Conditional Risk Premium Research Articles

Can Individual Investors Beat the Market?

Abstract We document persistent superior trading performance among a subset of individual investors. Investors classified in the top performance decile in the first half of our sample subsequently earn risk-adjusted returns of about 6% per year. These returns are not confined to stocks in which the investors are likely to have inside information, nor are they driven by illiquid stocks. Our results suggest that skilled individual investors exploit market inefficiencies (or perhaps conditional risk premiums) to earn abnormal profits, above and beyond any profits available from well-known strategies based on size, value, momentum, or earnings announcements. (JEL G11, G14, G40, G51) Received: October 11, 2020 Editorial decision: January 4, 2021 Editor: Jeffrey Pontiff

Extreme value estimation of the conditional risk premium in reinsurance

In the paper we study the estimation of reinsurance premiums when the claim size is observed together with additional information in the form of random covariates. Using extreme value arguments, we propose an estimator for the risk premium conditional on a value for the covariate, and derive its asymptotic properties, after suitable normalization. The finite sample behavior is evaluated with a simulation experiment, and we apply the methodology to a dataset of automobile insurance claims from Australia.

Conditional Risk Premiums and the Value Function of Prospect Theory

This paper examines whether stock returns are consistent with the value function of prospect theory. We find that beta given a gain yields positive conditional premiums on returns while beta given a loss yields negative conditional premiums. This reflects the fact that the value function is concave for gains and convex for losses, implying risk-averse behavior for gains and risk-seeking behavior for losses respectively. Furthermore, the absolute value of the premiums is greater for losses, which is in line with the value function being steeper in this state. These new findings provide indication that investors behave according to prospect theory.

Forecasting commodity futures returns with stepwise regressions: Do commodity-specific factors help?

The aim of this paper is to assess whether three well-known commodity-specific variables (basis, hedging pressure, and momentum) may improve the predictive power for commodity futures returns of models otherwise based on macroeconomic factors. We compute recursive, out-of-sample forecasts for the monthly returns of fifteen commodity futures, when estimation is based on a stepwise model selection approach under a probability-weighted regime-switching regression that identifies different volatility regimes. We systematically compare these forecasts with those produced by a simple AR(1) model that we use as a benchmark and we find that the inclusion of commodity-specific factors does not improve the forecasting power. We perform a back-testing exercise of a mean–variance investment strategy that exploits any predictability of the conditional risk premium of commodities, stocks, and bond returns, also consider transaction costs caused by portfolio rebalancing. The risk-adjusted performance of this strategy does not allow us to conclude that any forecasting approach outperforms the others. However, there is evidence that investment strategies based on commodity-specific predictors outperform the remaining strategies in the high-volatility state.

Is the ex‐ante equity risk premium always positive? Evidence from a new conditional expectations model

AbstractWe model the conditional risk premium by combining principal component analysis and a statistical learning technique, known as boosted regression trees. The method is validated through various out‐of‐sample tests. We apply the estimates to test the positivity restriction on the risk premium and find evidence that the risk premium is negative in periods of low corporate and government bond returns, high inflation and downward‐sloping term structure. These periods are linked with changes in business cycles; the states when theories predict the existence of negative risk premium. Based on the evidence, we reject the conditional capital asset pricing model and raise a question over the practice of imposing the positive risk premium constraint in predictive models.

Forecasting Commodity Futures Returns: An Economic Value Analysis of Macroeconomic vs. Specific Factors

We test whether three well-known commodity-specific variables (basis, hedging pressure, and momentum) may improve the predictive power for commodity futures returns of models otherwise based on macroeconomic factors. We compute recursive, out-of-sample forecasts for fifteen monthly commodity futures return series, when estimation is based on a stepwise model selection approach under a probability-weighted regime-switching regression that identifies different volatility regimes. Comparisons with an AR(1) benchmark show that the inclusion of commodity-specific factors does not improve the forecasting power. We perform a back-testing exercise of a mean-variance investment strategy that exploits any predictability of the conditional risk premium of commodities, stocks, and bond returns, also taking into account transaction costs caused by portfolio rebalancing. The risk-adjusted performance of this strategy does not allow us to conclude that any forecasting approach outperforms the others. However, there is evidence that investment strategies based on commodity-specific predictors outperform the remaining strategies in the high-volatility state.

The conditional equity premium, cross-sectional returns and stochastic volatility

Bansal and Yaron (2004) demonstrate, by calibration, that the Consumption-based Capital Asset Pricing Model (CCAPM) can be rescued by assuming that consumption growth rate follows a stochastic volatility model. They show that the conditional equity premium is a linear function of conditional consumption and market return volatilities, which can be estimated handily by various Generalized Autoregressive Conditonal Heteroskedasticity (GARCH) and Stochastic Volatility (SV) models. We find that conditional consumption and market volatilities are capable of explaining cross-sectional return differences. The Exponential GARCH (EGARCH) volatility can explain up to 55% variation of return and the EGARCH model augmented with cay^ — a cointegrating factor of consumption, labor income and asset wealth growth — greatly enhances model performance. We proceed to test another hypothesis: if Bansal and Yaron estimator is an unbiased estimator of true conditional equity premium, then the instrumental variables for estimating conditional equity premium should no longer be significant. We demonstrate that once the theoretical conditional risk premium is added to the model, it renders all instrumental variables redundant. Also, the model prediction is consistent with observed declining equity premium.

Barriers to Portfolio Flows, Short Sales Constraints and International Asset Pricing: Theory and Evidence

We propose an international asset pricing model in a two-country framework where trading in the foreign market encounters barriers to portfolio flows and short-sale constraints. Under ownership restrictions, free assets are priced with a global risk premium whereas the restricted assets command a global risk premium, a conditional risk premium and a conditional discount. With binding ownership and short-sale constraints, some foreign assets become non-tradeable, however, pricing rules are not altered. We estimate our model using maximum likelihood approach for 18 major emerging markets over the period 1989-2007 and find strong support for our model.

Barriers to Portfolio Flows, Short Sales Constraints and International Asset Pricing: Theory and Evidence

We propose an international asset pricing model in a two-country framework where trading in the foreign market encounters barriers to portfolio flows and short-sale constraints. Under ownership restrictions, free assets are priced with a global risk premium whereas the restricted assets command a global risk premium, a conditional risk premium and a conditional discount. With binding ownership and short-sale constraints, some foreign assets become non-tradeable, however, pricing rules are not altered. We estimate our model using maximum likelihood approach for 18 major emerging markets over the period 1989-2007 and find strong support for our model.

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Time-varying risk aversion and asset prices

This paper uses a variant of the consumption-based representative agent model in Campbell and Cochrane [Campbell, J.Y., Cochrane, J.H., 1999. By force of habit: Consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251] to study how investors’ time-varying risk aversion affects asset prices. First, we show that a countercyclical variation of risk aversion drives a procyclical conditional risk premium. Second, we show that with a small value for the volatility of the log surplus consumption ratio, a large value of risk aversion may not determine whether the equity premium and the risk-free rate puzzles can be resolved or not. Third, we show that countercyclical risk aversion may not help explain the predictability of long-horizon stock returns, the univariate mean-reversion of stock prices and the “leverage effect” in return volatility.

Equity Market Volatility and Expected Risk Premium

This paper revisits the time-series relation between the conditional risk premium and variance of the equity market portfolio. The main innovation is that we construct a measure of the ex ante equity market risk premium using corporate bond yield spread data. This measure is forward-looking and does not rely critically on either realized equity returns or instrumental variables. We find strong support for a positive risk-return tradeoff, and this result is not sensitive to a number of robustness checks, including alternative proxies of the conditional stock variance and controls for hedging demands.

Fiscal, monetary policy and the conditional risk premium in short-term interest rate differentials: an application of Tobin's portfolio theory

This paper proposes a Multivariate-Arch in Mean model to analyze the potential channels through which domestic fiscal and monetary policy as well as changes in the international economic environment may affect interest rate differentials across countries. This technique is illustrated by analyzing the behavior of short-term interest rates in a number of European countries prior to the introduction of the common currency. The key feature of our results is that macroeconomic variables exert both a direct and indirect influence on the short-term interest rate differential. This indirect effect is captured through the conditional volatility of the differential, which is itself a statistically significant determinant of the level of the differential. This relationship is likely to be overlooked by more traditional models that focus solely on the first order moments of the process.

The Conditional Relationship Between the Equity Risk Premium and the Dividend Price Ratio

The dividend price ratio is among the most commonly proposed instruments for forecasting equity returns. Despite an ongoing debate struggling to establish the efficacy of regressions using the dividend price ratio to measure the conditional equity premium, such affine functions are now pervasive in literatures that use the conditional equity premium as an input. In this paper, I point out that economic models of risk speak directly to the properties of predictability regression statistics. Specifically, I demonstrate that in reasonable theoretical settings, predictability regressions may be badly misspecified. In particular, they may have low power to identify the conditional and nonlinear form of predictability suggested by structural treatments of risk. Additionally, simple predictive regressions produce estimates of the conditional risk premium which may be very different from the true values. Moreover, accommodating the implied instability in the relationship between the dividend price ratio and the equity risk premium can substantially improve out of sample forecasting power.

Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices

We analyze a general equilibrium exchange economy with a continuum of agents who have “catching up with the Joneses” preferences and differ only with respect to the curvature of their utility functions. While individual risk aversion does not change over time, dynamic redistribution of wealth among the agents leads to countercyclical time variation in the Sharpe ratio of stock returns. We show that both the conditional risk premium and the return volatility are negatively related to the level of stock prices. Therefore, our model exhibits many of the empirically observed properties of aggregate stock returns, for example, patterns of autocorrelation in returns, the “leverage effect” in return volatility, and long‐horizon return predictability.

Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices

We analyze a general equilibrium exchange economy with a continuum of agents who have 'catching up with the Joneses' preferences and differ only with respect to the curvature of their utility functions. While individual risk aversion does not change over time, dynamic redistribution of wealth among the agents leads to countercyclical time variation in the Sharpe ratio of stock returns. We show that both the conditional risk premium and the return volatility are negatively related to the level of stock prices, as observed empirically. Therefore, our model exhibits many of the empirically observed properties of aggregate stock returns, e.g., patterns of autocorrelation in returns, the 'leverage effect' in return volatility and long-horizon return predictability. For comparison, otherwise similar representative agent economies with the same type of preferences exhibit counter-factual behavior, e.g., a constant Sharpe ratio of returns and procyclical risk premium and return volatility.

Conditional Risk Premiums of Asian Real Estate Stocks

This paper uses a multi-factor latent variable model to examine the time variation of expected returns on Asian property stocks. Using data from 1990 to 1997, we found strong evidence of time-varying risk premium, suggesting property development based on constant discount rate may underestimate the cost of capital. A further study using a multi-country model suggests that conditional excess returns of many crisis-stricken economies appear to move quite closely with each other. This supports the hypothesis that the risk premiums in these Asian markets move closely over time As a result, they provide a partial explanation of market contagion in the region.

A discrete time model for pricing treasury bills, forward, and futures contracts.

This paper develops a discrete time model for valuing treasury bills and either forward or futures contracts written against them. It provides formulae for bill prices, forward prices, futures prices, and their conditional variances and risk premiums. The interest rate process is described by a multlphcatwe binomial random walk whose features conform to some principal characteristics of observed processes. Initial forward rates are constrained to match mltmlly observed term structure data. This paper uses a discrete time multlplicatlve binomial model of the spot interest rate process to derive pricing formulae for treasury bills, and forward and futures contracts written against them. All results are developed under assumptions of zero arbitrage profits. The model ~s constrained to match the initial term structure of interest rates, and uses an empirically plausible interest rate process. The model explicitly states the theoretical and empirical Importance of initially estimated forward rates, bond maturity dates, and forward and futures contract delivery dates. We find pricing formulae and time dependent expressions for the condltlonal variance and conditional risk premiums of bill prices, forward prices and futures prices. Finally, we use a property of binomial processes to relate conditional variances and risk premiums, and hence provide theoretical support for relations used m the empirical literature (ENGLE [1982], ENGLE, LILIEN and ROBINS [1987])

The predictability of returns on equity REITs and their co-movement with other assets

Recent evidence suggests that the variation in the expected excess returns is predictable and arises from changes in business conditions. Using a multifactor latent variable model with time-varying risk premiums, we decompose excess returns into expected and unexpected excess returns to examine what determines movements in expected excess returns for equity REITs are more predictable than all other assets examined, due in part to cap rates which contain useful information about the general risk condition in the economy. We also find that the conditional risk premiums (expected excess returns) on EREITs move very closely with those of small cap stocks and much less with those of bonds.

Optimal currency hedge ratios and interest rate risk

The objective of this article is to provide a framework for the interpretation of the optimal currency hedge ratios on foreign investments, taking into account interest rate risk. This is made possible by using a continuous-time setting in the spirit of Merton (1969). We focus on the importance of the interest rate differential (forward basis) in setting the optimal currency hedge because of the influence of interest rates on exchange rates. More specifically, we consider two discount bonds, a domestic and a foreign one, which follow stochastic processes possibly correlated with the other state variables of the model. It is shown that the optimal hedge ratio can be split into five components: (a) a ‘macro-economic’ component which is a function of the volatility of the interest rate differential and its covariance with currency movements; this term depends on the currency considered but not on the asset being hedged; (b) an ‘asset-specific’ term which is directly related to the covariance of the foreign currency asset return with exchange and interest rate movements; (c) a ‘speculative’ term function of the investor's risk preference and of the conditional risk premium on the exchange rate, and (d) two stochastic opportunity set hedging terms. The analysis of the optimal hedge ratio is illustrated on the period December 1970–1989 for stock and bond investments in seven countries. (JEL G15, F31)