a structural time series model for the intra-day price dynamics of fragmented financial markets. We generalize the structural model of Hasbrouck (1993) to a multivariate setting. We discuss identification issues and propose a new measure for the contribution of each market to price discovery. We illustrate the model by an empirical example using Nasdaq dealer quotes.

High-frequency data, microstructure, structural time series models

Abstract:
We consider mean-variance portfolio choice of a robust investor. The investor receives advice from J experts, each with a different prior for the distribution of returns. Confronted with these multiple priors the investor follows a min-max portfolio strategy. We study the structure of the robust mean-variance portfolio and empirically compare its performance with a variety of alternative portfolio strategies. The empirical tests are based on bootstrap simulations on the 25 Fama-French portfolios and on 81 European country and value portfolios. We find that the robust portfolio performs well in both settings. Robust portfolios do not exhibit the extreme weights typically observed in naive mean-variance portfolios. Robust portfolios are also better diversified than portfolios that impose short-sell constraints to suppress the symptoms of extreme weights.

Mean-variance, model uncertainty, portfolio choice

Abstract:
In this paper we compare time series and cross section estimates of the well known Vasicek [1977] and Cox, Ingersoll and Ross [1985] term structure models for a dataset of daily bond prices and short term interest rates for the Netherlands. The main conclusion of this paper is the great similarity of the cross sectional estimated term structures of interest between the two models. Using the estimated parameters of both models to value bond options, an almost similar result is obtained. It looks as though bonds are priced as if the spot riksfree rate is random walk. From a time series perspective, we find that the two models also provide similar results. For some maturities the data reject the constant volatility Vasicek model and indicate the presence of the CIR volatility effects.

Abstract:
This paper uses Reuters exchange rate data to investigate the contributions to the price discovery process by individual banks in the foreign exchange market. We propose multivariate time series models as well as models in tick time to study the dynamic relations between the quotes of individual banks. We investigate the hypothesis that German banks are price leaders in the deutschmark/dollar market. Our empirical results suggest an important but not exclusive role for German banks in the price discovery process. There is also a group of banks, German and non-German, that lags behind the market and does not contribute to the price discovery process. We do not find evidence for stronger price leadership of Deutsche Bank on days with suspected Bundesbank interventions in the foreign exchange market.

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:
This paper studies the empirical performance of stochastic volatility models for twenty years of weekly exchange rate data. We concentrate on the effects of the distribution of the exchange rate innovations for parameter estimates and for estimates of the latent volatility series. We approximate the density of the log of exchange rate innovations by a mixture of normals. The major findings of the paper are that: (i) explicitly incorporating fat-tailed innovations increases the estimates of the persistence of volatility dynamics; (ii) estimates of the latent volatility series depend strongly on the estimation technique; (iii) the estimation error of the volatility time series is so large that finance applications to option pricing should be interpreted with care. We reach these conclusions using three different estimation techniques: quasi maximum likelihood, simulated EM, and a Bayesian procedure based on the Gibbs sampler.

Abstract:
This paper investigates whether a continental factor in real estate returns exists. To this end, a numeraire independent form of principal component analysis is used to see if real estate returns for countries within a continent move together. The methodology is applied on return indices of property shares for 12 countries from 3 continents. The findings indicate that real estate returns for countries within a continent indeed show common movements. This has two implications. The first is that investors cannot realize optimal international real estate diversification by investing in only one continent. To achieve that goal, a truly global scope is needed. The second implication is that international real estate investors can achieve near- optimal international diversification by investing in one country from each continent.

Abstract:
This paper explores nonlinear dynamics for the time series of the short term interest rate in the United States. The proposed model is an autoregressive threshold model augmented by conditional heteroskedasticity. The performance of the model is evaluated by considering its implications for the term structure of interest rates. The nonlinear dynamics imply a form of nonlinearity in the levels relation between the long and the short rate. Empirical results indicate that the implied nonlinearity is present in the data.

Abstract:
In this paper we propose and implement a Bayesian procedure for the empirical valuation of bond options given the observed term structure of interest rates, and given assumptions about the time series behavior of the instantaneous spot rate. The Bayesian approach is motivated by some empirical problems that arise if the implied volatility is estimated directly by cross sectional fitting of the yield curve. The proposed method is applied to a dataset of Dutch bond prices.

Abstract:
We use data from a television game show, involving elementary lotteries and substantial prize money, as a natural experiment to measure risk attitudes. We find robust evidence of substantial risk aversion. As an extension, we esimate the various models using transformations of the etruei probabilities to decision weights. The estimated degree of risk aversion increases further, while players tend to overestimate substantially their chances of winning. Constant Relative Risk Aversion (CRRA) and Constant Absolute Risk Aversion (CARA) utility specifications perform approximately equally well, with CARA having the advantage that the players' decisions do not depend on their initial wealth.

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.