Knowledge that Transforms

We show that several asset pricing models that rely on long-run risks imply that the state of the economy can be captured by factors derived from the price-dividend ratios of stock portfolios. We find two factors with small growth and large value tilts are important for this purpose, thereby relating the Fama-French model and the Bansal-Yaron and Merton intertemporal asset pricing models. As predicted by the model, these price-dividend ratio factors track consumption volatility and predict future consumption and stock dividends, and the covariance of returns with their innovations explains the cross-section of average returns of several stock portfolios.

Reduced-form models of default calibrated to expected default losses and comovements between default losses and an equity-based pricing kernel generate CDS spreads that tend to fall below historical values. In frictionless markets, resolving this credit spread puzzle requires credit-market investors, especially those in high-quality debt, to be more risk adverse than equity-market investors. In the absence of market segmentation, however, the puzzle points to a liquidity component that, depending on themodel specification, can account for more than half of historical CDS spreads. These findings caution against fitting reduced-formmodels to CDS spreads without accounting for market segmentation or frictions. (JEL G12, G13, G22, G24) It has been a long-standing puzzle that structural credit riskmodels calibrated to historical default and recovery rates produce investment-grade (IG) cor-porate bond yield spreads that are below historical values. While structural models offer much needed economic content to credit risk modeling, this credit spread puzzle cautions against their unconditional use. Reduced-form credit risk models, on the other hand, offer less economic content but

Using structural credit risk models to estimate default dependence requires estimates of correlations of changes in distance-to-default. We present a structural model that yields simple relations between asset value, distance-to-default, and CDS spreads, allowing the correlations to be estimated from CDS spreads. We generalize the model to include a randomly varying default boundary; in this version the distance-to-default dynamics also depend on the movement of the default boundary. The CDS spread correlations we estimate exceed equity correlations, consistent with a randomly varying default boundary. We also present evidence that variations in funding liquidity affect the correlations, consistent with recent models.

As a result of poor asset allocation decisions by 401(k) participants, 72% of all plans now offer target date funds, and participants heavily invest in them. Here, we study the characteristics and performance of TDFs, providing a unique view by employing data on TDFs holdings. We show that additional expenses charged by TDFs are largely offset by the low-cost share classes they hold, not normally open to their investors. Additionally, TDFs are very active in their allocation decisions and increasingly bet on nonstandard asset classes. However, TDFs do not earn alpha from timing or their selection of individual assets.

Stock returns are characterized by extreme observations, jumps that would not occur under the smooth variation typical of a Gaussian process. Jumps are prevalent in most countries, but their cross-country comovements have not been extensively documented. This is important because international diversification is less effective if jumps are frequent, unpredictable, and strongly correlated. We investigate using returns on broad equity indexes from eighty-two countries and modern statistical measures of jumps. We find that jumps are weakly correlated internationally, except within Europe. Although the variation in ordinary returns seems to reflect systematic global factors, jumps are more idiosyncratic.

A closet indexer is more likely to meet a value-weighted investment benchmark by value weighting the portfolio. Following this intuition, we introduce a simple measure of active management, the absolute difference between the value weights and actual weights held by a fund, summed across its holdings. This proxy captures managerial skill: active funds outperform passive ones by 2.5% annually. Compared with known measures of skill, our proxy robustly predicts fund flows, asset growth, factor-adjusted performance, and value added. Its predictive ability is orthogonal to that of other measures and is robust to controlling for volatility timing, past performance, and style.

We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average first-order autocorrelation coefficient of hedge fund returns, and show that it has strong and robust in- and out-of-sample forecasting power for 72 portfolios of international equities, U.S. corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables. We rationalize these findings using a simple equilibrium model, in which hedge funds provide liquidity in asset markets.

We study price linkages between assets held by financial institutions that maintain fixed capital structures over time. Firms in the banking sector manage their leverage ratios to conform to prespecified levels. Our analysis suggests that regulatory policies aimed at stabilizing the system by imposing capital constraints on banks may have unintended consequences: banks’ deleveraging activities may amplify asset return shocks and lead to large fluctuations in realized returns. The same mechanism can cause spillover effects, where assets held by leverage targeting banks can experience hikes or drops caused by shocks to otherwise unrelated assets held by the same banks.

Journal Article Announcements Get access The Review of Asset Pricing Studies, Volume 4, Issue 2, December 2014, Page 161, https://doi.org/10.1093/rapstu/rau008 Published: 08 November 2014

Journal Article Subscription Page Get access The Review of Asset Pricing Studies, Volume 4, Issue 2, December 2014, Page i3, https://doi.org/10.1093/rapstu/rat014 Published: 08 November 2014