Negative Premium Research Articles

Compensation for Earnings Risk under Worker Heterogeneity

We use two large data sets to estimate the Risk Augmented Mincer equation and test for risk compensation in expected earnings. We replicate earlier findings of a positive premium for risk and a negative premium for skew and add confirmation of the key results if we control for individual ability. We compare risk compensation and risk distributions between some labor market groups and find that immigrants and natives do not differ in risk attitudes, that public sector workers are undercompensated for their risk, and that risk compensation by gender is not fully consistent with higher risk aversion for women. We express concern that a linear compensation model may be too simple.

Pricing unexpected illiquidity

Abstract The well documented positive relation between returns and lagged illiquidity suggests that illiquidity is a priced characteristic of stocks. Recent studies suggest that stock returns are inversely related to the contemporaneous unexpected illiquidity, which is consistent with price revisions to reflect realized illiquidity. This study analyzes the relations between stock returns and illiquidity innovations and finds that that the negative illiquidity shock premium persists beyond the contemporaneous interval. However, transaction costs overwhelm any potential profits from strategies that attempt to exploit the price adjustments to the shocks, suggesting the markets are efficient with respect to illiquidity information.

Monetary Policy Risk and the Cross-Section of Stock Returns

The effects of monetary policy shocks on the equity premium and the cross-section of stock returns are analyzed in general equilibrium. Policy shocks affect real stock returns as a result of nominal product price rigidities. Two opposite effects determine the impact of policy shocks on stock returns. A contractionary shock increases the marginal utility of consumption, reduces aggregate output, and increases production markups. The output reduction requires a positive premium in expected returns. The markup increase acts as a consumption hedge and involves a negative premium. Low elasticities of intertemporal substitution of consumption and labor amplify the markup effect and can generate a negative net effect on the equity premium. In the cross-section, a contractionary shock reduces the relative output and expands the relative markup of a more rigid price industry with respect to a more flexible price industry. If the relative markup expansion dominates the relative output decline, the expected stock return of the more flexible price industry is higher than that of the more rigid price one. As the responsiveness of the policy to economic conditions increases, the effects of policy shocks on the equity premium and the cross-section decline. In addition, the policy-induced markup variation generates time variation in expected returns.

Spot and Forward Prices in the Brussels SE: Time Value v. Convenience Premiums

Until the mid-90s, the more active among the Brussels-listed stocks were traded in two parallel segments: spot'' (that is, with (t 3) settlement) and forward'' (periodic settlement at the end of a two- or three-week period). In this paper we study the opening prices from the angle of what drives the observed forward premiums. We test whether forward premiums are related to time to settlement and interest rates, and, if not, whether they seem to reflect extra costs (or shadow costs) of running out of either cash balances or long stock positions.The settlement effect is tested in each market separately and then on cross-market price differences. In spot markets there is very little evidence in favor or against a settlement effect, perhaps because the time value item has a very small variability. As expected, the time value signals are somewhat stronger in forward prices and noticeably so in forward premiums, but the estimates remain below our theoretical priors.Next, we show theoretically that a positive forward premium is more likely in a situation in which the order volume from cash-constrained buyers exceeds that of sellers without a long position. Likewise, a negative forward premium typically means that the order volume from sellers without long positions exceeds that of cash-constrained buyers. We find that abnormally high forward premiums are 2.5-3 times more frequent and larger than negative premiums, and that they persist in time, unlike negative premiums. Thus, contrary to what many academics may have expected, getting money loans seems to be a more frequent, more expensive, and more persistent problem than asset borrowing.

International financial integration through the law of one price: The role of liquidity and capital controls

This paper takes advantage of the fact that some stocks trade both in domestic and international markets to characterize the degree of international financial integration. The paper argues that the cross-market premium (the ratio between the domestic and the international market price of cross-listed stocks) provides a valuable measure of international financial integration and the effectiveness of capital controls. Using Autoregressive (AR) models to estimate convergence speeds and non-linear Threshold Autoregressive (TAR) models to identify non-arbitrage bands, the paper shows that price deviations across markets are rapidly arbitraged away and bands are narrow, particularly so for liquid stocks. The paper also shows that regulations on cross-border capital flows effectively segment domestic markets. As expected, the effects of both types of capital controls are asymmetric but in the opposite direction: controls on outflows induce positive premia, while controls on inflows generate negative premia. Both vary with the intensity of capital controls.

Optimal investments in volatility

Volatility has evolved as an attractive new asset class of its own. The most common instruments for trading volatility are variance swaps. Mean returns of DAX and ESX variance swaps over the time period of 1995 to 2004 are strongly negative, and only part of the negative premium can be explained by the negative correlation of variance swap returns with stock market indices. We analyze the implications of this observation for optimal portfolio composition. Mean-variance efficient portfolios are characterized by sizable short positions in variance swaps. Typically, the stock index is also sold short to achieve a better portfolio diversification. To capture heterogeneous preferences for higher moments, we use a variant of the polynomial goal programming method. We assume that investors strive for a high Sharpe ratio, high skewness, and low kurtosis. Our analysis reveals that it is often not possible to achieve a balanced tradeoff between Sharpe ratio and skewness. Investors are advised to hold the extreme portfolios (Sharpe ratio driven, skewness driven, or kurtosis driven) and avoid the middle ground. This “all-or-nothing” characteristic is reflected in jumps of asset weights when certain thresholds of preference parameters are crossed. These empirical findings can explain why many investors are so reluctant to implement option-based short-selling strategies.

The Closed-End Fund Premium Puzzle and Portfolio/Fund Risk Differences

Seemingly at odds with market efficiency, it is well-known that closed-end funds (CEF) trade at a discount (negative premium) to the net asset values (NAVs) of the portfolios these CEFs hold. Yet, since the CEF shares and the underlying securities held by the CEF trade in completely different markets (with limited means of cross-market arbitrage), the returns on the CEF and the returns on the underlying portfolio may not move in lock-step. In this paper, we investigate whether the returns of closed-end funds (CEFs) behave differently than the returns of the underlying portfolio of securities held by the CEF. We show that, on average, the returns on CEFs have significantly (both economically and statistically) higher risk (i.e., factor loadings) and volatility than the returns on their underlying portfolios (i.e., NAV returns), but have roughly the same mean returns. We also show that the difference in risk and performance between the CEF and its NAV explain cross-sectional variation in the size of difference between the NAV and the price of the CEF (i.e., the CEF premium). Possibly adding to the puzzle though, we find that idiosyncratic risk is positively related to CEF premiums (higher relative idiosyncratic risk for the CEF results in higher relative CEF price to NAV). Our conclusion is that CEFs have a life of their own and that the difference in the return behavior rationally accounts for (at least a portion) of the CEF premium puzzle.

Risk Factors for the Swiss Stock Market

Summary The four risk factors controlling for the market, size, value, and momentum effect have become a state-of-the-art framework for various applications in financial markets research. However, previous work shows that these broadly recognized risk factors are country-specific. For these reasons, this paper develops and analyses these factors for the Swiss stock market from January 1990 to December 2005, building on a high quality dataset and taking into account specific characteristics of the Swiss stock market. We find a negative size premium of −0.67% p.a. and a positive value premium of 2.35% p.a. Both, however, show a time-varying character. The momentum effect is the most pronounced with a premium of 10.33% p.a. The results are robust and validated by a comparison to data from the US. Furthermore, we find that the explanatory power of the factors is high, confirming their relevance to the Swiss stock market.

Asymptotical analysis of negative insurance premiums in critical situations

The paper considers the risks of the insurance companies that conduct purely rent operations. The asymptotic of certain distribution functions are found in the case of a heavy traffic and regular tail variation of the premium distribution function.

Relation between distress risk, book‐to‐market ratio and return premium

PurposeEarlier research found that firms with the highest distress risk have low book‐to‐market (B/M) ratios and low returns. This paper aims to examine the robustness of those's results and provide further evidence that high distress‐risk firms do not enjoy the same high returns earned by high B/M firms and that distress risk is unlikely to explain the Fama and French high‐minus‐low (HML) B/M factor.Design/methodology/approachA distress‐risk measure, distressed‐minus‐solvent (DMS), is calculated and a range of zero investment distress‐risk trading strategies is investigated. Value‐ and equal‐weighted portfolios are examined both with negative book‐equity firms and without. These most distressed firms have low or negative B/M values and would either not be included in the Fama and French sample or included in the low B/M portfolio.FindingsThe paper finds that the DMS factor is negative and significant, and none of the zero investment strategies earns significantly positive returns.Research limitations/implicationsThe findings suggest that exposure to distress risk does not earns investors a positive risk premium. It appears that over the period examined, market inefficiencies drive the market value and returns of high distress‐risk firms.Originality/valueThe distress‐risk premium is shown to be negative and, therefore, cannot be driven by bankruptcy risk alone. The negative premium is not consistent with a financial distress explanation for the Fama and French HML factor.

Foreign exchange risk and the cross-section of stock returns

We examine the relation between the cross-section of US stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange-sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's [2004. Forecast dispersion and the cross-section of expected returns. Journal of Finance, 59, 1957–1978] option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.

Optimal Investments in Volatility

Volatility has evolved as an attractive new asset class of its own. The most common instruments for trading volatility are variance swaps. Mean returns of DAX and ESX variance swaps over the time period from 1995 to 2004 are strongly negative, and only part of the negative premium can be explained by the negative correlation of variance swap returns with stock market indices. We analyze the implications of this observation for optimal portfolio compositions. Mean-variance efficient portfolios are characterized by sizable short positions in variance swaps. Typically, the stock index is also sold short to achieve a better portfolio diversification. To be able to capture heterogeneous preferences for higher moments, we use a variant of the Polynomial Goal Programming method. We assume that investors strive for a high Sharpe ratio, high skewness and low kurtosis. Our analysis reveals that a balanced trade-off between Sharpe ratio and skewness often does not exist. Investors are advised to hold the extreme portfolios (Sharpe ratio driven, skewness driven or kurtosis driven) and avoid to be stuck in the middle. This 'all-or-nothing' characteristic is reflected in jumps of asset weights when certain thresholds of preference parameters are crossed. These empirical findings can explain why many investors are so reluctant to implement option-based short-selling strategies.

EBay auctions for Third Eye Blind concert tickets

The band Third Eye Blind recently completed a tour, selling tickets exclusively on eBay. Many tickets were bundled with either VIP passes or autographed posters. These data are used to measure variations in price across different markets, as well as the premiums paid for different ticket types. Auctioning the tickets allows the seller to practice Third Degree Price Discrimination and bundling, without having to determine prices in each market and for each different bundle. We find: tickets bundled with VIP passes command a substantial positive premium; tickets bundled with autographed posters command a small negative premium; different prices emerge in different geographic markets; and auction prices are positively related to the fixed price at which tickets could be purchased by way of Buy-it-Now.

Pricing general insurance with constraints

Deterministic control theory is used to find the optimal premium strategy for an insurer in order to maximise a given objective. The optimal strategy can be loss-leading depending on the model parameters, which may result in negative premium values. In such circumstances, it is optimal to capture as much of the market as possible before making a profit towards the end of the time horizon. In reality, the amount by which an insurer can lower premiums is constrained by borrowing restrictions and the risk inherent in building up a large exposure. Consequently, the effect of constraining the pricing problem is analysed with two forms of constraint: a bounded premium and a solvency requirement. If a lower bound is placed on the premium then an analytical solution can be found, which is not necessarily a smooth function of time. The optimal premium strategy is described in qualitative terms, without recourse to specifying particular parameter values, by considering the value of the terminal optimal premium. Solvency constraints lead to an optimisation problem which is coupled to the state equations and so there is no analytical solution. Numerical results are presented for a subset of the parameter space using control parameterisation, which turns the optimisation problem into a nonlinear programming problem.

Idiosyncratic volatility, fundamentals, and institutional herding: Evidence from the Japanese stock market

Using Japanese data from 1975 to 2003, we show that both institutional herding and firm earnings are positively related to idiosyncratic volatility. We reject the hypothesis that institutional investors herd toward stocks with high idiosyncratic volatility and systematic risk. Our results suggest that a behavior story may explain the negative premium earned by high idiosyncratic volatility stocks found by Ang et al. [Ang, Andrew, Hodrick, Robert J., Yuhang Xing, Xiaoyan Zhang, 2004. The cross-section of volatility and expected returns, Forthcoming Journal of Finance]. We also find that the dispersions of change in institutional ownership and return-on-asset move together with the market aggregate idiosyncratic volatility over time. Our results suggest that investor behavior and stock fundamentals may both help explain the time-series pattern of market aggregate idiosyncratic volatility.

Compensation for Earnings Risk Under Worker Heterogeneity

We use two large Dutch datasets to estimate the Risk Augmented Mincer equation and test for risk compensation in expected earnings. We replicate earlier findings of a positive premium for risk and a negative premium for skew and add confirmation of the key results if we control for individual ability. We find that immigrants have graduated in more risky educations but obtain identical risk compensation. Among recent graduates, women receive higher risk compensation than men, consistent with their higher risk aversion, while for a labour force cross-section, lower average compensation for women is consistent with their presence in less risky educations. Lower average compensation for vocational graduates than for university graduates is consistent with presumed higher risk aversion and lower observed risk.

Estimation of the Risk Premiums in Energy Markets

In this paper I attempt to estimate the risk premiums in energy markets using the closing prices from futures and options contracts of natural gas. Solving for the instantaneous parameters is conducted over several parametric models where the results suggest a model that incorporates both return and volatility jumps best captures the return dynamics for this energy commodity. Solving for the market price(s) of risk requires calibrating the model by combining both the risk-neutral and real world distributions. In using both the current futures price and the cross-section of option prices, estimation of the parameters is conducted using a simulated method of moments technique by minimizing the difference between the estimated and actual realized volatility and option prices. A statistically significant negative volatility and price premium for natural gas contracts is found. Controlling for seasonality suggest differences in premia across different seasons, with winter months having higher negative premiums.

Foreign Exchange Risk and the Cross-Section of Stock Returns

We examine the relation between the cross-section of U.S. stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's (2004) option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.

Discrimination and neighborhood effects: understanding racial differentials in US housing prices

Because race and neighborhood characteristics are strongly correlated, studies of racial housing price differentials have yielded results that vary widely depending on the types of neighborhood controls used. This paper shows that even with relatively thorough neighborhood controls, there is still evidence that correlation between the error term and regressors is a source of bias. While recent studies have tended to find evidence of a negative premium for blacks, fixed effects estimates in this paper indicate that black owners pay premiums of around 10 percent for housing. Moreover, house values decline in neighborhoods as the percentage of blacks increases, suggesting prejudicial attitudes.

Hitting probabilities in a Markov additive process with linear movements and upward jumps: Applications to risk and queueing processes

Motivated by a risk process with positive and negative premium rates, we consider a real-valued Markov additive process with finitely many background states. This additive process linearly increases or decreases while the background state is unchanged, and may have upward jumps at the transition instants of the background state. It is known that the hitting probabilities of this additive process at lower levels have a matrix exponential form. We here study the hitting probabilities at upper levels, which do not have a matrix exponential form in general. These probabilities give the ruin probabilities in the terminology of the risk process. Our major interests are in their analytic expressions and their asymptotic behavior when the hitting level goes to infinity under light tail conditions on the jump sizes. To derive those results, we use a certain duality on the hitting probabilities, which may have an independent interest because it does not need any Markovian assumption.