Portfolio-level Analysis Research Articles

Disagreement in Option Market and Cross Section Stock Returns

In the paper, we find out that there is a significant relation between option trading volume and open interest distributions across various strike levels and expected stock returns. Specifically, we construct volume and open interest weighted option strike dispersions. Portfolio level analysis and firm-level cross-sectional regression both indicate a negative and significant relation between expected returns and option strike dispersion. The results are consistent with Miller (1977) theory. The option strike dispersion can be regarded as a proxy for investors’ belief dispersion. Long-short strategy purchasing stocks with low option strike dispersion and shorting those with high option strike dispersion earns annualized abnormal return 14.05% with sharp ratio 0.79.

Do Extreme Returns Matter in Emerging Markets? Evidence from the Chinese Stock Market

Recent evidence in the U.S. and Europe indicates that stocks with high maximum daily returns in the previous month, perform poorly in the current month. We investigate the presence of a similar effect in the emerging Chinese stock markets with portfolio-level analysis and firm-level Fama-MacBeth cross-sectional regressions. We find evidence of a MAX effect similar to the U.S. and European markets though the effect appears stronger for longer holding periods. Contrary to U.S. and European evidence, the MAX effect in China does not weaken much less reverse the anomalous IV effect. Both the MAX and IV effects appear to independently coexist in the Chinese stock markets. Interpreted together with the strong evidence of risk-seeking behaviour among Chinese investors, our results are consistent with the suggestion that the negative MAX effect is driven by investor preference for stocks with lottery-like features.

Three Essays on Momentum Returns

This dissertation consists of three essays on momentum returns. The first essay is entitled ‘Momentum Returns, Market States and the Global Financial Crisis.’ This essay investigates the profitability of the momentum trading strategy in the stock exchanges of Shanghai, Shenzhen and Hong Kong over the period 1994 to 2010. My results show that there are significantly large momentum returns for Shanghai and Hong Kong but small and insignificant momentum returns for Shenzhen. Momentum returns remain almost the same for all datasets even after adjusting for the Fama-French risk factors. However, the momentum trading strategy generates negative returns for all markets during the Global financial crisis; it appears that the momentum trading strategy fails during a financial or stock market crisis and especially in the months when the market conditions improve. I find no significant relationship between momentum returns and market states, which contradicts the results of an earlier study conducted in the U.S. market. Instead of market state it appears that it is economic activity that explains momentum returns. In the second essay, entitled ‘Momentum Returns and Information Uncertainty’, I study the impact of information uncertainty on the profitability of the momentum trading strategy. Prior literature attributes returns of the momentum trading strategy to investor behavioural biases, such as under reaction to new information, and provides evidence that firms with higher information uncertainty earn lower future returns and higher momentum returns. This study investigates the relationship between information uncertainty, future returns and the momentum trading strategy in China over 1994 to 2010. Using age, volatility, volume and firm size as information uncertainty proxies, I find that firms with higher information uncertainty earn higher average returns over the succeeding 6-month period when information uncertainty is defined in terms of firm size and volume, consistent with the traditional risk based theories. However, firms with high information uncertainty earn lower returns if information uncertainty is defined in terms of firm age; however, firm age might not be an important factor in explaining future returns as the age difference among young and old firms is quite small and it might be the other firm-specific characteristics that drive lower future returns for the younger firms instead of their age. Therefore, my study rejects the findings of Jiang, Lee and Zhang (2005) that stocks with higher information uncertainty earn lower returns over the succeeding 6-month period. Using portfolio-level analysis and firm-level Fama and Macbeth regressions, I find that no robust significant relationship exists between information uncertainty and momentum returns. My findings suggest that it might be the activities of retail investors that drive momentum returns since China’s market is dominated by retail investors, whereas the momentum effect is weak among the U.S. stocks with higher institutional holdings.In the third and final essay, entitled ‘Momentum Returns, Long-Term Reversal and Idiosyncratic Volatility’, I study the impact of idiosyncratic volatility (IV) on the profitability of momentum and long-term reversal trading strategies in China over the period 1994 to 2010. The literature suggests that IV deters arbitrage, which results in higher momentum and reversal returns for stocks with high idiosyncratic volatility. However, my results indicate that the choice of the proxy used for IV, sorting method and number of portfolios (tercile versus quintile) play critical roles in determining the existence and significance of a relationship between IV and the profitability of momentum or reversal trading strategies. Both portfolio-level analysis and firm-level Fama and Macbeth regressions indicate that no robust relation exists between IV and momentum or reversal, which contradicts the results of earlier studies in the U.S. market. However, my findings suggest that reversal returns might be related to transaction costs since I find greater reversal returns among the stocks with high transaction costs. My findings also do not support the suggestion that momentum and reversal are part of same phenomenon.

A methodology for portfolio-level analysis of system commonality

Complex systems are increasingly being developed as part of portfolios or sets of related complex systems. This enables synergies such as commonality between portfolio systems that can significantly reduce portfolio life-cycle cost and risk. While offering these benefits, commonality usually also incurs up-front as well as life-cycle penalties in cost and risk due to increased design complexity. The resulting trade-off needs to be carried out during the architecting stage of the portfolio life cycle when there is maximum leverage to improve life-cycle properties due to degrees of freedom available in architectural and design decisions. This paper outlines a 4-step methodology for the identification and assessment of commonality opportunities in complex systems portfolios during the architecting stage of the portfolio life cycle. The methodology transforms a solution-neutral description of a portfolio of aerospace systems based on system functionality, requirements, and metrics into a set of preferred portfolio design solutions with commonality. The methodology is based on a 2-stage approach that identifies preferred architectures for each system in the portfolio individually prior to heuristic commonality analysis between systems based on a pairwise assessment of system overlap in functionality, technologies, operational environments, and scale. Application of the methodology is demonstrated with a retrospective analysis of NASA’s Saturn launch vehicle portfolio.

Learning to invest better: Using ex post investment analysis on agri-environmental research and development

Public investment in agri-environmental, or natural resources management research, will be an ongoing challenge for evaluation. Two decades of triple bottom line research evaluation on publically funded portfolio investments are presented here as a useful example of research evaluation. These applications of the method to investments in a A$125 m (in present value terms) portfolio included 39 case studies incorporating 641 projects over two decades led by a government agency (Land & Water Australia). This portfolio-level analysis, with conservative assumptions and explicit attribution, shows that the reported returns to economic, environmental, and social values provide useful information. The program and project case studies have been published progressively to inform ex ante investments and this article provides a synthesis of that work. This article presents portfolio-level lessons from the conservative analysis of selected investments to show that for each dollar invested, >$5 of benefits were returned. The rate of return was 26%, making research investment in natural resource management a strongly performing investment. Despite the advances made using this method, there remain challenges in fully describing social and environmental outcomes. This method has now been applied to 15 other agencies investing >$441 m annually in Australian agri-environmental research and development. This portfolio evaluation of agri-environmental research and development is also a useful entry to the devilish details and a wealth of research evaluation knowledge. Copyright The Author 2012. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com, Oxford University Press.

By Force of Habitat? A First Look at Insurers' Government Bond Portfolios

We perform portfolio level analysis to trace the preferred habitat investment behavior in the government bond market. With a preferred habitat, investors would have an inelastic demand to bonds at given horizons. This is confirmed by the empirical evidence that the aggregate portfolios of insurance firms exhibit restrained elasticities to interest rate changes. We further investigate two forms of habitat --- a liability habitat driven by the need to immunize the interest rate risk of operating liabilities, and a horizon habitat due to the preference for holding securities with riskfree returns for the investment horizon. Consistent with the two effects, we fnd that insurers' portfolio interest rate risk is strongly related to that of the operating liabilities, and that the size of liability and risk aversion dampen insurers' portfolio response to term structure changes.

Accruals and the performance of stock returns following external financing activities

This paper investigates the relation of the external financing anomaly with the accrual anomaly, by focusing separately on working capital accruals and long-term accruals. We find that external financing and accrual hedge portfolios not only generate superior returns, but they also constitute statistical arbitrage opportunities. Portfolio-level analysis and firm-level cross-sectional regressions show that the ability of external financing measures in predicting future returns remains strong, after controlling for working capital accruals. However, this ability is substantially reduced after controlling for long-term accruals. Our results appear to be consistent with investors’ failure to recognise agency-related overinvestment and/or opportunistic earnings management.

On the correlation between fraud and default risk

Identity fraud is one of the fastest growing white-collar crimes today and a serious concern in our information-based economy. This paper studies one type of identity fraud: new account fraud, where an impostor opens lines of credit using a false identity, made-up or stolen. Relying on a unique data set of consumer bank accounts, that contains information on both, fraud and default losses, I analyze the correlation between fraud and default risk. I find that common socio-economic/demographic account holder characteristics have opposite effects on estimated default and fraud probabilities. For example, women possess a lower fraud probability, but a higher default probability, compared to men, and foreigners are more likely to engage in account fraud but less likely to default than Germans. Also, the portfolio level analysis indicates that portfolio loss distributions are quite sensitive to ex ante portfolio characteristics like the share of foreigners or blue-collar workers. These findings have important implications for banks managing their consumer credit portfolios using limiting rules based on borrower characteristics, and for the adequacy of banks’ capital levels.

Leverage,Stock Returns,Taxes and Industry Concentration

We investigate the effect of firm’s leverage on stock returns. We start with the explicit valuation model of Modigliani and Miller (1958) and expand the model by including other variables and undertaking a firm and portfolio level analysis. We show that stock returns decline in leverage and that the relation is linear. The Utilities sector is the exception. In this sector, returns increase in leverage. We show that the negative relation between leverage and stock returns holds for tax-paying firms and firms in competitive low-concentration industries.

Risk Analysis for Critical Asset Protection

This article proposes a quantitative risk assessment and management framework that supports strategic asset-level resource allocation decision making for critical infrastructure and key resource protection. The proposed framework consists of five phases: scenario identification, consequence and criticality assessment, security vulnerability assessment, threat likelihood assessment, and benefit-cost analysis. Key innovations in this methodology include its initial focus on fundamental asset characteristics to generate an exhaustive set of plausible threat scenarios based on a target susceptibility matrix (which we refer to as asset-driven analysis) and an approach to threat likelihood assessment that captures adversary tendencies to shift their preferences in response to security investments based on the expected utilities of alternative attack profiles assessed from the adversary perspective. A notional example is provided to demonstrate an application of the proposed framework. Extensions of this model to support strategic portfolio-level analysis and tactical risk analysis are suggested.

Critical Asset and Portfolio Risk Analysis: An All‐Hazards Framework

This article develops a quantitative all-hazards framework for critical asset and portfolio risk analysis (CAPRA) that considers both natural and human-caused hazards. Following a discussion on the nature of security threats, the need for actionable risk assessments, and the distinction between asset and portfolio-level analysis, a general formula for all-hazards risk analysis is obtained that resembles the traditional model based on the notional product of consequence, vulnerability, and threat, though with clear meanings assigned to each parameter. Furthermore, a simple portfolio consequence model is presented that yields first-order estimates of interdependency effects following a successful attack on an asset. Moreover, depending on the needs of the decisions being made and available analytical resources, values for the parameters in this model can be obtained at a high level or through detailed systems analysis. Several illustrative examples of the CAPRA methodology are provided.