Does Interest Rate Exposure Explain the Low Volatility Anomaly? Saturday, 24 September, 2016

Related to:
#6 - Volatility Effect in Stocks - Long-Short Version

Authors: Driessen, Kuiper, Beilo

Title: Does Interest Rate Exposure Explain the Low Volatility Anomaly?

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2831157

Abstract:

We show that part of the outperformance of low volatility stocks can be explained by a premium for interest rate exposure. Low volatile portfolios have a positive exposure to interest rates, whereas the more volatile stocks have a negative exposure. Incorporating an interest rate premium explains part of the anomaly. Depending on the methodology chosen the reduction of unexplained excess return is between 20% and 80%. Our results provide evidence that interest rate risk is priced differently in the bond and equity market. Our results imply a strong implicit exposure of low volatility portfolios to bonds.

Notable quotations from the academic research paper:

"A relation between the low volatility anomaly and government bonds makes sense if volatility is thought of as an indicator of how far equity is removed from bonds in the capital structure. In this study our main finding is that the outperformance of low volatility stocks can be explained by differences in interest rate exposure. We find that low volatility portfolios have more exposure to this risk. Our results imply a strong implicit exposure to interest rate risk of low volatility portfolios. We estimate that the duration of the lowest volatility decile corresponds to a 30% weight to bonds. The duration of the highest decile corresponds to a short position of 100% short bonds.

Because of the differences in exposure, the risk premium that we estimate explains part of the excess return of a long short portfolio. We find a monthly compensation of interest rate risk in equities of 0.91%, with a standard error of 0.20%. The differences in interest rate exposure combined with the large estimated risk premium, results in a significantly reduced mispricing of low volatility stocks. We find these results to be robust for taking into account the time variance of the interest rate exposure.

For our study we use ten portfolios over the period from July 1963 to December 2014, defined by sorts on residual variance of individual US stocks using the Fama French 3 factor model. In section 3 we elaborate further on this. We define an interest rate factor as the return of an equal weight portfolio consisting of US government bonds with various maturities. In order to estimate the interest rate exposure we run time series regressions. Fama MacBeth regressions are employed to estimate the premium for the interest rate exposure. Combined these two enable us to evaluate the impact of this effect on the unexpected excess return of the long short portfolio. We use several different estimations of the premium in order to test the robustness of our findings."


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Carry Trade Returns and Political Risks Tuesday, 13 September, 2016

Related to #5 - FX Carry Trade

Author: Kesse

Title: Exchange Rates, Carry Trade Returns and Political Risks

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2813028

Abstract:

This paper elucidates the channels through which sovereign risk, exchange rates and currency risk premia are related. I show that the channels are different depending on whether a country is classified as emerging or an advanced economy. Generally, for emerging market economies, local sovereign risk factors, namely country-specific political risk and macroeconomic risk do play a significant role in the depreciation of the local currency relative to the U.S. dollar. Whilst there is no convincing evidence that local determinants of sovereign risk cause a depreciation of currencies of advanced economies before the 2007 financial crisis, I do find that political risk does matter for advanced economies in the post-crisis era. For both sets of economies, global factors also play an important role in the relationship between sovereign risk and exchange rates. Secondly, double-sorting 34 currencies into different portfolios based on the level of macro risk and political risk, I provide evidence that local determinants of sovereign risk are priced in the FX markets, i.e. they can forecast currency carry trade excess returns in the cross-section. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. This is the first research to explain carry trade excess returns with local sovereign risk factors as against sovereign risk as a whole.

Notable quotations from the academic research paper:

"The measure of country political risk is derived from the political risk rating of the International Country Risk Guide (ICRG). It is forward-looking and reflects political risk as opposed to an aggregate or broad measure of country risk which also incorporates macro-economic factors. While ICRG's rating is mostly subjective assessments of various country experts, there is ample evidence in the literature that it correctly reects the adverse effects of political risk on investment values across countries

The political risk rating is composed of 12 subcomponents namely: government stability, socioeconomic conditions, investment profile, internal conflict, external conflict, corruption, military in politics, religious tensions, ethnic tensions, law and order, democratic accountability and bureaucratic quality. This measure ranges from 0-100 with higher scores reflecting low level of political risk. Following (Bekaert et al., 2014), I construct country political risk as the difference of the log inverse of the ICRG rating for a country and the log inverse of the equivalent rating for the U.S.A, i.e. log(1/pr^f ) - log(1/pr^us).

I find that for emerging markets, an increasing level of political risk generally leads to a depreciation of the currency. A rising level of the other country-specific component of sovereign risk, i.e. macroeconomic risk also generally leads to a depreciation of the local currency. Of the two country-specific risks, political risk seems to have the stronger effect on currency depreciation in terms of magnitude. Whereas I find no such effect of country-specific political risk and macroeconomic risk on exchange rates for developed economies in the pre-2007 financial crisis period, I do find that political risk does matter for advanced economies post-2007 crisis. For both sets of economies, increasing global risk aversion generally leads to a depreciation of the currency under all sub-samples.

Secondly, I investigated whether our local determinants of sovereign risk have the ability to explain currency carry trade excess returns. I do find that they indeed do. Portfolios double-sorted on country-political risk and macroeconomic risk produce excess returns and slopes that increase from low political risk portfolios to high political risk portfolios under all macro risk groups in the post-2007 crisis sub-period. The argument for political risk being priced is less convincing under the pre-2007 crisis sub-sample. Instead, there is a stronger case for macro risk being priced pre-2007 financial crisis whereas the argument for macro risk is weaker post-2007 financial crisis."


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Quantopian & Quantpedia Trading Strategy Series: Reversal during Earnings Announcements Friday, 9 September, 2016

We are really excited that Quantopian & Quantpedia Trading Strategy Series continues with a second article focused on Reversal Effect during Earning Announcements (Strategy #307).

Click on a "View Notebook" button to read a complete analysis:
https://www.quantopian.com/posts/quantpedia-trading-strategy-series-reversal-during-earnings-announcements

Eric C. So of MIT and Sean Wang of UNC in their paper News-Driven Return Reversals: Liquidity Provision Ahead of Earnings Announcements show that abnormal short-term returns reversals take place during the period immediately surrounding earnings announcements. They surmise that this reversal results from market makers' response to a temporary demand imbalance, as they temporarily shift the stock's price to ride out the imbalance.

Quantopian's analysis by Nathan Wolfe confirms initial findings of So & Wang original academic paper. Nathan finds evidence of returns reversal during earnings announcements; while the paper tested using data from 1996 to 2011, Nathan used data from 2007 to 2016. The average reversal among all stocks in his data is 0.449%, compared to a result of 1.448% in the paper. He found that we can reasonably increase the reversal to 0.6% by selecting firms based on a minimum average dollar volume percentile, or based on a minimum market cap.

In order to ensure liquidity, the strategy limits its universe to those stocks in the Q500US which are at or above the 95th percentile of average dollar volume among all equities on the platform. One day before each earnings announcement for each company, the algorithm determines the stock's 5-day returns quintile among all equities. Since reversal is expected, the algorithm goes short on the stock if it's in the highest quintile and long if it's in the lowest quintile. Positions are usually held for one day.

The final Quantopian OOS equity curve looks again really good:

Strategy's performance

Perfect work from Nathan!

You may also check first article in this series if you liked the current one. We are again looking forward to the next one ...

Effect of Maturity Structure of Roll Yields in Commodity Futures Strategies Sunday, 4 September, 2016

Related to multiple commodity futures long/short strategies, mainly to term-structure based strategies (like #22 - Term Structure Effect in Commodities) ...

Authors: Ghoddusi

Title: Maturity Structure of Commodity Roll Strategies: Evidence from the Energy Futures

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2820228

Abstract:

We investigate the maturity-structure of roll strategy returns in the energy futures markets. Our innovation is to report and analyze the risk/return profile, the Sharpe ratio, and the asset pricing loadings of rollover strategies based on futures contracts of the same underlying commodity but with maturities between two and 12 months. We find that a conditional rollover strategy, which takes a long position in backwardation and a short position in contango, delivers the highest Sharpe ratio for all commodities. While we don't observe a significant difference in terms of asset pricing beta for different roll positions, the Sharpe ratio tends to be higher for contracts with a shorter time to maturity. We also report some distinct patterns of maturity-structure across energy commodities. Findings of the paper have implications for managing commodity-based investments.

Notable quotations from the academic research paper:

"The rollover (or roll) strategy includes entering a futures contract with a given time-to-maturity, holding the futures contracts for a certain time period (typically for one month), and then closing the position to realize the return generated by changes in the price of the underlying futures contract. The investor then opens a new futures contract position (with the same time-to-maturity as before) and repeats the strategy.

The main contribution of the current paper is to examine the performance of rollover strategies de ned on futures contracts with di fferent time-to-maturity or what we call maturity structure of roll yields. By allowing the investment strategy to enter and exit futures contracts beyond the front month and to hold the contract for a time shorter than its maturity, we construct the maturity structure and discuss its properties for the ve selected commodities.

We document a monotonic relationship between the length of futures contracts and three key measures: the average return, the volatility of returns, and the Sharpe ratio. The results are robust for all commodities. The average return and volatility curves all decline with the length of the futures contract. However, the slope of the Sharpe ratio curve depends on the investment strategy chosen. For unconditional investment strategies the slope is positive, meaning that the further into the future the maturity date of the futures contracts, the higher is the Sharpe ratio. The relationship gets reversed when the investment position is conditioned on the slope of the forward curve."


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Equity Anomalies Persist in International Markets Monday, 22 August, 2016

A very important academic paper suggests that investors should trade global equity markets if they want to pursue equity long-short strategy ... Related to multiple equity long/short strategies...

Authors: Jacobs, Muller

Title: Anomalies Across the Globe: Once Public, No Longer Existent?

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2816490

Abstract:

Motivated by McLean and Pontiff (2016), we study the pre- and post-publication return predictability of 138 anomalies in 39 stock markets. Based on more than a million anomaly country-months, we find that the United States is the only country with a statistically significant and economically meaningful post-publication decline in long/short returns. The surprisingly large differences between the U.S. and international markets cannot be fully explained with general time effects or differences in limits to arbitrage, in-sample anomaly profitability, data availability, or local risk factor exposure. Our results have implications for the recent literature on arbitrage trading, data mining, and market segmentation.

Notable quotations from the academic research paper:

"In this study, we explore post-publication effects of 138 anomalies in the U.S. and 38 international stock markets.

International stock markets are economically important. During our sample period from January 1981 to December 2013, non-U.S. countries account on average for about 59% of the world market capitalization and for 72% of global GDP. Existing asset pricing tests in general tend to focus on the U.S. stock market. International out-of-sample tests may help to provide novel insights into the price discovery process and to enrich or challenge our understanding of price formation.

Indeed, we fi nd surprisingly large differences between post-publication effects in the U.S. stock market and international markets. Among the 39 stock markets that we study, only the U.S. market shows a signifi cant post-publication decline in long/short returns. In contrast, the same econometric framework suggests that none of the 38 international markets yields a signi ficant post-publication decline in anomaly returns. Overall, we do not find reliable evidence for an arbitrage-driven decrease in anomaly pro tability in international markets.

We explore several possible mechanisms behind the surprisingly large differences between the return dynamics in the U.S. and international markets, but are unable to fully explain the results. Our findings are consistent with the idea that sophisticated investors learn about mispricing from academic studies, but then focus mainly on the U.S. market. In addition to these event-time publication effects, there is a general negative calendar-time trend in anomaly returns in the U.S. stock market, but not in other major stock markets.

Averaged over our whole sample period, long/short anomaly returns in (various subsets of) international markets turn out to be similar in magnitude as the estimates for the U.S. market. This unconditional view suggests that many anomalies tend to be a global phenomenon and thus are unlikely to be mainly driven by data mining.

Our findings add to the large literature on international stock market segmentation. We contribute to this debate by providing evidence for seemingly strong geographic stock market segmentation which appears to have significant effects on the formation of prices. From a practical point of view, these findings may offer quantitative arbitrageurs insights into ways to optimize their investment process. A thorough analysis of geographic differences in capital invested in quantitative arbitrage strategies is needed.

"


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