Ex-ante Returns Research Articles

Portföy Optimizasyonuna Yönelik Ampirik Bir Karşılaştırma: Oyun Teorisi ve Modern Portföy Teorisi

Portföy optimizasyonu gerçekleştirebilmek için menkul kıymetlerin ne zaman ve ne oranda portföye dâhil edilmesi gerektiğinin belirlenmesine ihtiyaç duyulmaktadır. Bu doğrultuda kullanılan modellerden oyun teorisi, minimaks ilkesi ile en düşük risk seviyesinde gerçekleşebilecek en yüksek getirili portföyü oluşturmayı amaçlamaktadır. Modern portföy teorisi ise, verilen risk düzeyinde en yüksek getiriyi sunan ya da verilen getiri düzeyinde riski en düşük portföylere ulaşmayı hedeflemektedir. Çalışmada, Borsa İstanbul'da 2013-2021 yılları arasında kesintisiz her ay işlem gören, işlem hacmi en yüksek 200 hisse senedi kullanılarak, oyun teorisi minimaks ilkesi kapsamında 12 ayrı doğrusal programlama modeli ve modern portföy teorisi kapsamında 12 ayrı kuadratik programlama modeli çözülerek her ay için optimum portföylerin oluşturulması amaçlanmıştır. Her iki teori kapsamında ulaşılan portföylerin performansları, gerek kendi aralarında gerekse alternatif yatırım araçlarının getirisi ile karşılaştırılmıştır. Elde edilen bulgular, geçmişe dönük analizde modern portföy teorisinin; geleceğe dönük uygulamada oyun teorisinin oluşturduğu portföylerin daha başarılı sonuçlar verdiğini ortaya koymaktadır.

The Implied Equity Term Structure

We propose a new methodology to estimate the equity term structure, based on the cross-section of stock prices and the implied cost of capital approach. Specifically, instead of focusing on the realized returns of maturity-specific dividend assets, we imply the term structure of expected returns based on the observed market prices and projected firm-level cash flows. Using US data for 1976-2019, we find an unconditionally upward sloping term structure of risk premia with rich cross-sectional patterns. Namely, large and growth firms exhibit an upward sloping term structure, whereas the smallest and value firms mostly have a downward sloping term structure. We also detect that the slope of the term structure changes from negative to positive in the late 1990s for the largest firms, as well as that the slope tends to flatten out or even invert in recessions. Thus, using a direct measure of ex-ante returns, we are able to provide new evidence on the debated properties of the equity term structure.

The Time-varying Relationship between Liquidity and Stock Returns: Evidence from Germany

This study investigates the structural relationship between illiquidity and ex-ante returns in the German stock market over time. In line with other authors, we show that illiquidity is still a significant factor, but has had a weakened impact in more recent times. When considering structural breaks, illiquidity is not priced during times of financial turmoil, which explains the weakened relationship between illiquidity and returns in the recent past. Incorporating structural breaks in portfolio decisions results in significantly better portfolio returns explained by increasing illiquidity premia. The results are robust to different variations of Amihud’s illiquidity measures and when controlled for Fama-French factors.

Markowitz with regret

Providing a framework to integrate regret as an additional decision criterion in Markowitz’s model of portfolio selection, we propose two different views on regret: An investor might feel regret with respect to the ex-post best alternative either in terms of return or in terms of preference value. Under both views, regret can be captured by adjusting the vector of expected returns or alternatively by adjusting the return covariance matrix, retaining the tractability of the Markowitz model. The regret model, however, has very different implications for how asset characteristics affect optimal portfolios. While the impact of the skewness of an asset is strengthened, the impact of the variance shrinks. Moreover, we show for a variety of real portfolios that the effects of regret on optimal portfolio weights and the ex-ante return distribution are large.

Option to Abandon and Investment Return

We analyze returns to lumpy projects with multiple investors. Since each investor's commitment increases the likelihood of project completion it exerts a positive externality on other investors. We show that due to this externality either a rise in the cost of abandoning the project or decreased volatility of returns to abandonment can increase ex-ante returns. These findings provide exceptions to the standard results that investment irreversibility (high abandonment costs) decreases returns and option volatility increases returns. Finally, we show that the optimal number of investors is either large or very small.

Normative portfolio theory

In this paper, we correct the adverse impact of estimation risk on both portfolio weights and performance with two new equity allocation methods we implement with estimation-free and estimated ex-ante returns. Portfolios with estimation-free ex-ante returns and systematic-to-unsystematic risk weights have statistically higher Sharpe ratios than both similar portfolios with estimated ex-ante returns and 1/N′th portfolios. Optimal portfolio methods with well-behaved weights guide investors in a way not hitherto possible (normative portfolio theory).

Ethical Investing has No Portfolio Performance Cost

We compare ethically constrained versus unconstrained investing with optimal portfolio methods that force well-behaved weights. In Sharpe ratio analysis, we find no evidence of a performance cost for sin-free, carbon-free, or Shariah portfolios even though, in the most exacting case, Shariah investing eliminates roughly 65% of the universe of common shares from security selection. We identify the optimal portfolio adjustments needed to prevent an ethical-portfolio performance cost. The US stock market is large enough − with respect to the number of publicly traded companies − that common shares in other sectors replicate the portfolio characteristics of sin-stocks for a negligible Sharpe-ratio loss. Adjustment for carbon-free investing increases the optimal number of common-shares for better diversification and increases the weight for bank stocks − which act as carbon substitutes. Carbon common shares have below average ex-ante return and, thus, their exclusion increases mean portfolio return to moderate the Sharpe-ratio loss. Shariah adjustment concentrates on fewer high portfolio-appeal common shares, which increases the Pharmaceutical sector-weight and, also, increases mean portfolio return to moderate the Sharpe ratio loss from higher portfolio return standard deviation.

Intertemporal risk-return relationship in BRIC equity markets after the US financial crisis

PurposeThis paper aims to attempt to capture the intertemporal/time-varying risk–return relationship in the Brazil, Russia, India and China (BRIC) equity markets after the global financial crisis (2007-2009), i.e. during a relative calm period. There has been a significant increase in advanced economies’ equity allocations to the emerging markets ever since the financial crisis. So, the present study is an attempt to account for the said relationship, thereby justifying investments made by the international investors.MethodologyThe study uses non-linear models comprising asymmetric component generalised autoregressive conditional heteroskedastic model in mean (CGARCH-M) (1,1) model, generalised impulse response functions under vector autoregressive framework and Markov regime switching in mean and standard deviation model. The span of data ranges from 1 July 2009 to 31 December 2014.FindingsThe ACGARCH-M (1,1) model reports a positive and significant risk-return relationship in the Russian and Chinese equity markets only. There is leverage and volatility feedback effect in the Russian market because falling returns further increase conditional variance making the investors to expect a risk premium in the expected returns. The impulse responses indicate that for all of the BRIC markets, the ex-ante returns respond positively to a shock in the long-term risk component, whereas the response is negative to a shock in the short-term risk component. Finally, the Markov regime switching model confirms the existence of two regimes in all of the BRIC markets, namely, Bull and Bear regimes. Both the regimes exhibit negative relationship between risk and return.Practical implicationsIt is an imperative task to comprehend the relationship shared between risk and returns for an investor. The investors in the emerging economies should understand the risk-return dynamics well ahead of time so that the returns justify the investments made under riskier environment.Originality/valueThe present study contributes to the literature in three senses. First, the data relate to a period especially after the global financial crisis (2007-2009). Second, the study has used a relatively newer version of GARCH based model [ACGARCH-M (1,1) model], generalised impulse response functions and Markov regime switching model to account for the relationship between risk and return. Finally, the study provides an insightful understanding of the risk–return relationship in the most promising emerging markets group “BRIC nations”, making the study first of its kind in all the perspectives.

The Interaction of Skewness and Analysts' Forecast Dispersion in Asset Pricing

I develop a new asset pricing theory that bridges two seemingly unrelated pricing effects from separate literatures: (1) the negative relationship between ex-ante return skewness and expected returns and (2) the negative relationship between dispersion in financial analysts' earnings forecasts and expected returns. I show that both effects arise intrinsically from market clearing of stochastic demand in a standard noisy rational expectations economy that incorporates skewed assets followed by financial analysts. Positive correlation between forecast dispersion and investor heterogeneity arises endogenously. The theory generates several novel testable predictions regarding the interaction of ex-ante skewness and forecast dispersion on asset prices.

Weighted Least Squares Estimates of Return Predictability Regressions

Time varying volatility causes substantial heteroskedasticity in return predictability regressions, making OLS estimates less efficient than least squares estimates weighted by ex-ante return variance (WLS-EV). In small sample simulations, I show that using WLS-EV instead of OLS results in large efficiency gains, fewer false negatives, and avoids the bias associated with ex-post weighting schemes. Using WLS-EV also changes several important conclusions based on OLS estimates: traditional predictors such as the dividend-to-price ratio perform better in- and out-of-sample, whereas WLS-EV estimates of the predictability afforded by proxies for the variance risk premium, politics, the weather, and the stars are not significant.

Equity Allocation Without Estimation Risk

We jointly control the ill-behaviour of mean-variance weights and outperform 1/N’th investing with two equity allocation methods that moderate or eliminate the adverse impact of estimation-risk on portfolio weights. Normalized systematic to unsystematic-risk weight portfolios moderate estimation-risk. Ex-ante excess-return weight portfolios eliminate estimation-risk and have the highest Sharpe ratio above the 1/N’th strategy. We find high Sharpe ratios in industry-rotation with high-return industries and in security-selection with high-return common shares that we identify with Blazenko and Fu’s (2013) ex-ante returns without explicit risk analysis and without estimation.

CAPM and DCF: Does SML Relationship Gives Cost of Equity? – Ex-Ante Stock Returns are Not Same as Implied Discount Rates

When Capital Asset pricing Model (CAPM) is considered as valid asset pricing theory, Security Market Line (SML) is supposed to give ex-ante returns for the single period investment horizon. Since the required returns should be same as the cost of equity (discount rates) in efficient markets, SML relationship is used for deriving cost of equity. Similarly, SML derived returns are used as parameter for performance evaluation like ascertaining alpha.This paper shows that the SML derived returns need not be same as implied discount rates even when CAPM is applicable and markets are efficient. This is because the stock returns and discount rates will be same mathematically only when the discount rates are expected to remain constant over the forecast period. The single period return of CAPM changes every year as the market changes with economic conditions implying that the market discount rates are changing. When the implied discount rates are varying, the ex-ante returns will have no resemblance to the implied discount rate for the year in consideration. This paper shows that the SML derived ex-ante returns may, if at all, only represent a geometric mean of the discount rates over a several investment periods into future. Similarly, the ex-ante returns can not be used for performance evaluation for single period investment horizon as it would only give the expected geometric mean of returns for the future periods making the concept of alpha evaluation erroneous.Similarly, when we extend this concept to equity risk premiums for the market, any historical risk premium can only be applicable for a similar period into the future. It is not possible to predict the equity risk premium for any individual year which again has implication for the surveys on equity risk premiums.The paper illustrates these ideas using two illustrations: Valuation of a firm using DCF Model with time-varying discount rates and Past Valuation data of S&P 500 using DDM Model.

A Volatility Model for Financial Time Series in the Generalized Pearson Setting

Our objective is to review the existing literature on modeling financial asset return distributions and propose additional models and techniques that provide a better fit for a given financial asset return series such as global stock indices, industry segments and foreign exchange. One possible way is to adjust the model within the whole family of parameters, or only within the family of parameters, which make economic sense. The ideal model specification is the one that can handle structural change and time dependence in conditional mean, variance, skewness, and kurtosis. This may have more economic appeal than assuming fundamental nonnormality. We postulate that the simultaneous estimation of time-varying first-four moments using a flexible family of probability distributions such as the Pearson type distributions might provide a better explanation of risks, and hence, robust design of portfolio allocation systems beyond the traditional first-two moments framework. In a study of fractual structures in exchange rates, Richards (2000) finds in a simulation experiment that the best performing model among non-linear time series models is a GARCH, in which a generalized error distribution was modified to allow for wider tails.In this research, we will combine an autoregressive conditional heteroskedasticity model with an asymmetric information structure due to Daniel B. Nelson (1991) with a flexible family of distributions, developed by Karl Pearson (1895). Within this framework, a nonlinear parametric model with time-varying higher moments is proposed. We, hereby, attempt to extend the time-varying conditional variance nature of traditional ARCH/GARCH-type models to include either time-varying skewness or kurtosis for it might improve our understanding of risks and risk premia seen in financial markets. To this end, we will explore the possible ill behavior of standardized residuals in many types of the time-varying conditional variance models and show that these residuals lead us to the modeling of time-varying skewness and kurtosis. We will fit the Pearson distribution directly to sample data by calculating the second, third and fourth central moments of the observed values and using the definitions of skewness and kurtosis. However, observed values of the third and fourth moments could be sensitive to outliers. This would question the validity of the equation, which takes advantage of the time-varying properties of kurtosis. Moreover, the sensitivity of higher moments’ estimates to a small number of extreme returns also means that ex-post returns may have quite different properties from ex-ante returns. We are also planning to incorporate the concepts of L-moments, introduced by Hosking (1990). L-moments are defined to be the expected values of linear expectations of the order statistics. They are less sensitive to outliers than ordinary moments, and often provide a better identification of the parent distribution that generates a particular data sample. One might use L-moments to fit a particular distribution to data by equating the first few sample and population L-moments, analogously to the method of moments. The resulting estimators of parameters and quantiles are sometimes more accurate than the maximum-likelihood estimates, in case of generalized extreme value distributions, Hosking et al. (1985), and some instances of the generalized Pareto distribution, Hosking and Wallis (1987). If the mean of the distribution exists, then all the higher-order L-moments do as well (see “Theorem 1” in Hosking (1996)). Thus, L-moments can describe fat-tailed distributions whose variance or higher-order regular moments may be infinite. Moreover, for standard errors of sample L-moments to be finite, the largest moment that needs to be finite is the second moment; i.e., variance. We believe the use of L-moments for a leptokurtic distribution such as the Pearson type-VII might be of some value due to the success of L-moments with other heavy-tailed distributions.

Expert elicitation of cost, performance, and RD&D budgets for coal power with CCS

There is uncertainty about the ex-ante returns to research, development, and demonstration programs in the United States on carbon capture and sequestration (CCS) technology. To quantify this uncertainty, we conducted a written expert elicitation of thirteen experts in fossil power and CCS technologies from the government, academia, and the private sector. We asked experts to provide their recommended budget and allocation of RD&D funds by specific fossil power and CCS technology and type of RD&D activity (i.e. basic research, applied research, pilot plants, and demonstration plants) for the United States. The elicitation instrument was structured around estimating the cost and performance of coal-fired power plants with and without CCS in the years 2010 and 2030 under four funding scenarios for federal fossil energy RD&D in the USA. The most important areas identified for basic research were chemical looping combustion and membrane technology. The most important area for commercial demonstration was integrated gasification combined cycle (IGCC). There was substantial disagreement between experts on both the current and future capital cost to build a new coal-fired power plant with CCS. There was also disagreement across experts as to whether the capital cost of a new coal plant with CCS would increase or decrease if federal RD&D funding stayed constant at current levels. However, there was a consensus among our experts that accelerated federal RD&D would (weakly) lower the capital cost requirements for a new coal plant with CCS. On average, experts estimated that if their recommended RD&D portfolio was implemented, the capital cost of new coal plants with CCS in 2030 would decrease by 10% in addition to the cost reductions/increases that would occur by 2030 through non-public RD&D related factors.

Determinants of Profits: Modern and Indian Views

Profit is the most popular term in the world and it even divided the mankind into two groups namely profit-driven capitalists and the non-profit welfare driven socialists. It can even be said that the whole world is driven by profit and not by the mankind. The economic literature defined profit variously and identified the determinants of profits as monopoly power or monopoly conditions of market, business power, entrepreneurial service or functions, the difference between ex-post returns over the ex-ante returns, the residue, the difference between revenue and costs, due to efficiency, innovation, uncertainty, inflation, changes in the economy, wrong value system, wages, etc. This paper attempts to present the determinants or rather obstructions to profit, a profit model, implications for corporate social responsibility and a corporate social responsibility index of public welfare based on an Indian Management Thought – The Arthasastra claimed to date from 321-296 BC. Yet they seem to be relevant to the word even today.

Expected Returns, Yield Spreads, and Asset Pricing Tests

We use corporate bond yield spreads to gauge investors' return expectations. We then replace standard ex-post, averaged measures of return with our ex-ante return measures in asset pricing assets. We find that the market beta plays a significant role in the cross-section of returns when expectations are measured ex-ante. The expected size and value premia are significantly positive and countercyclical, but there is no evidence of ex-ante positive momentum profits.

The conditional relation between beta and returns in the Hong Kong stock market

Published results of empirical tests over the past two decades indicate that the risk-return relation in the Hong Kong stock market is negative. Such findings refute the positive risk-returnrelation stipulatedinthe traditional CAPM. However, traditional CAPM invokes expected or ex-ante returns while empirical tests have used ex-post returns as an imperfect proxy. Thus, in this paper, the risk-return relationship in the Hong Kong stock market is examined using the conditional method based on the work of Pettengill et al., which takes into consideration the dominating ex-post negative excess market returns found in the Hong Kong stock market. Under the conditional Pettengill et al. method, test results demonstrate a strong conditional positive and negative risk-return relationships in the Hong Kong stock market. The results show that the estimated risk premiums in both up and down markets are insignificantly different from the corresponding expected risk premiums. But the estimated risk premiums of the up and the down markets are asymmetric with the magnitude of the down market premium greater than that of the up market. Thus, under the conditional CAPM, the estimated security market line (SML) in the down market is negatively steeper than is the positively sloped estimated SML in the up market. The significant results are not driven by abnormal return behaviour in some of the months or by a particular beta group. Thus, in general, the test results suggest that the conditional CAPM is still practically a useful equilibrium pricing model in the Hong Kong stock market.

On Stock Market Returns and Monetary Policy

Boudoukh, Richardson, and Whitelaw (BRW) presented theoretical and empirical evidence explaining the expected inflation/stock return correlation. In concluding they stated that whether monetary policy has real effects is an open question. This paper addresses this question by examining how BRW's industry stock return data respond to monetary policy shocks. Monetary policy is measured by innovations in the federal funds rate and nonborrowed reserves, by narrative indicators, and by an event study of Federal Reserve policy changes. In every case the evidence indicates that expansionary policy increases ex-post stock returns. Results from estimating a multi-factor model also indicate that exposure to monetary policy increases an asset's ex-ante return.