Academic literature on the topic 'International finance. Tail risk. Asset pricing'

Abstract I document that dividend growth and returns on the aggregate U.S. stock market are more correlated with consumption growth in bad economic times. In a consumption-based asset pricing model with a generalized disappointment-averse investor and small, IID consumption shocks, this feature results in a realistic equity premium despite low risk aversion. The model is consistent with the main facts about stock market risk premiums inferred from equity index options, remains tightly parameterized, and allows for analytical solutions for asset prices. An extension with non-IID dynamics accounts for excess volatility and return predictability, while preserving the model’s consistency with option moments. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

The article shows how the international capital asset pricing model (ICAPM) with Markov regime switching can model the asset returns in the emerging market of Mexico. For most assets, although significant, the international risk premium factor is not subject to regime switching, but the domestic factor is. The probabilities of regimes are correlated with the volatility of assets. A GARCH(1,1) Markov regime switching model offers better adjustment than a non-GARCH. JEL Classification: C58, F36, F65, G12, G15

Using over 25 years of quarterly U.S. and Japanese time series data, this paper examines the determinants of demand for an important class of real assets: commercial real estate. We specify a structural model of market equilibrium that considers direct effects of real investment on built asset price. Our empirical findings are consistent across countries and produce several new results. First, we find that real investment exerts a significant positive direct effect on asset price, which in turn feeds back to impact investment decisions. Second, idiosyncratic risk is found to be strongly positively related to asset price, and to complement supply effects. Third, systematic risk is priced as expected, where the strength of the relation between asset price and systematic risk is found to be higher than in previous studies of capital asset prices. Fourth, lagged values of price determinants (of up to two years) are consistently important in real asset demand estimation. Alternative explanations for our findings are analyzed and discussed. Implications for asset pricing model specification and interpretation are also considered.

This study explores the sensitivity of the performance of Australian real estate investment trusts (A-REITs) to changes in short and long term interest rates. Based on the intertemporal capital asset pricing model in Merton (1973), we propose an asset pricing model that consists of market returns, macroeconomic indicators, and short and long term interest rates. The effect of market capitalisation is also explored. High debt funds show greater sensitivity to adverse movements in long term interest rates compared to low debt funds. This suggests that gearing levels play a significant role in the returns generating process. All size based portfolios exhibit strong exposure to market risk with medium size A-REITs displaying greater sensitivity to movements in both short and long term interest rates. Although market risk became a stronger driver of returns during the Global Financial Crisis (GFC), the impact was less prominent post-GFC possibly due to already low levels of interest which created an environment of cheap credit. The implications for asset allocation strategies are that portfolio managers and other investors can reduce exposure to interest rate risk by selecting funds with less leverage and are large in size. High debt funds benefit more during periods of low interest but this may be offset when there is a corresponding increase in long term interest rates.

AbstractOne striking feature of international portfolio investment is the extent to which equity portfolios are concentrated in the domestic equity market of the investor—the home bias puzzle. I examine the role of investors' perception of foreign investment risk on their portfolio choices. The expected returns and risk of foreign investment are specified through an asset pricing model with the home portfolio being the benchmark asset—Pastor's (2000) domestic CAPM. The model serves as a reference point around which investors can center their prior beliefs. I focus on investors' prior beliefs that are consistent with the literature on confidence in the familiar—foreign equities, in terms of both expected returns and risk, being viewed less favorably than domestic equities. These prior beliefs are then combined with the data on G7 equities, and the revised beliefs are used to obtain the global optimal asset allocation. To hold predominantly domestic equities, each G7 investor has to believe that the risk of foreign investment is several times higher than the actual risk. The home bias is more of a puzzle for a U.S. investor during the 1970s. Specifying investors' prior beliefs around the world CAPM does not help resolve the puzzle.

Purpose The capital asset pricing model (CAPM) is the most widely used asset pricing model that measures risk–return relationship. The CAPM is based on Markowitz’s mean variance analysis. The advancement of Islamic finance leads to the question whether or not the practice of modern investment theories and analyses such as the Markowitz’s mean variance analysis and CAPM are in accordance to shariah and could be used in pricing Islamic financial assets. Therefore, this paper aims to present a review of the CAPM and to discourse the set of assumptions underlying the model in terms of shariah compliance. Design/methodology/approach Although most of the assumptions are not contradictory to shariah principles, there are Islamic variables such as prohibition of short selling, purification and zakat that should be taken into consideration when pricing Islamic financial assets. We then develop a mathematical model which is a modification of the traditional CAPM that incorporates principles of Islamic finance and integrating zakat, purification of return and exclusion of short sales. Findings As a proof-of-concept, this paper presents the results of an empirical study on the proposed shariah-compliant CAPM in comparison to the traditional CAPM. The results show that the proposed Islamic CAPM is appropriate and applicable in examining the relationship between risk and return in the Islamic stock market. Originality/value This study contributes to existing body of knowledge by presenting an algorithm and mathematical derivation of the shariah-compliant CAPM which has been lacking in the literature of Islamic finance. The paper offers a novel approach in pricing Islamic financial assets in accordance to shariah, advocated by modern investment theories of Markowitz’s mean variance analysis and CAPM.

This study presents further evidence of the predictability of excess equity REIT (real estate investment trust) returns . Recent evidence on forecasting excess returns using fundamental variables has resulted in diminishing returns from the 1990’s onward. Trading strategies based on these forecasts have not significantly outperformed the buy/hold strategy of the 1990’s. We have developed an alternative strategy that is based on the time variation of the risk premium of investors. Our results indicate that it is possible to outperform the buy/hold strategy by modeling the time variation of the risk premium. By modeling the dynamic behavior of the risk premium, we are able to implicitly capture economic risk premiums that are not captured by conventional multi beta asset pricing models.

The goal of this thesis is to study the two key aspects of complexity of the financial system: interconnectedness and nonlinear relationships. In Chapter 1, I contribute to the literature that focuses on modelling the nonlinear relationship between variables at the extremes of their distribution. In particular, I study the nonlinear relationship between stock prices and short selling. Whereas most of the academic literature has focused on measuring the relationship between short selling and asset returns on average, in Chapter 1, I focus on studying the relationship that arises in the extremes of the two variables. I show that the association between financial stock prices and short selling can become extremely strong under exceptional circumstances, while at the same time being weak in normal times. The tail relationship is stronger for small cap firms, a result that is intuitively in line with the empirical findings that stocks with lower liquidity are more price-sensitive to short selling. Finally, results show that the adverse tail correlation between increases in short selling and declines in stock prices was not always lower during the ban periods, but had declined markedly towards the end of the analysis window. Such results cast doubts about the effectiveness of bans as a way to prevent self-reinforcing downward price spirals during the crisis. In Chapter 2, I propose a measure of interconnectedness that takes into account the time-varying nature of connections between financial institutions. Here, the parameters underlying comovement are allowed to evolve continually over time through permanent shifts at every period. The result is an extremely flexible measure of interconnectedness, which uncovers new dynamics of the US financial system and can be used to monitor financial stability for regulatory purposes. Various studies have combined statistical measures of association (e.g. correlation, Granger causality, tail dependence) with network techniques, in order to infer financial interconnectedness (Billio et al. 2012; Barigozzi and Brownlees, 2016; Hautsch et al. 2015). However, these standard statistical measures presuppose that the inferred relationships are time-invariant over the sample used for the estimation. To retrieve a dynamic measure of interconnectedness, the usual approach has been to divide the original sample period into multiple subsamples and calculate these statistical measures over rolling windows of data. I argue that this is potentially unsuitable if the system studied is time-varying. By relying on short subsamples, rolling windows lower the power of inference and induce dimensionality problems. Moreover, the rolling window approach is known to be susceptible to outliers because, in small subsamples, these have a larger impact on estimates (Zivot and Wang, 2006). On the other hand, choosing longer windows will lead to estimates that are less reactive to change, biasing results towards time-invariant connections. Thus, the rolling window approach requires the researcher to choose the window size, which involves a trade-off between precision and flexibility (Clark and McCracken, 2009). The choice of window size is critical and can lead to different results regarding interconnectedness. The major novelty of the framework is that I recover a network of financial spillovers that is entirely dynamic. To do so, I make the modelling assumption that the connection between any two institutions evolves smoothly through time. I consider this assumption reasonable for three main reasons. First, since connections are the result of many financial contracts, it seems natural that they evolve smoothly rather than abruptly. Second, the assumption implies that the best forecast of a connection in the future is the state of that connection today. This is consistent with the notion of forward-looking prices. Third, the assumption allows for high flexibility and for the data to speak for itself. The empirical results show that financial interconnectedness peaked around two main events: the Long-Term Capital Management crisis of 1998 and the great financial crisis of 2008. During these two events, I found that large banks and broker/dealers were among the most interconnected sectors and that real estate companies were the most vulnerable to financial spillovers. At the individual financial institution level, I found that Bear Stearns was the most vulnerable financial institution, however, it was not a major propagator, and this might explain why its default did not trigger a systemic crisis. Finally, I ranked financial institutions according to their interconnectedness and I found that rankings based on the time-varying approach were more stable than rankings based on other market-based measures (e.g. marginal expected short fall by Acharya et al. (2012) and Brownlees and Engle (2016)). This aspect is significant for policy makers because highly unstable rankings are unlikely to be useful to motivate policy action (Danielsson et al. 2015; Dungey et al. 2013). In Chapter 3, rather than assuming interconnectedness as an exogenous process that has to be inferred, as is done in Chapter 2, I model interconnectedness as an endogenous function of market dynamics. Here, I take interconnectedness as the realized correlation of asset returns. I seek to understand how short selling can induce higher interconnectedness by increasing the negative price pressure on pairs of stocks. It is well known that realized correlation varies continually through time and becomes higher during market events, such as the liquidation of large funds. Most studies model correlation as an exogenous stochastic process, as is done, for example, in Chapter 2. However, recent studies have proposed to interpret correlation as an endogenous function of the supply and demand of assets (Brunnermeier and Pedersen, 2005; Brunnermeier and Oehmke, 2014; Cont and Wagalath, 2013; Yang and Satchell, 2007). Following these studies, I analyse the relationship between short selling and correlation between assets. First, thanks to new data on public short selling disclosures for the United Kingdom, I connect stocks based on the number of common short sellers actively shorting them. I then analyse the relationship between common short selling and excess correlation of those stocks. To this end, I measure excess correlation as the monthly realized correlation of four-factor Fama and French (1993) and Carhart (1997) daily returns. I show that common short selling can predict one-month ahead excess correlation, controlling for similarities in size, book-to-market, momentum, and several other common characteristics. I verify the confirm the predictive ability of common short selling out-of-sample, which could prove useful for risk and portfolio managers attempting to forecast the future correlation of assets. Moreover, I showed that this predictive ability can be used to establish a trading strategy that yields positive cumulative returns over 12 months. In the second part of the chapter I concentrate on possible mechanisms that could give rise to this effect. I focus on three, non-exclusive, mechanisms. First, short selling can induce higher correlation in asset prices through the price-impact mechanism (Brunnermeier and Oehmke, 2014; Cont and Wagalath, 2013). According to this mechanism, short sellers can contribute to price declines by creating sell-order imbalances i.e. by increasing excess supply of an asset. Thus, short selling across several stocks should increase the realized correlation of those stocks. Second, common short selling can be associated with higher correlation if short sellers are acting as voluntary liquidity providers. According to this mechanisms, short sellers might act as liquidity providers in times of high buy-order imbalances (Diether et al. 2009b). In this cases, the low returns observed after short sales might be compensations to short sellers for providing liquidity. In a multi-asset setting, this mechanism would result in short selling being associated with higher correlation mechanism. Both above-mentioned mechanisms deliver a testable hypothesis that I verify. In particular, both mechanisms posit that the association between short selling and correlation should be stronger for stocks which are low on liquidity. For the first mechanism, the price impact effect should be stronger for illiquid stocks and stocks with low market depth. For the liquidity provision mechanism, the compensation for providing liquidity should be higher for illiquid stocks. The empirical results cannot confirm that uncovered association between short selling and correlation is stronger for illiquid stocks, thus not supporting the price-impact and liquidity provision hypothesis. I thus examine a third possible mechanism that could explain the uncovered association between short selling and correlation i.e. the informative trading mechanism. Short sellers have been found to be sophisticated market agents which can predict future returns (Dechow et al. 2001). If this is indeed the case, then short selling should be associated with higher future correlation. I found that informed common short selling i.e. common short selling that is linked to informative trading, was strongly associated to future excess correlation. This evidence supports the informative trading mechanism as an explanation for the association between short selling and correlation. In order to further verify this mechanism, I checked if informed short selling takes place in the data, whilst controlling for several of the determinants of short selling, including short selling costs. The results show evidence of both informed and momentum-based non-informed short selling taking place. Overall, the results have several policy implications for regulators. The results suggest that the relationship between short selling and future excess correlation is driven by informative short selling, thus confirming the sophistication of short sellers and their proven importance for market efficiency and price informativeness (Boehmer and Wu, 2013). On the other hand, I could not dismiss that also non-informative momentum-based short selling is taking place in the sample. The good news is that I did not find evidence of a potentially detrimental price-impact effect of common short selling for illiquid stock, which is the sort of predatory effect that regulators often fear.
Doctorat en Sciences économiques et de gestion
info:eu-repo/semantics/nonPublished

[Truncated abstract] This thesis examines competing asset-pricing models in Australia with the goal of establishing the model which best explains cross-sectional stock returns. The research employs Australian equity data over the period 1980-2001, with the major analyses covering the more recent period 1990-2001. The study first documents that existing asset-pricing models namely the capital asset pricing model (CAPM) and domestic Fama-French three-factor model fail to meet the widely applied Merton?s zero-intercept criterion for a well-specified pricing model. This study instead documents that the US three-factor model provides the best description of Australian stock returns. The three US Fama-French factors are statistically significant for the majority of portfolios consisting of large stocks. However, no significant coefficients are found for portfolios in the smallest size quintile. This result initially suggests that the largest firms in the Australian market are globally integrated with the US market while the smallest firms are not. Therefore, the evidence at this point implies domestic segmentation in the Australian market. This is an unsatisfying outcome, considering that the goal of this research is to establish the pricing model that best describes portfolio returns. Given pervasive evidence that liquidity is strongly related to stock returns, the second part of the major analyses derives and incorporates this potentially priced factor to the specified pricing models ... This study also introduces a methodology for individual security analysis, which implements the portfolio analysis, in this part of analyses. The technique makes use of visual impressions conveyed by the histogram plots of coefficients' p-values. A statistically significant coefficient will have its p-values concentrated at below a 5% level of significance; a histogram of p-values will not have a uniform distribution ... The final stage of this study employs daily return data as an examination of what is indeed the best pricing model as well as to provide a robustness check on monthly return results. The daily result indicates that all three US Fama-French factors, namely the US market, size and book-to-market factors as well as LIQT are statistically significant, while the Australian three-factor model only exhibits one significant market factor. This study has discovered that it is in fact the US three-factor model with LIQT and not the domestic model, which qualifies for the criterion of a well-specified asset-pricing model and that it best describes Australian stock returns.

Cette thèse de doctorat consiste en trois chapitres qui traitent des sujets de choix de portefeuilles de grande taille, et de mesure de risque. Le premier chapitre traite du problème d’erreur d’estimation dans les portefeuilles de grande taille, et utilise le cadre d'analyse moyenne-variance. Le second chapitre explore l'importance du risque de devise pour les portefeuilles d'actifs domestiques, et étudie les liens entre la stabilité des poids de portefeuille de grande taille et le risque de devise. Pour finir, sous l'hypothèse que le preneur de décision est pessimiste, le troisième chapitre dérive la prime de risque, une mesure du pessimisme, et propose une méthodologie pour estimer les mesures dérivées. Le premier chapitre améliore le choix optimal de portefeuille dans le cadre du principe moyenne-variance de Markowitz (1952). Ceci est motivé par les résultats très décevants obtenus, lorsque la moyenne et la variance sont remplacées par leurs estimations empiriques. Ce problème est amplifié lorsque le nombre d’actifs est grand et que la matrice de covariance empirique est singulière ou presque singulière. Dans ce chapitre, nous examinons quatre techniques de régularisation pour stabiliser l’inverse de la matrice de covariance: le ridge, spectral cut-off, Landweber-Fridman et LARS Lasso. Ces méthodes font chacune intervenir un paramètre d’ajustement, qui doit être sélectionné. La contribution principale de cette partie, est de dériver une méthode basée uniquement sur les données pour sélectionner le paramètre de régularisation de manière optimale, i.e. pour minimiser la perte espérée d’utilité. Précisément, un critère de validation croisée qui prend une même forme pour les quatre méthodes de régularisation est dérivé. Les règles régularisées obtenues sont alors comparées à la règle utilisant directement les données et à la stratégie naïve 1/N, selon leur perte espérée d’utilité et leur ratio de Sharpe. Ces performances sont mesurée dans l’échantillon (in-sample) et hors-échantillon (out-of-sample) en considérant différentes tailles d’échantillon et nombre d’actifs. Des simulations et de l’illustration empirique menées, il ressort principalement que la régularisation de la matrice de covariance améliore de manière significative la règle de Markowitz basée sur les données, et donne de meilleurs résultats que le portefeuille naïf, surtout dans les cas le problème d’erreur d’estimation est très sévère. Dans le second chapitre, nous investiguons dans quelle mesure, les portefeuilles optimaux et stables d'actifs domestiques, peuvent réduire ou éliminer le risque de devise. Pour cela nous utilisons des rendements mensuelles de 48 industries américaines, au cours de la période 1976-2008. Pour résoudre les problèmes d'instabilité inhérents aux portefeuilles de grandes tailles, nous adoptons la méthode de régularisation spectral cut-off. Ceci aboutit à une famille de portefeuilles optimaux et stables, en permettant aux investisseurs de choisir différents pourcentages des composantes principales (ou dégrées de stabilité). Nos tests empiriques sont basés sur un modèle International d'évaluation d'actifs financiers (IAPM). Dans ce modèle, le risque de devise est décomposé en deux facteurs représentant les devises des pays industrialisés d'une part, et celles des pays émergents d'autres part. Nos résultats indiquent que le risque de devise est primé et varie à travers le temps pour les portefeuilles stables de risque minimum. De plus ces stratégies conduisent à une réduction significative de l'exposition au risque de change, tandis que la contribution de la prime risque de change reste en moyenne inchangée. Les poids de portefeuille optimaux sont une alternative aux poids de capitalisation boursière. Par conséquent ce chapitre complète la littérature selon laquelle la prime de risque est importante au niveau de l'industrie et au niveau national dans la plupart des pays. Dans le dernier chapitre, nous dérivons une mesure de la prime de risque pour des préférences dépendent du rang et proposons une mesure du degré de pessimisme, étant donné une fonction de distorsion. Les mesures introduites généralisent la mesure de prime de risque dérivée dans le cadre de la théorie de l'utilité espérée, qui est fréquemment violée aussi bien dans des situations expérimentales que dans des situations réelles. Dans la grande famille des préférences considérées, une attention particulière est accordée à la CVaR (valeur à risque conditionnelle). Cette dernière mesure de risque est de plus en plus utilisée pour la construction de portefeuilles et est préconisée pour compléter la VaR (valeur à risque) utilisée depuis 1996 par le comité de Bâle. De plus, nous fournissons le cadre statistique nécessaire pour faire de l’inférence sur les mesures proposées. Pour finir, les propriétés des estimateurs proposés sont évaluées à travers une étude Monte-Carlo, et une illustration empirique en utilisant les rendements journaliers du marché boursier américain sur de la période 2000-2011.
This thesis consists of three chapters on the topics of portfolio choice in a high-dimensional context, and risk measurement. The first chapter addresses the estimation error issue that arises when constructing large portfolios in the mean-variance framework. The second chapter investigates the relevance of currency risk for optimal domestic portfolios, evaluates their ability of to diversify away currency risk, and study the links between portfolio weights stability and currency risk. Finally, under the assumption that decision makers are pessimistic, the third chapter derives the risk premium, propose a measure of the degree of pessimism, and provide a statistical framework for their estimation. The first chapter improves the performance of the optimal portfolio weig-hts obtained under the mean-variance framework of Markowitz (1952). Indeed, these weights give unsatisfactory results, when the mean and variance are replaced by their sample counterparts (plug-in rules). This problem is amplified when the number of assets is large and the sample covariance is singular or nearly singular. The chapter investigates four regularization techniques to stabilizing the inverse of the covariance matrix: the ridge, spectral cut-off, Landweber-Fridman, and LARS Lasso. These four methods involve a tuning parameter that needs to be selected. The main contribution is to derive a data-based method for selecting the tuning parameter in an optimal way, i.e. in order to minimize the expected loss in utility of a mean-variance investor. The cross-validation type criterion derived is found to take a similar form for the four regularization methods. The resulting regularized rules are compared to the sample-based mean-variance portfolio and the naive 1/N strategy in terms of in-sample and out-of-sample Sharpe ratio and expected loss in utility. The main finding is that regularization to covariance matrix significantly improves the performance of the mean-variance problem and outperforms the naive portfolio, especially in ill-posed cases, as suggested by our simulations and empirical studies. In the second chapter, we investigate the extent to which optimal and stable portfolios of domestic assets can reduce or eliminate currency risk. This is done using monthly returns on 48 U.S. industries, from 1976 to 2008. To tackle the instabilities inherent to large portfolios, we use the spectral cut-off regularization described in Chapter 1. This gives rise to a family of stable global minimum portfolios that allows investors to select different percentages of principal components for portfolio construction. Our empirical tests are based on a conditional International Asset Pricing Model (IAPM), augmented with the size and book-to-market factors of Fama and French (1993). Using two trade-weighted currency indices of industrialized countries currencies and emerging markets currencies, we find that currency risk is priced and time-varying for global minimum portfolios. These strategies also lead to a significant reduction in the exposure to currency risk, while keeping the average premium contribution to total premium approximately the same. The global minimum weights considered are an alternative to market capitalization weights used in the U.S. market index. Therefore, our findings complement the well established results that currency risk is significantly priced and economically meaningful at the industry and country level in most countries. Finally, the third chapter derives a measure of the risk premium for rank-dependent preferences and proposes a measure of the degree of pessimism, given a distortion function. The introduced measures generalize the common risk measures derived in the expected utility theory framework, which is frequently violated in both experimental and real-life situations. These measures are derived in the neighborhood of a given random loss variable, using the notion of local utility function. A particular interest is devoted to the CVaR, which is now widely used for asset allocation and has been advocated to complement the Value-at-risk (VaR) proposed since 1996 by the Basel Committee on Banking Supervision. We provide the statistical framework needed to conduct inference on the derived measures. Finally, the proposed estimators