Knowledge that Transforms

Prior literature shows that implied volatility spreads between call and put options are positively related to future underlying stock returns. In this paper, however, we demonstrate that the volatility spreads are negatively related to future out-of-the-money call option returns. Using unique data on option volumes, we reconcile the two pieces of evidence by showing that option demand by sophisticated, firm investors drives the positive stock return predictability based on volatility spreads, while demand by less sophisticated, customer investors drives the negative call option return predictability. Overall, our evidence suggests that volatility spreads contain information about both firm fundamentals and option mispricing. (JEL G12, G13, G14, L83)

Journal Article Announcements Get access The Review of Asset Pricing Studies, Volume 2, Issue 2, December 2012, Page 111, https://doi.org/10.1093/rapstu/ras009 Published: 10 November 2012

Affine term structure models imply an affine relation between yields and factors, and between yields and yields. Hence, a necessary condition for the affine class to hold is that yield changes are linearly related to changes in as many other yields as the number of underlying risk factors. At the same time, yield changes should be unrelated to changes in nonlinear transformations of other yields. We test this hypothesis using weekly data on U.S. Treasury yields for the June 1961–December 2002 sample period. Bootstrap-adjusted tests lead to only weak rejections of the affine class, and a simulation shows that these tests have correct size and high power. Imposing the cross-equation restrictions deriving from a no-arbitrage affine term structure model leads to stronger rejections, but these stronger rejections have more to do with the no-arbitrage restrictions than with the implication of linearity. In an out-of-sample hedging exercise, the constant hedge ratios implied by the affine class generally outperform time-varying hedge ratios implied by nonlinear models.

Berk and Green (2004) make a theoretical argument that performance persistence should not exist since new money flows into well-performing mutual funds and there are diseconomies of scale, or because successful funds capture excess returns by raising fees. We find that performance prediction continues when we examine samples of larger and larger funds and that past performance predicts future performance for holding periods up to three years. Funds that outperform index funds of the same risk can be identified. We find that expense ratios are lower for large funds, and decrease as funds get larger or perform well.

This study examines battles between short sellers and firms. Firms use a variety of methods to impede short selling, including legal threats, investigations, lawsuits, and various technical actions intended to create a short squeeze. These actions create short sale constraints. Consistent with the hypothesis that short sale constraints allow stocks to be overpriced, firms taking anti-shorting actions have in the subsequent year very low abnormal returns of about −2% per month.

We show that credit risk accounts for only a small fraction of yield spreads for investment-grade bonds of all maturities, with the fraction lower for bonds of shorter maturities, and that it accounts for a much higher fraction of yield spreads for high-yield bonds. This conclusion is shown to be robust across a wide class of structural models. We obtain such results by calibrating each of the models to be consistent with data on the historical default loss experience and equity risk premia, and demonstrating that different models predict similar credit risk premia under empirically reasonable parameter choices. (JEL G13, G12, G33, G24)

Global asset pricing models have failed to capture the cross-section of country equity returns. Emerging markets display robust positive pricing errors, and country-level characteristics play a role in pricing international equities. This paper offers a risk-based explanation for such asset pricing deviations. A world credit risk factor is significantly priced in the cross-section of country equity returns. In its presence, the positive pricing errors in emerging markets disappear and country-level characteristics no longer play a role. The risk premium for exposure to the credit risk factor is 80 basis points per month and has increased in recent years. (JEL G12, G14, G15)

Government bonds comove more strongly with bond-like stocks: stocks of large, mature, low-volatility, profitable, dividend-paying firms that are neither high growth nor distressed. Variables that are derived from the yield curve that are already known to predict returns on bonds also predict returns on bond-like stocks; investor sentiment, a predictor of the cross-section of stock returns, also predicts excess bond returns. These relationships remain in place even when bonds and stocks become “decoupled” at the index level. They are driven by a combination of effects including correlations between real cash flows on bonds and bond-like stocks, correlations between their risk-based return premia, and periodic flights to quality.

We analyze mutual fund industry selectivity—the performance of a fund’s industry allocation relative to the market. We find that industry selection accounts for a full third of fund performance based on two-digit standard industrial classification (SIC) codes, with the remaining attributable to the performance of individual stocks relative to their own industries. More importantly, we find that industry-selection skill drives persistence in relative performance. Unlike stock-selection ability, industry selectivity is not eroded by increasing fund assets. Our results suggest that accounting for a manager’s ability to pick outperforming industries provides information beyond standard performance measures that can enhance a fund investor’s future performance. (JEL G11, G14, G23)

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this article, we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds.