The Size Effect Has a Lottery-Style Payoff Friday, 11 January, 2019

A new research paper related mainly to:

#25 - SIze Premium

Authors: McGee, Olmo

Title: The Size Premium As a Lottery

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3279645

Abstract:

We investigate empirically the dependence of the size effect on the top performing stocks in a cross-section of risky assets separated by industry. We propose a test for a lottery-style factor payoff based on a stochastic utility model for an under-diversified investor. The associated conditional logit model is used to rank different investment portfolios based on size and we assess the robustness of the ranking to the inclusion/exclusion of the best performing stocks in the cross-section. Our results show that the size effect has a lottery-style payoff and is spurious for most industries once we remove the single best returning stock in an industry from the sample each month. Analysis in an asset pricing framework shows that standard asset pricing models fail to correctly specify the size premium on risky assets when industry winners are excluded from the construction of the size factor. Our findings have implications for stock picking, investment management and risk factor analysis.

Notable quotations from the academic research paper:

" Firms with small market capitalization tend to outperform larger companies. Investors are attracted to lottery-like assets with positively skewed returns because they o ffer a very large payoff with a small probability, which the investors overweight. This demand makes positively skewed securities overpriced and likely to earn low returns. In this article we test whether the size/market capitalization attribute, and associated factor-mimicking portfolios, receive a lottery-like payoff . The implications of this are that most small stocks do not payoff and the returns to a size strategy are driven by a small number of winners. This type of payo ff can be captured through diversi fication but leaves an under-diversifi ed investor exposed. The risk being that they will not include winning stocks and their resulting return expectation is negative.

To investigate the e ffect of winning stocks on the performance of investment portfolios based on the size we propose a conditional logit model for ranking di fferent investment portfolios based on size and assess the robustness of the ranking to the inclusion/exclusion of the best performing stocks in the cross-section. This parametric choice is embedded within a stochastic utility model for explaining the investment decisions of under-diversi fied size investors aiming to exploit the so-called size premium. under-diversifi ed individuals maximize their expected utility in each period by choosing the stock that is predicted to yield the highest return (highest positive skew). This choice is driven by market capitalization of the portfolio and modeled parametrically using the conditional logit model.

In order to obtain cross-sectional variation on the relationship between the size e ffect and portfolio performance we split the whole cross-section of stocks into di fferent industries and fi t the conditional logit model to each industry separately. We apply the conditional logit model at an industry-speci fic level across three ranked sorted portfolios based on market capitalization: a small, mid-size and big portfolio created from the stocks in each tercile of the cross-section of assets in a speci fic industry ranked by asset size. This exercise is repeated for 20 industries over the period January 1970 to November 2015. Our results reveal that the size e ffect vanishes once the top performing stocks in an industry are removed from the sample.

size lottery

Our empirical findings also highlight the role of industry momentum in determining the relationship between market capitalization and portfolio performance. Speci fically, market capitalization has signi ficantly better predictive ability for portfolio return performance in the months following a positive return in an industry than in the months following a negative industry return.

Given these findings, we investigate further the influence of the winning stocks in industry-speci fic size portfolios. In particular, we propose an alternative size portfolio that we denominate as the winner-weighted index, based on the forecast rank probabilities of stocks provided by the conditional logit model. Intuitively, those stocks that are predicted to be winners in the next period receive a larger allocation of wealth than those stocks that have a low probability of becoming winners. More formally, the allocation of wealth to each asset in the portfolio is determined by the forecast winning probabilities obtained from the conditional logit model and driven by asset size. The performance of this portfolio is compared against a cap-weighted index benchmark portfolio. The weights in the latter portfolio are also driven by market capitalization, however, in contrast to our winner-weighted index portfolio, smaller stocks within an industry receive a smaller allocation of wealth. We consider statistical and economic measures such as the Sharpe ratio, Sortino ratio, the certainty equivalent return of a mean-variance investor and portfolio turnover. We observe the existence of two regimes in portfolio performance. During positive industry momentum periods, the winner-weighted index outperforms the cap-weighted portfolio for 19 out of 20 industries, the exception being the utilities industry. This result is, however, reversed in periods of negative industry momentum for which the cap-weighted index outperforms the winner-weighted index in 18 out of 20 industries.

Our second objective is to explore the influence of winning stocks on the size portfolio pricing factor widely used in the empirical asset pricing literature. Our empirical results for both a top-minus-bottom trading portfolio and a long-only portfolio show that standard asset pricing models are not able to adequately capture the contribution of the size premium to the overall risk premium when the winning stocks are removed from the size factor portfolio. In contrast, we note that the factor loadings ( Beta's) associated to the size portfolio pricing factor in standard models are robust to the inclusion/exclusion of the winning stocks. The removal of winning stocks is a ffecting the risk premium rather than the covariance of portfolios with the risk factor."


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Quantpedia’s Solution for Bear Markets Sunday, 6 January, 2019

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ETFs Increase Correlation of International Equity Markets Friday, 4 January, 2019

Everybody can see that international equity markets are highly correlated (and especially during past 10-15 years). A new interesting financial research paper shows that ETF arbitrage mechanism is one of the key channels through which U.S. shocks propagate to local economies leading to increased return correlation with the U.S. market:

Authors: Filippou, Gozluklu, Rozental

Title: ETF Arbitrage and International Correlation

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3287417

Abstract:

Assets under management of exchange-traded funds (ETF) have been growing significantly, yet the majority of ETF trades still occur on U.S. exchanges. We show that investment decisions of both institutional and retail investors when trading international country ETFs are mostly driven by shocks related to U.S. fundamentals, measured by VIX, rather than local country risks. Investors react only to negative news about local economies. When U.S. economic uncertainty increases, investors leave the country ETF market and switch to Cash ETF products. We demonstrate that ETF arbitrage mechanism is one of the key channels through which U.S. shocks propagate to local economies leading to increased return correlation with the U.S. market both in time-series and cross-sectional dimensions. We find that countries with stronger ETF price-discovery and lower limits to arbitrage tend to have a higher comovement with the U.S. market.

Notable quotations from the academic research paper:

"Signi ficant innovations in financial products made international investments increasingly possible. Over the recent years, exchange-traded funds experienced a double-digit growth in assets under management. Nevertheless, the short-run interdependence of trading across major international ETFs and its association with local and global risk aversion remain understudied. While the majority of earlier studies focuses on direct eff ects of ETFs on the underlying securities in the basket that it tracks, we examine the indirect e ffect of ETF trading as a transmission mechanism of U.S. market shocks to foreign country equity markets.

We provide a view that as the U.S. accommodates the largest share of ETF global trading volume, its market conditions directly impact the decisions of country ETF investors. We show that international ETF market participants trade based on shocks related to U.S. fundamentals rather than local ones, and propagate those shocks to local markets. The shock transmission is performed via ETF arbitrage. We argue that such arbitrage activity is one of the few mechanisms responsible for increasing correlation between the U.S. market and the rest of the world.

This high cross-country correlation limits the ability of investors to cheaply diversify U.S. risk via international ETF investments. In addition, ETFs often provide an easier access to less integrated emerging markets or to countries were direct investments are costly (e.g., Brazil). However, the transmission of U.S. shocks to those markets limits the diversi fication bene ts of emerging market strategies.

correlation

We fi rst test the hypothesis whether country ETF investors react to changes in the U.S. rather than local economic uncertainty, as measured by CBOE Volatility Index (VIX). To this end, we compute order imbalances of retail investors (e.g., Boehmer, Jones, and Zhang, 2017), and trades of di fferent size, capturing high frequency trading (HFT) and institutional trades. Focusing on a large cross-section of 41 countries, we find strong association between ETF order imbalances and U.S. VIX, indicating that international investment decisions are mainly driven by the latter measure, rather than its local counterparts. For example, an increase in the U.S. VIX results in a selling pressure in the country ETF market. Such result is robust to di fferent volatility regimes and is consistent across di fferent types of investors. Asymmetric response analysis confi rms that country ETF investors only react to positive changes in local VIX, which correspond to negative news in the local markets. Moreover, we observe that, when reacting to an increase in U.S. uncertainty, investors switch to safer assets such as cash equivalent ETFs. We also find that investors respond to changes in U.S. political uncertainty di fferently than to economic uncertainty - they leave the U.S. stock market and buy international country-level ETFs. However, they do not react to local political uncertainty and the economic eff ect of political risk is much smaller than of changes in U.S. VIX.

In order to access the impact of ETF arbitrage on correlation of country returns with the U.S. market, we regress daily innovations in such correlation on a proxy for ETF arbitrage during di fferent volatility regimes. We provide time-series evidence that during periods of high volatility in the U.S., an increase in the arbitrage activity by the authorized participant (AP) (as measured by net share creation/redemption) results in an increase in innovation in such daily correlation. We argue that during periods of high volatility in the U.S. market, it is harder for investors to distinguish between noise and fundamental component of the order flow. Consequently, based on wake-up call hypothesis investor may treat U.S. shocks as relevant to their own country and consume such shocks via ETF arbitrage.

We also explain cross-country variation in return correlation with the U.S. market. According to Ben-David, Franzoni, and Moussawi (2018), non-fundamental shocks must be reversed over time. This suggests that if all shocks transmitted from ETF market to local economies were non-fundamental, ETF arbitrage would not contribute towards increased correlation. In contrast, if the price deviation from the NAV is due to faster incorporation of fundamental information in ETF market, then arbitrage should a ffect returns of underlying index, and such e ffect should not be reverted. If such fundamental information is common both to U.S. and local market, one should observe a higher correlation between them.

Consistent with the literature, we argue that ETF transmits both fundamental and noise shocks to the underlying economies. We show that countries that have a higher degree of price discovery in their ETFs have on average a higher correlation with the U.S. market. In these markets fundamental information gets incorporated into ETF prices faster than in the Net Asset Value (NAV), and therefore, market makers closely follow and learn from changes in ETF prices. This is the case when derivative securities price the underlying assets, rather than the other way around. In addition, in order for fundamental shocks to get transmitted to underlying markets, the authorised participants (AP) must engage in arbitrage activity. We find that the lower the limits to ETF arbitrage the higher is the correlation between a country and the U.S. market. Neither the international trade channel nor the business cycles alter this result."


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FOMC Equity Drift Occurs in Periods of High Uncertainty Thursday, 27 December, 2018

A new research paper related mainly to:

#75 - Federal Open Market Committee Meeting Effect in Stocks

Authors: Martello, Ribeiro

Title: Pre-FOMC Announcement Relief

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3286745

Abstract:

We show that the pre-FOMC announcement drift in equity returns occurs mostly in periods of high market uncertainty or risk premium. Specifically, this abnormal return is explained by a significant reduction in the risk premium (implied volatility and variance risk premium) prior to the announcement, but only when the risk premium is high, e.g., when it is above its median. Likewise, the magnitude of the FOMC Cycle and other related patterns varies with uncertainty and risk premium. Market uncertainty measures are persistent and are not related to policy uncertainty or expectations. Markets become only marginally stressed in the days prior to the announcement and changes in uncertainty appear to be of lower frequency. We also explain why recent studies suggest that the pre-FOMC drift might have disappeared in the past decade, as this moderation is due to time variation that was also present in older data. Additionally, CAPM only works on FOMC dates when the risk premium is high, e.g., implied vol above its prior median level. The results are robust to different samples and measures of risk premium and uncertainty.

Notable quotations from the academic research paper:

"We show that pre-announcement return drift is associated with significant declines in risk (premium) during times of high risk (premium). Implied volatility and the variance risk premium decrease in the hours before the announcement in an almost perfect mirror image of the increase in market prices. Moreover, we show that the magnitude of the return drift and the decline in risk depends on the level of market implied volatility, or other related variables, days or even weeks prior to the announcement.

Just to exemplify, the average pre-FOMC drift when implied volatility is above its prior median is 109 basis points (bps), while it is only 9.7 bps when it is below its median. In the bottom 20% of implied volatilities, the drift is close to zero or even negative, depending on the specification. Lucca and Moench [2015] also showed the importance of the VIX in their analysis, but here we show that this and other market uncertainty variables are actually essential for a better understanding of the pre-announcement return drift and all FOMC announcement related patterns. Figure 2 replicates a figure in Lucca and Moench [2015] that shows stock market performance around FOMC releases. Here we show that the pre-announcement drift is much stronger in periods of high risk premium and uncertainty.

We also provide clear evidence of investor relief, i.e., a decline in implied volatility or other risk measures, hours before the announcement using intraday information. Panel B of Figure 2 also shows that uncertainty is going down as a mirror image of the realized return. The magnitude of this pre-announcement investor relief also depends on the level of market uncertainty, as it tends to go down more when it is high. Considering the squared value of the VIX as our priced risk proxy, we show that, during high volatility periods, implied variance declines by 103.5 bps in anticipation of the announcement, while during low volatility periods, it rises by insignificant 0.3 bps. Hence, high volatility periods present both higher realized equity returns and greater resolution of market uncertainty hours before pre-scheduled announcements.

FOMC return patterns"


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US Fiscal Cycle and the Dollar Wednesday, 19 December, 2018

A new research paper related mainly to:

#129 - Dollar Carry Trade
#8 -
FX Momentum

Authors: Jiang

Title: US Fiscal Cycle and the Dollar

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3278339

Abstract:

When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. This pattern is unique to the US, explaining 50% of the low-frequency variation in the dollar's value and absorbing the return predictability of the forward premium. In a model with sticky prices, I show this pattern is driven by the comovement between the US fiscal cycle and the US investors' risk appetite: During US expansions, higher US government surpluses increase the nominal value of the dollar, while less risk-averse US investors require lower returns to hold foreign currencies. Consistent with this view, the US fiscal cycle also explains the term premium, the dollar carry trade, the currency return momentum, and the US investors' capital flows.

Notable quotations from the academic research paper:

"The US fiscal cycle lines up with the dollar's value and future return against foreign currencies. Figure 1 plots the US government surplus-to-debt ratio along with the dollar index and the dollar's excess return against foreign currencies in the following 4 quarters. The surplus-to-debt ratio measures the net fraction of its outstanding debt the US government pays down in each quarter, reflecting a slow-moving fiscal cycle. Since the late 1980s, a higher US government surplus-to-debt ratio corresponds to a stronger dollar today and predicts a higher expected return on the dollar in the future.

us dollar cycle

This finding is also unique to the US: Higher government surplus-to-debt ratios do not correlate with higher nominal exchange rates in 8 out of 10 other developed countries, and do not predict higher currency returns in 9 out of 10 other developed countries.

I conjecture that this relationship between the US fiscal cycle and the dollar is driven by two mechanisms. On the one hand, the fiscal theory of the price level shows that currency value reflects the present value of government surpluses. When the US government surpluses are higher, the dollar is stronger. On the other hand, higher US government surpluses indicate US expansions. During expansions US investors require a lower compensation for holding foreign currencies. As foreign currencies have a lower risk premium with respect to the dollar, the dollar has a higher expected return with respect to foreign currencies.

The fiscal theory mechanism a ects the dollar's nominal value, whereas the risk premium mechanism a ffects the dollar's real return. Price stickiness is required to connect the nominal and the real exchange rates. In a reduced-form new-Keynesian model, I derive the dollar's real exchange rate as future cash flows minus future expected returns. Higher government surpluses increase the dollar's cash flows, whereas a lower risk premium of the US investors increases the dollar's expected returns against foreign currencies. In this way, the dollar is a special asset whose cash flow is positively correlated with its expected return. When the US fiscal condition is stronger, the dollar has a higher valuation and a higher expected return.

Because the US investors' risk premium also a ffects other asset returns and capital flows, the comovement between the US fi scal cycle and the risk premium has broader implications. Indeed, it provides an organizing principle for the following asset pricing phenomena:

First, the forward premium puzzle finds that a higher forward premium of the dollar predicts a higher excess return on the dollar in the short run.

Second, a higher US government surplus-to-debt ratio is associated with a lower term premium and a lower Cochrane and Piazzesi (2005) bond factor, both of which measure the risk premium of long-term US government bonds.

Third, Lustig, Roussanov and Verdelhan (2014) construct a dollar carry trade that buys foreign currencies against the dollar whenever the dollar's forward premium is below 0, and shorts foreign currencies against the dollar otherwise. Since the US government surplus-to-debt ratio comoves with the dollar's forward premium, I construct currency portfolios that exploit the time-series variation in the surplus-to-debt ratio. These portfolios have similar Sharpe ratios and explain the abnormal return of the dollar carry trade, providing evidence for the out-of-sample return predictability of the surplus-to-debt ratio.

Fourth, Burnside, Eichenbaum and Rebelo (2011) find momentum e ects in currency returns. My model shows that when the US government fiscal condition improves, the dollar appreciates and is expected to have a higher return in the future. In this way, the US fiscal cycle drives the common variation in past and future currency returns. Consistent with this result, past currency returns no longer predict future currency returns once I control for the US government surplus-to-debt ratio."


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