Knowledge that Transforms

Journal Article Subscription Page Get access The Review of Asset Pricing Studies, Volume 6, Issue 2, December 2016, Page i3, https://doi.org/10.1093/rapstu/rav017 Published: 15 November 2016

This paper examines the effects of macro-level disagreement on the cross-section of stock returns. Using forecast dispersion measures from the Survey of Professional Forecasters database as proxies for macro disagreement, I find that high macro beta stocks earn lower future returns relative to low macro beta stocks following high macro disagreement states. This negative relation between returns for macro factors and macro disagreement is robust and exists for a large set of macroeconomic factors, suggesting that high macro beta stocks are overvalued compared with low macro beta stocks due to their greater sensitivity to aggregate disagreement

We document that speed of information dissemination within mutual fund families positively affects fund performance. This suggests that the resultant benefits of higher information precision far outweigh free-riding costs associated with fast internal dissemination. The performance effect is stronger when information travels across managers from different, rather than the same, styles. This is consistent with fast information diffusion aggregating complementary insights that sharpen information precision, but also with fewer free-riding opportunities among managers from different styles. Managers rationally exploit the resultant higher information precision by trading more, relying less on public information, and investing differently than unaffiliated peers.

This paper examines whether investors receive compensation for holding stocks with a strong sensitivity to extreme market downturns in a sample covering forty countries. Worldwide, stocks with strong crash sensitivity deliver average returns of more than 7% p.a. higher than stocks with weak crash sensitivity. The effect is robust across geographical subsamples and is not explained by systematic risk factors and alternative firm characteristics. I show that the risk premium is particularly pronounced in countries that display negative market skewness, high income per capita, and rank high on Hofstede’s individualism index.

Asset pricing models predict a strong connection between the real risk-free interest rate and the macroeconomy, but prior research finds little empirical support for the connection when examining expected growth. This paper documents a robust relation between the interest rate and macroeconomic uncertainty (i.e., conditional variance). Consistent with precautionary savings, high uncertainty is associated with a low interest rate using numerous data sources, time periods, and measures. A relation between habit and the interest rate disappears after including uncertainty, and the relation is stronger using long-run uncertainty. The results imply that analyses of the interest rate without uncertainty are seriously incomplete.

This paper shows that Edgeworth expansions for option valuation are equivalent to approximating option payoffs using Hermite polynomials. Consequently, the value of an option is the value of an infinite series of replicating polynomials. The resultant formulas express option values in terms of skewness, kurtosis, and higher moments. Unfortunately, the Hermite series diverges for fat-tailed models, so we provide alternative moment-based formulas. These formulas are a computationally efficient alternative to Fourier transform valuation and can value options even when the characteristic function is unknown. Applications include the first convergent solution for Hull and White’s stochastic volatility model.

We analyze the contribution of leisure preferences to a model of long-run risks in leisure and consumption growth. The marginal utility of consumption is affected by short- and long-run risks in leisure under nonseparable and recursive preferences. We match equity risk premia and macroeconomic moments with plausible coefficients of relative-risk aversion. Additionally, the model generates a less negative to positively sloped average real yield curve, depending on the elasticity of substitution between the consumption of nondurables and services and leisure. Further, the incorporation of leisure in utility allows us to derive model implications for the return on human capital.

We propose a novel regime-switching model to study correlation asymmetries in international equity markets. We decompose returns into frequent-but-small diffusion and infrequent-but-large jumps and derive an estimation method for many countries. We find that correlations due to jumps, not diffusion, markedly increase in bad markets, leading to correlation breaks during crises. Our model provides a better description of correlation asymmetries than do GARCH, copula, and stochastic volatility models. Good and bad regimes are persistent. Regime changes are detected rapidly, and risk diversification allocations are improved. Asset allocation results in- and out-of-sample are superior to other models, including the 1/N strategy.

We propose a dynamic asset pricing model in which two assets with identical cash flows can trade at different prices not only because of differences in liquidity but counterparty risk. Counterparty risk reduces lenders or borrowers’ willingness to supply funds and collateral, incentives to shortsell and lend, and the likelihood for new bonds to be on special, thereby narrowing on-/off-the-run spreads and affecting asset prices in spot markets. Consistent with this prediction, we find that on-/off-the-run spreads are low when counterparty risk is high and this relationship is much stronger during the financial crisis.