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Abstract:
Traditional approaches to valuing equities have largely focused on the Dividend Discount Model. It may be hard to reliably estimate dividend processes in small samples and market participants focus primarily on earnings and other accounting information in analyzing stocks. For these reasons we try to value stocks using earnings and book value. Building on the seminal work of Miller and Modigliani (1961) and Ohlson (1990, 1995) we develop a Generalized Earnings Model of stock valuation which uses earnings and book values. This is a general no-arbitrage model which uses stochastic pricing kernels. The model can be implemented by assuming the driving variables follow affine processes which allows tractable calculations. We apply the model to several individual stocks.

Abstract:
Over the long-run from 1926 to 2001, the CAPM can account for the spread in the returns of portfolios sorted by book-to-market ratios. In contrast, using data covering the period after 1963, many studies find strong evidence of a book-to-market effect using conventional asymptotic standard errors. To conduct correct small sample inference, we estimate a conditional CAPM with time-varying betas and find that post-1963 book-to-market effect is statistically insignificant. We find some evidence of a book-to-market effect among medium-sized stocks, but not among the smallest stocks. We also find that while the momentum effect is robust to small sample biases, the reversal effect is not.

book-to-market effect, value effect, conditional CAPM, momentum effect, reversal effect, time-varying beta

Abstract:
If investors are more averse to the risk of losses on the downside than of gains on the upside, investors ought to demand greater compensation for holding stocks with greater downside risk. Downside correlations better capture the asymmetric nature of risk than downside betas, since conditional betas exhibit little asymmetry across falling and rising markets. We find that stocks with high downside correlations with the market, which are correlations over periods when excess market returns are below the mean, have high expected returns. Controlling for the market beta, the size effect, and the book-to-market effect, the expected return on a portfolio of stocks with the greatest downside correlations exceeds the expected return on a portfolio of stocks with the least downside correlations by 6.55% per annum. We find that part of the profitability of investing in momentum strategies can be explained as compensation for bearing high exposure to downside risk.

asymmetric risk, cross-sectional asset pricing, downside correlation, downside risk, momentum effect

Abstract:
We examine how volatility risk, both at the aggregate market and individual stock level, is priced in the cross-section of expected stock returns. Stocks that have past high sensitivities to innovations in aggregate volatility have low average returns. We also find that stocks with past high idiosyncratic volatility have abysmally low returns, but this cannot be explained by exposure to aggregate volatility risk. The low returns earned by stocks with high exposure to systematic volatility risk and the low returns of stocks with high idiosyncratic volatility cannot be explained by the standard size, book-to-market, or momentum effects, and are not subsumed by liquidity or volume effects.

Systematic risk, stochastic volatility, idiosyncratic volatility

Abstract:
We examine the pricing of aggregate volatility risk in the cross-section of stock returns. Consistent with theory, we find that stocks with high sensitivities to innovations in aggregate volatility have low average returns. In addition, we find that stocks with high idiosyncratic volatility relative to the Fama and French (1993) model have abysmally low average returns. This phenomenon cannot be explained by exposure to aggregate volatility risk. Size, book-to-market, momentum, and liquidity effects cannot account for either the low average returns earned by stocks with high exposure to systematic volatility risk or for the low average returns of stocks with high idiosyncratic volatility.

Abstract:
We ask whether stock returns in France, Germany, Japan, the UK and the US are predictable by three instruments: the dividend yield, the earnings yield and the short rate. The predictability regression is suggested by a present value model with earnings growth, payout ratios and the short rate as state variables. We use this model imposing a constant risk premium to examine the finite sample evidence on predictability. Not only do we find the short rate to be a relevant state variable theoretically, it is also the only robust short-run predictor of equity returns. The evidence in Lamont (1998) on earnings and dividend yield predictability is not robust to our increased sample period, does not survive finite sample corrections and does not extend to other countries. We find no evidence of long-horizon predictability once we account for finite sample influence. Finally, cross-country predictability appears stronger than predictability using local instruments.

Abstract:
We ask whether stock returns in France, Germany, the UK and the US are predictable by three instruments: the dividend yield, the earnings yield and the short rate. The predictability regression is suggested by a present value model with earnings growth, payout ratios and the short rate as state variables. We use this model imposing a constant risk premium to examine the finite sample evidence on predictability. Not only do we find the short rate to be a relevant state variable theoretically, it is also the only robust short-run predictor of equity returns. The evidence in Lamont (1998) on earnings and dividend yield predictability is not robust to our increased sample period, does not survive finite sample corrections and does not extend to other countries. We find no evidence of long-horizon predictability once we account for finite sample influence. Finally, cross-country predictability appears stronger than predictability using local instruments.

Present value model, predictability, international predictability, short rates, dividend yield, earnings yield

Abstract:
It is widely believed that correlations between international equity markets tend to increase in highly volatile bear markets. This has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a US investor faced with a time-varying investment opportunity set which may be characterized by correlations and volatilities that increase in bad times. We model the state dependance of US, UK, and German equity returns using a regime-switching model and find evidence for the existence of a high volatility regime, in which returns are more highly correlated and have lower means. Solving the dynamic asset allocation problem for a CCRA investor, we show international diversification is still valuable with regime changes. Currency hedging imparts further benefit. The costs of ignoring the regimes are small for moderate levels of risk aversion, and the intertemporal hedging demands induced by time-varying correlations are negligible.

Abstract:
It is widely believed that correlations between international equity markets tend to increase in highly volatile bear markets. This has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a US investor faced with a time-varying investment opportunity set which may be characterized by correlations and volatilities that increase in bad times. We model the state dependence of US, UK and German equity returns using a regime-switching model and find evidence for the existence of a high volatility regime, in which returns are more highly correlated and have lower means. Solving the dynamic asset allocation problem for a CRRA investor, we show international diversification is still valuable with regime changes. Currency hedging imparts further benefit. The costs of ignoring the regimes are small for moderate levels of risk aversion, and the intertemporal hedging demands induced by time-varying correlations are negligible.

Abstract:
Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time-varying prices of risk, and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve in the U.S. is fairly flat around 1.3%. In one real rate regime, the real term structure is steeply downward sloping. An inflation risk premium that increases with maturity fully accounts for the generally upward sloping nominal term structure.

Abstract:
Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time-varying prices of risk and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, but slightly humped. In one regime, the real term structure is steeply downward sloping. Real rates (nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with real rates. An inflation risk premium that increases with the horizon fully accounts for the generally upward sloping nominal term structure. We find that expected inflation drives about 80% of the variation of nominal yields at both short and long maturities, but during normal times, all of the variation of nominal term spreads is due to expected inflation and inflation risk.

Abstract:
Changes in nominal interest rates must be due to either movements in real interest rates or expected inflation, or both. We develop a term structure model with regime switches, time-varying prices of risk and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, but slightly humped. In one regime, the real term structure is steeply downward sloping. Real rates (nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with real rates. An inflation risk premium that increases with the horizon fully accounts for the generally upward sloping nominal term structure. We find that expected inflation drives about 80% of the variation of nominal yields at both short and long maturities, but during normal times, all of the variation of nominal term spreads is due to expected inflation and inflation risk.

regime-switching term structure model, inflation risk premium, business cycles

Abstract:
A lot, including a few things you may not expect. Previous studies find that the term spread forecasts GDP but these regressions are unconstrained and do not model regressor endogeneity. We build a dynamic model for GDP growth and yields that completely characterizes expectations of GDP. The model does not permit arbitrage. Contrary to previous findings, we predict that the short rate has more predictive power than any term spread. We confirm this finding by forecasting GDP out-of-sample. The model also recommends the use of lagged GDP and the longest maturity yield to measure slope. Greater efficiency enables the yield-curve model to produce superior out-of-sample GDP forecasts than unconstrained OLS regressions at all horizons.

Abstract:
A lot, including a few things you may not expect. Previous studies find that the term spread forecasts GDP but these regressions are unconstrained and do not model regressor endogeneity. We build a dynamic model for GDP growth and yields that completely characterizes expectations of GDP. The model does not permit arbitrage. Contrary to previous findings, we predict that the short rate has more predictive power than any term spread. We confirm this finding by forecasting GDP out-of-sample. The model also recommends the use of lagged GDP and the longest maturity yield to measure slope. Greater efficiency enables the yield-curve model to produce superior out-of-sample GDP forecasts than unconstrained OLS at all horizons.

GDP Forecasting; Short Rate; Term Spread; Arbitrage-Free Term Structure Models; Out-of-Sample Forecast

Abstract:
Correlations between US stocks and the aggregate US market are much greater for downside moves, especially for extreme downside moves, than for upside moves. We develop a new statistic for measuring, comparing and testing asymmetries in conditional correlations. Conditional on the downside, correlations in the data differ from the conditional correlations implied by a normal distribution by 11.6%. We find that conditional asymmetric correlations are fundamentally different from other measures of asymmetry like skewness and co-skewness. We find that small stocks, value stocks and past loser stocks have more asymmetric movements. Controlling for size, we find that stocks with lower betas exhibit greater correlation asymmetries and we find no relationship between leverage and correlation asymmetries. Correlation asymmetries in the data reject the null of multivariate normal distributions at daily, weekly and monthly frequencies. However, several empirical models with greater flexibility, particularly regime-switching models, perform much better at capturing correlation asymmetries.

Abstract:
Regime-switching models are well suited to capture the non-linearities in interest rates. This paper examines the econometric performance of regime-switching models for interest rate data from the US, Germany and the UK. There is strong evidence supporting the presence of regime switches but univariate models are unlikely to yield consistent estimates of the model parameters. Regime-switching models incorporating international short rate and term spread information forecast better, match sample moments better, and classify regimes better than univariate models. We show that the regimes in interest rates correspond reasonably well with business cycles, at least in the US. This may explain why regime-switching models forecast interest rates better than single regime models. Finally, the non-linear interest rate dynamics implied by regime-switching models have potentially important implications for the macroeconomic literature documenting the effects of monetary policy shocks on economic aggregates. Moreover, the implied volatility and drift functions are rich enough to resemble those recently estimated using non-parametric techniques.

Abstract:
This paper examines the econometric performance of regime switching models for interest rate data from the US, Germany and the UK. There is strong evidence supporting the presence of regime switches but univariate models are unlikely to yield consistent estimates of the model parameters. Regime-switching models incorporating international short rate and term spread information forecast better, match sample moments better, and classify regimes better than univariate models. We show that the regimes in interest rates correspond reasonably well with business cycles, at least in the US. This may explain why regime-switching models forecast interest rates better than single regime models. Finally, the non-linear interest rate dynamics implied by regime switching models have potentially important implications for the macro-economic literature documenting the effects of monetary policy shocks on economic aggregates. Moreover, the implied volatility and drift functions are rich enough to resemble those recently estimated using non-parametric techniques.

Abstract:
While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time-varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk-free rates, predictable risk premiums and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large mis-valuations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time-variation in risk-free rates and factor loadings.

present value, term structure of discount rates, time-varying beta, time-varying risk premium, capital budgeting

Abstract:
While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time-varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk-free rates, predictable risk premiums and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large mis-valuations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time-variation in risk-free rates and factor loadings.

Abstract:
While many studies document that the market risk premium is predictable and that betas are not constant, the standard dividend discount model ignores these effects. This paper shows how to value cashflows with changing risk-free rates, predictable risk premiums and time-varying betas, by calculating a series of discount rates which take into account these effects. Using a constant discount rate can produce large misvaluations in portfolio data, which are mostly driven at long horizons by variation in risk-free rates and factor loadings.

present value, discount rates, term structure of expected returns, time-varying beta, time-varying risk premium, capital budgeting

Abstract:
Economists have long recognized that investors care differently about downside losses versus upside gains. Agents who place greater weight on downside risk demand additional compensation for holding stocks with high sensitivities to downside market movements. We show that the cross section of stock returns reflects a downside risk premium of approximately 6% per annum. Stocks that covary strongly with the market during market declines have high average returns. The reward for beasring downside risk is not simply compensation for regular market beta, nor is it explained by coskewness or liquidity risk, or by size, value, and momentum characteristics. (JEL C12, C15, C32, G12)

Abstract:
Economists have long recognized that investors care differently about downside losses versus upside gains. Agents who place greater weight on downside risk demand additional compensation for holding stocks with high sensitivities to downside market movements. We show that the cross-section of stock returns reflects a premium for downside risk. Specifically, stocks that covary strongly with the market when the market declines have high average returns. We estimate that the downside risk premium is approximately 6% per annum. The reward for bearing downside risk is not simply compensation for regular market beta, nor is it explained by coskewness or liquidity risk, or size, book-to-market, and momentum characteristics.

Abstract:
Agents who place greater weight on the risk of downside losses than they are attach to upside gains demand greater compensation for holding stocks with high downside risk. We show that the cross-section of stock returns reflects a premium for downside risk. Stocks that covary strongly with the market when the market declines have high average returns. We estimate that the downside risk premium is approximately 6% per annum and demonstrate that the compensation for bearing downside risk is not simply compensation for market beta. Moreover, the reward for downside risk is not subsumed by coskewness or liquidity risk, and is robust to controlling for momentum and other cross-sectional effects.

asymmetric risk, cross-sectional asset pricing, downside risk, first-order risk aversion, higher-order moments

Abstract:
International equity returns are characterized by episodes of high volatility and unusually high correlations coinciding with bear markets. We develop models of asset returns that match these patterns and use them in asset allocation. First, the presence of regimes with different correlations and expected returns is difficult to exploit within a framework focused on global equities. Nevertheless, for all-equity portfolios, a regime-switching strategy dominates static strategies out-of-sample. Second, substantial value is added when an investor chooses between cash, bonds and equity investments. When a persistent bear market hits, the investor switches primarily to cash. There are large market timing benefits because the bear market regimes tend to coincide with periods of relatively high interest rates.

Abstract:
Everyone who has studied international equity returns has noticed the episodes of high volatility and unusually high correlations coinciding with a bear market. We develop quantitative models of asset returns that match these patterns in the data and use them in two quantitative asset allocation analyses. First, we show that the presence of regimes with different correlations and expected returns is difficult to exploit with within a global asset allocation framework focussed on equities. The benefits of international diversification dominate the costs of ignoring the regimes. Nevertheless, for all-equity portfolios, a regime-switching strategy out-performs static strategies out-of-sample. Second, we show that substantial value can be added when the investor chooses between cash, bonds and equity investments. When a persistent bear market hits, the investor switches primarily to cash. This desire for market timing is enhanced because the bear market regimes tend to coincide with periods of relatively high interest rates.

market timing, tactical asset allocation, regime switching, international diversification

Abstract:
We characterize the joint dynamics of dividends, expected returns, stochastic volatility, and prices. In particular, with a given dividend process, one of the processes of the expected return, the stock volatility, or the price-dividend ratio fully determines the other two. For example, together with dividends, the stock volatility process fully determines the dynamics of the expected return and the price-dividend ratio. By parameterizing one or more of expected returns, volatility, or prices, common empirical specifications place strong, and sometimes counter-factual, restrictions on the dynamics of the other variables. Our relations are useful for understanding the risk-return trade-off, as well as characterizing the predictability of stock returns.

Abstract:
We characterize the joint dynamics of dividends, expected returns, stochastic volatility, and prices. In particular, with a given dividend process, one of the processes of the expected return, the stock volatility, or the price-dividend ratio fully determines the other two. For example, together with cashflows, the stock volatility process fully determines the dynamics of the expected return and the price-dividend ratio. By parameterizing one or more of expected returns, volatility, or prices, common empirical specifications place strong, and sometimes counter-factual, restrictions on the dynamics of the other variables. Our relations are useful for understanding the risk-return trade-off, as well as characterizing the predictability of stock returns.

risk-return trade-off, risk premium,stochastic volatility, predictability

Abstract:
Recently much progress has been made in developing optimal portfolio choice models accomodating time-varying opportunity sets, but unless investors are unreasonably risk averse, optimal holdings include unreasonably large equity positions. One reason is that most studies assume investors behave as expected utility maximizers with power utility. In this article, we provide a formal treatment of both static and dynamic portfolio choice using the Disappointment Aversion preferences of Gul (1991). While different from the Kahneman-Tversky (1979) loss aversion utility, these preferences imply asymmetric aversion to gains versus losses and are consistent with the tendency of some people to like lottery-type gambles but dislike stock in-vestments. By calibrating a number of data generating processes to actual US data on stock and bond returns, we find very reasonable portfolios for moderately disappointment averse investors with utility functions exhibiting low curvature. Disappointment aversion preferences affect intertemporal hedging demands and the state dependence of asset allocation in such a way as to not be replicable by standard expected utility functions with higher curvature. Furthermore, it is easy to reconcile the large equity premium observed in the data with disappointment aversion utility of low curvature and reasonable disappointment aversion.

Abstract:
Recently much progress has been made in developing optimal portfolio choice models accomodating time-varying opportunity sets, but unless investors are unreasonably risk averse, optimal holdings include unreasonably large equity positions. One reason is that most studies assume investors behave as expected utility maximizers with power utility. In this article, we provide a formal treatment of both static and dynamic portfolio choice using the Disappointment Aversion preferences of Gul (1991). While different from the Kahneman-Tversky (1979) loss aversion utility, these preferences imply asymmetric aversion to gains versus losses and are consistent with the tendency of some people to like lottery-type gambles but dislike stock investments. By calibrating a number of data generating processes to actual US data on stock and bond returns, we find very reasonable portfolios for moderately disappointment averse investors with utility functions exhibiting low curvature. Disappointment aversion preferences affect intertemporal hedging demands and the state dependence of asset allocation in such a way as to not be replicable by standard expected utility functions with higher curvature. Furthermore, it is easy to reconcile the large equity premium observed in the data with disappointment aversion utility of low curvature and reasonable disappointment.

Abstract:
This paper describes the joint dynamics of bond yields and macroeconomic variables in a Vector Autoregression, where identifying restrictions are based on the absence of arbitrage. Using a term structure model with inflation and economic growth factors, we investigate how macro variables affect bond prices and the dynamics of the yield curve. The setup accommodates higher order autoregressive lags for the macro factors. The macro variables are augmented by traditional unobserved term structure factors. We find that the forecasting performance of a VAR improves when no-arbitrage restrictions are imposed. Models that incorporate macro factors forecast better than traditional term structure models with only unobservable factors. Variance decompositions show that macro factors explain up to 85% of the variation in bond yields. Macro factors primarily explain movements at the short end and middle of the yield curve while unobservable factors still account for most of the movement at the long end of the yield curve.

Abstract:
This paper describes the joint dynamics of bond yields and macroeconomic variables in a vector autoregression, where identifying restrictions are based on the absence of arbitrage. Using a term structure model with inflation and economic growth factors, we investigate how macro factors affect bond prices and the dynamics of the yield curve. Higher order autoregressive lags and moving-average error terms for macro factors are accommodated. The macro factors are augmented by traditional unobserved term-structure factors. Models that incorporate macro factors give better forecasts than traditional term-structure models with only unobservable factors. Variance decompositions show that macro factors explain up to 30\% of the variation in bond yields. Macro factors primarily explain movements at the short end and middle of the yield curve while unobservable factors still account for most movement at the long end of the yield curve.

Abstract:
Since the after-fee returns of funds-of-funds are, on average, lower than hedge fund returns, it is easy to conclude that funds-of-funds do not add value compared to hedge funds. However, funds-of-funds should not be evaluated relative to hedge fund returns in publicly reported databases. Instead, the correct fund-of-funds benchmark is the set of direct hedge fund investments an investor could achieve on her own without recourse to funds-of-funds. We use asset allocation concepts to estimate characteristics of the fund-of-funds benchmark distribution. Since the benchmark characteristics are reasonable, we conclude that funds-of-funds, on average, deserve their fees-on-fees.

Hedge funds, survivorship bias, performance evaluation, benchmarking, asset allocation

Abstract:
Since the after-fee returns of funds-of-funds are, on average, lower than hedge fund returns, it is easy to conclude that funds-of-funds do not add value compared to hedge funds. However, funds-of-funds should not be evaluated relative to hedge fund returns in publicly reported databases. Instead, the correct fund-of-funds benchmark is the set of direct hedge fund investments an investor could achieve on her own without recourse to funds-of-funds. We use asset allocation concepts to estimate characteristics of the fund-of-funds benchmark distribution. Since the benchmark characteristics are reasonable, we conclude that funds-of-funds, on average, deserve their fees-on-fees.

Abstract:
Since the after-fee returns in funds-of-funds are, on average, lower than hedge fund returns, it appears that funds-of-funds do not add value. However, we show that funds-of-funds should not be evaluated relative to hedge fund returns from reported databases. Instead, the correct fund-of-funds benchmark is the return an investor would achieve from direct hedge fund investments on her own without recourse to funds-of-funds. We use certainty equivalent concepts and revealed preference arguments to estimate attributes of the true, implied true fund-of-funds benchmark distribution. Since the benchmark characteristics seem reasonable, we conclude that, on average, funds-of-funds deserve their fees-on-fees.

hedge fund, fund-of-funds, portfolio allocation, certainty equivalent

Abstract:
Stocks with recent past high idiosyncratic volatility have low future average returns around the world. Across 23 developed markets, the difference in average returns between the extreme quintile portfolios sorted on idiosyncratic volatility is -1.31% per month, after controlling for world market, size, and value factors. The effect is individually significant in each G7 country. In the U.S., we rule out explanations based on trading frictions, information dissemination, and higher moments. There is strong comovement in the low returns to high idiosyncratic volatility stocks across countries, suggesting that broad, not easily diversifiable, factors may lie behind this phenomenon.

Abstract:
We examine the link between equity risk premiums and demographic changes using a very long sample over the twentieth century for the US, Japan, UK, Germany and France, and a shorter sample covering the last third of the twentieth century for fifteen countries. We find that demographic variables significantly predict excess returns internationally. However, the demographic predictability found in the US by past studies for the average age of the population does not extend to other countries. Pooling international data, we find that, on average, faster growth in the fraction of retired persons significantly decreases risk premiums. This demographic predictability of risk premiums is strongest in countries with well-developed social security systems and lesser-developed financial markets.

Abstract:
We examine the link between equity risk premiums and demographic changes using a very long sample over the whole twentieth century for the US, Japan, UK, Germany and France, and a shorter sample covering the last third of the twentieth century for fifteen countries. We find that demographic variables significantly predict excess returns internationally. However, the demographic predictability found in the US by past studies for the average age of the population does not extend to other countries. Pooling international data, we find that, on average, faster growth in the fraction of retired persons significantly decreases risk premiums. This demographic predictability of risk premiums is stronger for countries with well-developed social security systems and lesser-developed financial markets.

Population aging, demography, risk premiums, international predictability, social security

Abstract:
We examine the link between equity risk premiums and demographic changes using a very long sample over most of the twentieth century for the US, Japan, UK, Germany and France, and a shorter sample from 1970-1998 for fifteen countries. We find that demographic variables do predict excess returns internationally. However, the demographic predictability found in the US by past studies for the average age of the population does not extend to other countries. Pooling international data, we find that, on average, increases in the fraction of retired persons decrease risk premiums.

Population aging, demography, risk premiums, international predictability

Abstract:
Recent studies suggest that the underperformance of IPOs in the post-1970 sample may be a small sample effect or %u201CPeso%u201D problem. That is, IPO underperformance may result from observing too few star performers ex-post than were expected ex-ante. We develop a model of IPO performance that captures this intuition by allowing returns to be drawn from mixtures of outstanding, benchmark, or poor performing states. We estimate the model under the null of no ex-ante average IPO underperformance and construct small sample distributions of various statistics measuring IPO relative performance. We find that small sample biases are extremely unlikely to account for the magnitude of the post-1970 IPO underperformance observed in data.

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:
Recent studies suggest that the underperformance of IPO's in the post-1970 sample may be a small sample effect or Peso problem. That is, IPO underperformance may be due to observing too few star performers ex-post than were expected ex-ante. We develop a model of IPO performance that captures this intuition, by allowing returns to be drawn from mixtures of outstanding, benchmark, or poor performance. We estimate the model under the null of no ex-ante average IPO underperformance to construct small sample distributions of various statistics measuring IPO relative performance. We find that small sample biases are extremely unlikely to account for the magnitude of the post-1970 IPO underperformance observed in data.

IPO, long-run performance, small sample inference, peso problem

Abstract:
Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The magnitude is sensitive to a fund's age, expected return, volatility, and the liquidation cost upon failure. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.

hedge fund lockup, withdrawal, redemption notice period, suspension clause

Abstract:
Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs investors 1.5% of their initial investment. The magnitude is sensitive to a fund's age, expected return, and the liquidation cost upon failure. The cost of illiquidity can exceed 10% if the hedge fund manager suspends withdrawals.

Cost of illiquidity, hedge fund valuation, exercise restriction, redemption notice period, lockup, suspension clause

Abstract:
We examine the asymptotic efficiency of using individual stocks or portfolios as base assets to test cross-sectional asset pricing models. The literature has argued that creating portfolios reduces idiosyncratic volatility and enables factor loadings, and consequently risk premia, to be estimated more precisely. We show analytically and find empirically that the more efficient estimates of betas from creating portfolios do not lead to lower asymptotic variances of factor risk premia estimates. Instead, the standard errors of factor risk premia estimates are determined by the cross-sectional distribution of factor loadings and residual risk. Creating portfolios shrinks the dispersion of betas and leads to higher asymptotic standard errors of risk premia estimates.

Specifying Base Assets, Cross-Sectional Regression, Estimating Risk Premia

Abstract:
Using non-parametric estimation methods, various authors have shown distinct non-linearities in the drift and volatility function of the US short rate, which are inconsistent with standard affine term structure models. We document how a regime-switching model with state dependent transition probabilities between regimes can replicate the patterns found by the non-parametric studies. To do so, we use data from the UK and Germany in addition to US data and include term spreads in some of our models. We also examine the drift and volatility function of the term spread.

Short rate, term spread, drift, volatility, regime-switching

Abstract:
We estimate Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules. We find that inflation and output gap account for over half of the variation of time-varying excess bond returns and most of the movements in the term spread. Taylor rules estimated with no-arbitrage restrictions differ from Taylor rules estimated by OLS, and the resulting monetary policy shocks are somewhat less volatile than their OLS counterparts.

Abstract:
We estimate Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. We find that inflation and GDP growth account for over half of the timevariation of yield levels and we attribute almost all of the movements in the term spread to inflation. We find that Taylor rules estimated with no-arbitrage restrictions differ substantially from Taylor rules estimated by OLS and monetary policy shocks identified with no-arbitrage techniques are less volatile than their OLS counterparts. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules.

Affine term structure model, monetary policy, interest rate risk

Abstract:
Stocks with recent past high idiosyncratic volatility have low future average returns around the world. Across 23 developed markets, the difference in average returns between the extreme quintile portfolios sorted on idiosyncratic volatility is -1.31% per month, after controlling for world market, size, and value factors. The effect is individually significant in each G7 country. In the U.S., we rule out explanations based on trading frictions, information dissemination, and higher moments. There is strong comovement in the low returns to high idiosyncratic volatility stocks across countries, suggesting that broad, not easily diversifiable, factors may lie behind this phenomenon.

idiosyncratic volatility, Fama-MacBeth regression

Abstract:
Implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates, with implicit tax rates close to 100% using retail trades and above 70% for interdealer trades. These implied tax rates can be identified on the cross section of municipal bonds because a portion of secondary market municipal bond trades involve income taxes. After valuing the tax payments, market discount bonds, which carry income tax liabilities, trade at yields around 25 basis points higher than comparable municipal bonds not subject to any taxes. The high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions.

municipal bonds, income and capital gains tax, de minimis boundary, public finance, implicit tax rate

Abstract:
Implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates, with implicit tax rates close to 100% using retail trades and above 70% for interdealer trades. These implied tax rates can be identified on the cross section of municipal bonds because a portion of secondary market municipal bond trades involve income taxes. After valuing the tax payments, market discount bonds, which carry income tax liabilities, trade at yields around 25 basis points higher than comparable municipal bonds not subject to any taxes. The high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions.

Abstract:
Implicit tax rates priced in the cross section of municipal bonds are approximately two to three times as high as statutory income tax rates, with implicit tax rates close to 100% using retail trades and above 70% for interdealer trades. These implied tax rates can be identified on the cross section of municipal bonds because a portion of secondary market municipal bond trades involve income taxes. After valuing the tax payments, market discount bonds, which carry income tax liabilities, trade at yields around 25 basis points higher than comparable municipal bonds not subject to any taxes. The high sensitivities of municipal bond prices to tax rates can be traced to individual retail traders dominating dealers and other institutions.

Abstract:
Individuals must pay tax on the secondary market transactions of tax-exempt bonds. The profits involving changes in bond prices are taxed either as income or as a capital gain. We find that municipal bonds carrying market discount, which are subject to income tax, command higher yields than municipal bonds not subject to taxes arising from secondary market trades. However, the after-tax yields on municipal bonds with market discount are around 30 basis points higher than yields on comparable municipal securities not subject to market discount taxation. We estimate an implied tax rate of around 80% using trades of municipal bonds entering regions where income tax rates apply.

municipal bonds, income and capital gains tax, de minimis boundary, public finance

Abstract:
We develop a new methodology for estimating time-varying factor loadings and conditional alphas based on nonparametric techniques. We test whether long-run alphas, or averages of conditional alphas over the sample, are equal to zero and derive test statistics for the constancy of factor loadings. The tests can be performed for a single asset or jointly across portfolios. The traditional Gibbons, Ross and Shanken (1989) test arises as a special case when there is no time variation in the factor loadings. As applications of the methodology, we estimate conditional CAPM and Fama and French (1993) models on book-to-market and momentum decile portfolios. We reject the null that long-run alphas are equal to zero even though there is substantial variation in the conditional factor loadings of these portfolios.

Nonparametric estimator, time-varying beta, conditional alpha, book-to-market premium, momentum effect

Abstract:
Surveys do! We examine the forecasting power of four alternative methods of forecasting U.S. inflation out-of-sample: time series ARIMA models; regressions using real activity measures motivated from the Phillips curve; term structure models that include linear, non-linear, and arbitrage-free specifications; and survey-based measures. We also investigate several optimal methods of combining forecasts. Our results show that surveys outperform the other forecasting methods and that the term structure specifications perform relatively poorly. We find little evidence that combining forecasts using means or medians, or using optimal weights with prior information produces superior forecasts to survey information alone. When combining forecasts, the data consistently places the highest weights on survey information.

Abstract:
Surveys do! We examine the forecasting power of four alternative methods of forecasting U.S. inflation out-of-sample: time series ARIMA models; regressions using real activity measures motivated from the Phillips curve; term structure models that include linear, non-linear, and arbitrage-free specifications; and survey-based measures. We also investigate several optimal methods of combining forecasts. Our results show that surveys outperform the other forecasting methods and that the term structure specifications perform relatively poorly. We find little evidence that combining forecasts using means or medians, or using optimal weights with prior information produces superior forecasts to survey information alone. When combining forecasts, the data consistently places the highest weights on survey information.

ARIMA, Phillips curve, forecasting, term structure models

Abstract:
We estimate the effect of shifts in monetary policy using the term structure of interest rates. In our no-arbitrage model, the short rate follows a version of the Taylor (1993) rule where the coefficients on the output gap and inflation vary over time. The monetary policy loading on the output gap has averaged around 0.4 and has not changed very much over time. The overall response of the yield curve to output gap components is relatively small. In contrast, the inflation loading has changed substantially over the last 50 years and ranges from close to zero in 2003 to a high of 2.4 in 1983. Long-term bonds are sensitive to inflation policy shifts with increases in inflation loadings leading to higher short rates and widening yield spreads.

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:
We estimate the effect of shifts in monetary policy using the term structure of interest rates. In our no-arbitrage model, the short rate follows a version of the Taylor (1993) rule where the coefficients on inflation and output can vary over time. We find that monetary policy loadings on inflation, but not output, changed substantially over the last 50 years. Agents tend to assign a risk discount to monetary policy shifts and are willing to pay to be exposed to activist monetary policy. Over 1952-2006, if agents had assigned no value to active monetary policy, the slope of the yield curve would have been approximately 50 basis points higher, and up to twice as volatile, than what actually occurred in data.

Quadratic term structure model, Monetary policy, Interest rate risk, time-varying parameter model

Abstract:
Surveys do! We examine the forecasting power of four alternative methods of forecasting U.S. inflation out-of-sample: time series ARIMA models; regressions using real activity measures motivated from the Phillips curve; term structure models that include linear, non-linear, and arbitrage-free specifications; and survey-based measures. We also investigate several methods of combining forecasts. Our results show that surveys outperform the other forecasting methods and that the term structure specifications perform relatively poorly. We find little evidence that combining forecasts produces superior forecasts to survey information alone. When combining forecasts, the data consistently places the highest weights on survey information.

ARIMA, Phillips curve, forecasting, term structure models

Abstract:
Stocks with greater downside risk, which is measured by higher correlations conditional on downside moves of the market, have higher returns. After controlling for the market beta, the size effect and the book-to-market effect, the average rate of return on stocks with the greatest downside risk exceeds the average rate of return on stocks with the least downside risk by 6.55% per annum. Downside risk is important for explaining the cross-section of expected returns. In particular of the profitability of investing in momentum strategies can be explained as compensation for bearing high exposure to downside risk.

Abstract:
A conditional one-factor model can account for the spread in the average returns of portfolios sorted by book-to-market ratios over the long run from 1926-2001. In contrast, earlier studies document strong evidence of a book-to-market effect using OLS regressions in the post-1963 sample. However, the betas of portfolios sorted by book-to-market ratios vary over time and in the presence of time-varying factor loadings, OLS inference produces inconsistent estimates of conditional alphas and betas. We show that under a conditional CAPM with time-varying betas, predictable market risk premia, and stochastic systematic volatility, there is little evidence that the conditional alpha for a book-to-market trading strategy is statistically different from zero.

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:
International equity returns are characterized by episodes of high volatility and unusually high correlations coinciding with bear markets. This article provides models of asset returns that match these patterns and illustrates their use in asset allocation. The presence of regimes with different correlations and expected returns is difficult to exploit within a framework focused on global equities. Nevertheless, for global all-equity portfolios, the regime-switching strategy dominated static strategies in an out-of-sample test. In addition, substantial value was added when an investor switched between domestic cash, bonds, and equity investments. In a persistent high-volatility market, the model told the investor to switch primarily to cash. Large market-timing benefits are possible because high-volatility regimes tend to coincide with periods of relatively high interest rates.

Portfolio Management: Asset Allocation, Portfolio Construction, Rebalancing and Implementation