Return Puzzle Research Articles

Real exchange rate persistence and the excess return puzzle: The case of Switzerland versus the US

SummaryThe PPP puzzle refers to the wide swings of nominal exchange rates around their long‐run equilibrium values whereas the excess return puzzle represents the persistent deviation of the domestic‐foreign interest rate differential from the expected change in the nominal exchange rate. Using theI(2) cointegrated VAR model, much of the excess return puzzle disappears when an uncertainty premium in the foreign exchange market, proxied by the persistent PPP gap, is introduced. Self‐reinforcing feedback mechanisms seem to cause the persistence in the Swiss‐US parity conditions. These results support imperfect knowledge based expectations rather than so‐called “rational expectations”.

Corporate Hedging and the High Idiosyncratic Volatility Low Return Puzzle

AbstractThe literature offers various explanations to either support or refute the Ang et al. () high idiosyncratic volatility low return puzzle. Fu () finds a significantly positive contemporaneous relation between return and exponential generalized autoregressive conditional heteroskedastic idiosyncratic volatility. We use corporate hedging to shed light on this puzzle. Conceptually, idiosyncratic volatility matters to investors who face limits to diversification. But limits to diversification become less relevant for firms that consistently hedge. We confirm the main finding in Fu (), but only for firms that do not consistently hedge. For firms that adopt a consistent hedging policy, idiosyncratic volatility, whether contemporaneous or lagged, is insignificant in Fama–MacBeth regressions, controlling for size, book‐to‐market, momentum, liquidity, and industry effects.

Firm Liquidity and Issuing Activity

The paper shows that issuing activity does not result in additional liquidity. I find that even in the subsamples in which issuing is supposed to create more liquidity (severely underpriced IPOs, IPOs backed by venture capital, new issues with high-prestige underwriters) new issues are indeed more liquid, but so are their peers, and thus issuing does not create liquidity. The paper thus refutes the existing liquidity-based explanations of the new issues puzzle. The paper also shows that the low-minus-high turnover factor seems to explain the new issues puzzle and related anomalies only because it picks up volatility risk.

Assessing the idiosyncratic risk and stock returns relation in heteroskedasticity corrected predictive models using quantile regression

This paper examines the superiority-claim of the GARCH based measure in resolving the ‘idiosyncratic risk–return puzzle’ using Australian data. The least squares and the quantile regressions of stock-returns on lagged idiosyncratic-volatility estimated from daily data using two measures (including GARCH) fail to support such claim. The quantile regression estimation reveals the risk–return relationship to be quantile dependent; it is parabolic but significant only at the extreme quantiles. The parabolic-form is convex (concave) at the lower (upper) quantiles of the returns' conditional distribution. This changing relationship-form reflects uncertainty in predicting returns. Moreover, the idiosyncratic risk–return puzzle is a model specification problem.

The credit risk–return puzzle: Impact of credit rating announcements in Australia and Japan

Traditional asset pricing models postulate that high risk investments are usually associated with higher returns. However, this does not hold in the relationship between credit risk and return. There is a known credit risk–return puzzle, which highlights a negative relationship between credit risk and the stock market returns. The objective of this study is to assess the puzzling credit risk–return relationship of stocks; in particular, comparing the stock returns of high versus low credit risk firms, as measured by credit ratings from Standard and Poor's in Australia and Japan for a period from January 1990 to June 2012. Our results indicate that the credit risk–return puzzle exists in both Japan and Australia. However, it seems that the credit risk–return anomaly is explained by the downgrade announcements in the market and hence we conclude that downgrade announcements of a firm have a significant impact on the cross section of returns.

The new issues puzzle: evidence from non-US firms

For non-US stocks of firms in the G7 countries, we empirically test the new issues puzzle – stocks of firms that issue new equity are, on average, very poor investments relative to various benchmarks – by market capitalization. Only for the United Kingdom do we find evidence for a significantly negative relation between net share issues and expected returns for larger capitalization stocks. There is some evidence for Japanese stocks. For the other four countries, a positive relation between net share issues and expected returns is observed.

Asset Pricing and Monetary Policy

This paper examines the role of money in understanding the behavior of asset prices and whether and how monetary policy should react to asset prices such as stock prices and equity premiums from the vantage point of risk sharing. To do so, I introduce money via the form of transaction cost into a production economy with limited stock market participation where agents with lower inter-temporal elasticity of substitution (IES), called non-stockholders, have no access to stock market. In addition to facilitating transactions of consumption goods, money also redistributes wealth by counter-cyclically transferring resources from stockholders to non-stockholders, the main role of non-state contingent bonds. The benchmark model resolves quantitatively the risk premium puzzle and the risk-free return puzzle, matches macroeconomic behavior such as volatilities of output, consumption and investment, and is in line with empirically documented facts about money growth, ination and asset prices in literature. This model is then used to evaluate alternative policies for money growth rates. I nd that monetary policies are welfare improving for both stockholders and non-stockholders if they reduce equity premiums in the economy. These policies include a lower expected money growth, a pro-cyclical money growth rate, and growth rates of money being positively reacting to equity prices or equity premiums, all of which enhance the precautionary saving role of money.

Aggregate volatility risk: Explaining the small growth anomaly and the new issues puzzle

The paper shows that new issues earn low expected returns because they are a hedge against increases in expected aggregate volatility. Consistent with that, the ICAPM with the aggregate volatility risk factor can explain the new issues puzzle, as well as the small growth anomaly and the cumulative issuance puzzle. The key mechanism is that, all else equal, growth options become less sensitive to the underlying asset value and more valuable as idiosyncratic volatility goes up. Idiosyncratic volatility usually increases together with aggregate volatility, that is, in recessions.

Characterizing the Risk of IPO Long‐Run Returns: The Impact of Momentum, Liquidity, Skewness, and Investment

We study 6,686 initial public offerings (IPOs) spanning the period 1981‐2005 and find that the new issues puzzle disappears in a Fama‐French three‐factor framework. IPOs do not underperform in the aftermarket on a risk‐adjusted basis and do not underperform a matched sample of nonissuers. IPO underperformance is concentrated in the 1980s and early 1990s, and IPOs either perform the same as the market or outperform on a risk‐adjusted basis from 1998 to 2005. We find that outperformance in the later period is driven by large firms. Factors for momentum, investment, liquidity, and skewness help to explain aftermarket returns, although size and book‐to‐market tend to proxy for skewness. IPO investors receive smaller expected returns due to negative momentum and investment exposure and in exchange for higher liquidity.

Re-examining the risk–return relationship in banks using quantile regression

Financial data for the US banks listed during 2001–2007 are analysed to re-examine the risk–return relationship in the banking industry. A key feature of this study is the analysis of the changing distribution of return on equity across banks and over time by the quantile regression (hereafter QR) model and a meaningful comparative analysis with the results of the ordinary least squares estimates is examined. The following conclusions are drawn from the empirical results. First, while a positive risk–return relationship is presented for the profitable banks, the risk–return relationship is negative for the profitless banks. Second, the ‘V’ shape relationship between bank risk and profitability identified by this study could satisfactorily explain the existing risk–return puzzle among the prior empirical studies.

The U.S. Equity Return Premium: Past, Present, and Future

For more than a century, diversified long-horizon investments in America's stock market have consistently received much higher returns than investors in bonds: a return gap averaging 6 percent per year. An enormous amount of creative and ingenious work by a great many economists has gone into seeking explanations for the so-called “equity premium return puzzle,” but so far without a fully satisfactory answer. We first review the facts about the equity premium and then discuss a range of explanations that have been proposed. We conclude that the equity premium puzzle has not been solved: it remains a puzzle. And we anticipate that the equity return premium will continue, albeit at a smaller level than in the past—perhaps four percent per year. (The final draft of this paper was written before the recent stock market crash. As of October 2008, we can say that the crash does not fundamentally alter our conclusions and actually strengthens the case for a substantial future equity premium.)

Aggregate Volatility Risk: Explaining the Small Growth Anomaly and the New Issues Puzzle

The paper shows that small growth firms earn low expected returns because they are a hedge against expected aggregate volatility. Consistent with that, the ICAPM with the aggregate volatility risk factor can explain the small growth anomaly, as well as the new issues puzzle and the cumulative issuance puzzle. The key mechanism is that, all else equal, growth options become less sensitive to the underlying asset value and more valuable as idiosyncratic volatility goes up. Idiosyncratic volatility usually increases together with aggregate volatility, that is, in recessions.

The New Issues Puzzle: Testing the Investment-Based Explanation

An investment factor, long in low-investment stocks and short in high-investment stocks, helps explain the new issues puzzle. Adding the investment factor into standard factor regressions reduces the SEO underperformance by about 75%, the IPO underperformance by 80%, the underperformance following convertible debt offerings by 50%, and Daniel and Titman’s (2006) composite issuance effect by 40%. The reason is that issuers invest more than nonissuers, and the investment factor earns a significantly positive average return of 0.57% per month. Equity and debt issuers underperform matching nonissuers with similar characteristics in the post-issue years (e.g., Ritter, 1991; Loughran and Ritter, 1995; and Spiess and Affleck-Graves, 1995, 1999). We explore empirically the investment-based hypothesis of this underperformance. The q-theory of investment and the real options theory imply a negative relation between real investment and expected returns. If the proceeds from equity and debt issues are used to finance investment, then issuers should invest more and earn lower average returns than matching nonissuers.

A multiperiod evaluation of returns following seasoned equity offerings

In this paper, we argue that the evaluation of returns following an equity issue has been hampered by a narrow focus on the period immediately following the issue. We relax this constraint and compare the risk-adjusted performance of firms following an equity issue with their performance during periods when there was no issue activity. We employ this methodology in a calendar-time framework along with a six-factor-generating model of expected returns and a matched sample of non-issuing firms. Our results indicate that the six-factor model of expected returns cannot explain firm's underperformance following an issue as suggested by Eckbo, E., Masulis, R., and Norli, O. [(2000). Seasoned public offerings: Resolution of the ‘New issues puzzle. Journal of Financial Economics, 56, 251–291]. Our approach also produces new empirical evidence that weak returns following an equity issue are consistent with pseudo market timing by issuing firms as argued by Schultz [Schultz, P. (2003). Pseudo market timing and the long-run underperformance of IPO's. Journal of Finance, 58, 483–517; Schultz, P. (2004). Pseudo market timing and the stationarity of the event-generating process (Working Paper). University of Norte Dame].

The New Issue Puzzle in Malaysia: Performance and Earnings Management

The current study seeks to answer the puzzle as to why firms issuing equity produce poor returns to investors in the long run by exploring whether the post issue performance is being influenced by the potential opportuities of earnings management during the period prior to public listing. Using a sample of 187 IPO firms, results in the study shows that firms that go public over the period 1989‐1998 obtained significant negative share return relative to their control firms in the long run. Further analysis provides evidence that managers of Malaysian IPO firms manage their earnings prior to public listing. However, no significant relation is observed between prior earnings management and post issue long run performance. The result is robust with respect to IPO firms with either high or low level of earnings management. Thus, there is no evidence to suggest that the pre offering earnings management is able to predict the negative share return performance post issue. The decline in the post offering share price may be the result of price correction by investors on their beliefs of future earnings based on unfavourable earnings revealed over time by media, analysts reports and subsequent financial statements after listing.

Earnings Management as an Explanation of the Equity Issue Puzzle in the Spanish Market

The poor stock price performance of firms that raise capital through seasoned equity offerings is one of the recent puzzles in financial literature. In this study we investigate whether pre-issue earnings management can explain these results for rights issues in Spain. Consistent with this explanation, we notice that firms' issuing rights make use of discretionary accruals to report higher earnings at the time of the offering decision. Most interestingly, firms with higher level of discretionary accruals seem to experience more negative long-run abnormal returns.

Corporate finance and state enterprise reform in China

This paper uses a novel approach in addressing two puzzles in the field of corporate finance in China, where government is a major player. In addition to the traditional approach based on agency theory and information asymmetry, the paper uses the political costs approach in studying the stock dividend puzzle and rights issues puzzle. The paper finds that the extent of political interference, managerial entrenchment, and institutional control affects corporate financing choices and dividend distribution decisions. The result sheds new light on improving the important corporate governance aspects of state enterprise reform in China.

Looking for risk premium and contagion in Asia-Pacific foreign exchange markets

This article tests pure contagion effects among four Asian foreign exchange markets, namely, Japan, Hong Kong, Singapore, and Taiwan during the 1997 Asian crisis. A conditional version of international capital asset pricing model (ICAPM) in the absence of purchasing power parity (PPP) is used to control for economic fundamentals or systematic risks. The empirical results show strong contagion effects in both conditional means and volatilities of those markets after systematic risks have been accounted for. Specifically, the contagion-in-mean effects are mainly driven by the past return shocks in Hong Kong, Singapore, and Taiwan. As for contagion in volatility, the lead/lag relationships appear to be multidirectional among Japan, Singapore, and Taiwan, but between Hong Kong and Singapore, and between Hong Kong and Taiwan, they are unidirectional, with Hong Kong playing the dominant role in generating negative volatility shocks. In addition, the conditional ICAPM with asymmetric multivariate general autoregressive conditional heteroscedastic in mean (MGARCH(1,1)-M) structure is able to explain/predict on average 17.28% of the return variations in those markets. Therefore, this study provide a further evidence that the time-varying risk premium is a very strong candidate in explaining the predictable excess return puzzle [Lewis, K. K. (1994). Puzzles in international financial markets. NBER Working Paper No. 4951] since the risk premia founded in this article are not only statistically significant but also economically significant.

Propensity Score Matching and the New Issues Puzzle

The characteristic matching approach consistently provides evidence of long-term underperformance following seasoned equity offerings (SEOs). This paper discusses the limitations of standard matching procedures, and applies propensity score matching, i.e., matching on the probability of equity offering, on a sample of SEOs from 1970 to 1997. Using standard industry, size, and book-to-market matching procedures, I replicate the significant negative abnormal returns documented in prior studies. However, when applying propensity score matching on the same sample, I show there is no evidence of negative long-term abnormal returns. Because propensity score matching enables one to find more adequate control firms, I conclude that sufficient matching can explain away the underperformance of the equity issuers.

Seasoned Public Offerings: Resolution of the “New Issues Puzzle”

Seasoned Public Offerings: Resolution of the “New Issues Puzzle”