Equity Risk Research Articles

Quantitative Market Risk Assessment for Insurance Companies

The business strategy, the underwriting policy, the investment strategy of insurance companies and some external factors influence their ability to meet liabilities. The risk management mechanism, based on regulatory requirements and the best expertise, should allow to identify and assess all significant risks, including the market risk. The purpose of this research is comparing the European and Russian regulatory requirements for capital calculation for market risks of insurance companies. The methodological base is the comparison analysis of different capital calculation approaches for interest rate, FX, real estate and equity risks in accordance with Solvency II for the European insurers or Regulation 710-P for the Russian insurers. As a result, the author has found the compatibility of regulations to vary depending on the type of the risk in question. Regulations diverge the least when it comes to FX and real estate risks, yet the most in regards to interest rate and equity risks since the Central Bank of Russia has accounted for some national market peculiarities. Overall, the research results have a practical value and could be used by the Russian insurers in transition to the riskoriented regulation.

Equilibrium policy portfolios when some investors are restricted from holding certain assets

PurposeThe authors analyze the equilibrium effects of non-tradable assets on optimal policy portfolios. They study how the existence of non-tradable assets impacts optimal asset allocation decisions of investors who own such assets and of investors who do not have access to non-tradable assets.Design/methodology/approachIn this theoretical analysis, the authors analyze a model with tradable and non-tradable asset classes whose cash flows are jointly normally distributed. There are two types of investors, with and without access to non-tradable assets. All investors have constant absolute risk aversion preferences. The authors derive closed form solutions for optimal investor demand and equilibrium asset prices. They calibrated the model using US data for listed equity, bonds and private equity. Further, the authors illustrate the sensitivities of quantities and prices with respect to the main parameters.FindingsThe study finds that the existence of non-tradable assets has a large impact on optimal asset allocation. Investors with (without) access to non-tradable assets tilt their portfolios of tradable assets away from (toward) assets to which non-tradable assets exhibit positive betas.Practical implicationsThe model provides important insights not only for investors holding non-tradable assets such as private equity but also for investors who do not have access to non-tradable assets. Investors who ignore the effect of non-tradable assets when reverse-engineering risk premia from asset covariances and market capitalizations might severely underestimate the equity risk premium.Originality/valueThe authors provide the first comprehensive analysis of the equilibrium effects of non-tradability of some assets on optimal policy portfolios. Thus, this paper goes beyond analyzing the effects of market imperfections on individual portfolio choices.

Crude oil futures to manage the price risk of textile equities: An empirical evidence from India

The textile sector in India is the oldest manufacturing sector. As the raw materials for this sector are sourced from the petrochemical industries, the earnings of Indian textile companies are dependent on the crude oil price. The crude price in the international market has become more volatile and hence, the equity price of Indian textile companies has become more volatile. This study aims to develop two price risk management strategies for Indian textile equities. Using the vector autoregressive (VAR) model, a price forecast model, further the possibility of cross hedge for textile equities with the help of crude futures is examined using the Granger causality test and Pearson correlation statistics. The results of the study showed that crude futures price in India is one of the price determinants of textile industry stock prices.

Analisis Faktor-Faktor yang Mempengaruhi Equity Risk Premium (Studi Perusahaan Property dan Real Estate yang Terdaftar Di Bursa Efek Indonesia Tahun 2015-2020)

This study aims to empirically examine the factors that influence the equity risk premium in companies listed on the IDX. This study uses a data sample of 34 property and real estate companies listed on the Indonesia Stock Exchange with an observation period of 6 years from 2015-2020, which were taken using the purposive sampling method. The variables used in this study are audit tenure, book to market equity ratio, firm size, leverage, and earnings per share. The analytical technique used in this study is linear regression multiple, namely to determine the effect of audit tenure, book to market equity ratio, firm size, leverage, and earnings per share of the equity risk premium. The results showed that statistically the independent variable audit tenure had a positive effect and the book to market equity ratio had a negative effect on the equity risk premium. while the variables of firm size, leverage, and earnings per share have to effect on the equity risk premium.

Mortgage payments and equity premium puzzle

The equity premium puzzle argues that equity risk alone is insufficient to justify observed equity premiums with a reasonable value of risk aversion. Mortgages account for a substantial part of household debt. It is thus necessary to consider the mortgage payment obligations when addressing the puzzle. This paper examines how the mortgage payment obligations affect the stochastic discount factor in the pricing kernel and influence the equity premium. The proposed asset pricing model incorporating the mortgage payment factor explains the observed equity premium with an acceptable risk aversion value of 1.2. Mortgage payments affect the utility function in two dimensions. First, the payments hurt individuals by decreasing their overall utility level. Second, the counter-cyclical effect of the payments benefits individuals by decreasing the volatility of the utility stream. This paper contributes to the literature by highlighting the importance of mortgages in predicting the equity premium.

Global Diversification and the Cost of Equity

The conventional view in the standard finance textbooks is that organizational form does not matter for a firm’s cost of capital because firm diversification reduces only idiosyncratic risk and not systematic risk. In this study, we investigate the effect of global diversification on the ex-ante cost of equity implied by the residual income valuation model (Ohlson, Earnings, book value and dividends in security valuations. Contemporary Accounting Research, 11(2), 661–687, 1995), using a sample of US firms from 1997 to 2019. Employing the empirical approach developed in Easton et al. (Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment. Journal of Accounting Research, 40(3), 657–676, 2002), our results suggest that global diversification reduces the cost of equity capital for both single-segment firms and multi-segment firms. Our results highlight the effect of global diversification on the equity risk reduction, which may explain the increasing proliferation of foreign operations among US firms — a trend that neither the cash flow effect nor the capital structure effect proposed in previous studies can explain.

The Shape of the Expected Equity Risk Premium

While there is significant evidence of a positive historical <i>realized</i> equity risk premium (ERP), it is less clear how equity returns have varied in different bond yield environments (the <i>expected</i> ERP). This paper explores historical expected ERPs across 16 countries from 1870 to 2015 leveraging the Jordà-Schularick-Taylor Macrohistory database. We find evidence that while future equity returns have been lower during periods of lower bond yields, the decline is less than would be implied by a constant expected ERP. The predictive significance of bond yields varies significantly depending on the future return metric considered (nominal return versus real return, as well as total return versus price return), as well as whether dividend yields and recent inflation are considered. Overall, these results suggest that while equity returns are likely to be lower in a low bond yield environment, they are not likely to be as low as a constant ERP would suggest, and that the overall relation is relatively noisy.

The relationship between financial decisions and equity risk

This study was conducted to determine the impact of financial decisions on equity risk in enterprises. The factors representing financial decisions include investment decisions, working capital decisions, and funding decisions. The equity risk is represented by beta in firms. Research and analysis of panel data with generalized least squares (GLS) via industry construction companies listed on the Vietnam Stock Exchange from 2015 to 2019. The data analysis results show that investment decisions do not affect equity risk, working capital decisions have a positive impact on equity risk, and funding decisions have a negative impact on equity risk. Furthermore, this study shows that agency theory does not exist in the relationship between financial decisions and equity risk in industry-construction enterprises in Vietnam. From this result, the authors also provide implications to help investors and corporation managers make decisions according to their goals based on signs of financial decisions.

A LINKAGE BETWEEN THE FINANCIAL AND THE REAL ECONOMY

The aim of this paper is to present a linkage between the real economy (micro and macro) and the financial economy. This relationship is obtained from the non-arbitrage valuation of equities framework. The paper also investigates if this theoretical relationship is actually observed. For this purpose, it proposes and tests an empirical model for excess returns that includes the linkage as a crucial element. The actual observation of the linkage could be of special importance for the financial economics discipline, since it presents several features that are not usually seen in other asset pricing or macro-finance models: (a) the relationship is explicit and does not depend on the estimation of free parameters; (b) it is derived under arbitrage free arguments and does not introduce subjective concepts as utility function or risk aversion; and (c) it explains the observed level of equity risk premium without entering in contradiction with its theoretical foundations. The conclusions of the performed tests are in favor of the concepts provided by the framework, meaning that further research could offer an alternative understanding of the behavior of financial markets and their connection with the real economy.

Predicting the equity risk premium using the smooth cross-sectional tail risk: The importance of correlation

I provide a new monthly cross-sectional measure of stock market tail risk, SCSTR, defined as the average of the daily cross-sectional tail risk, rather than the tail risk of the pooled daily returns within a month. Through simulations, I find that SCSTR better captures monthly tail risk rather than merely the tail risk on specific days within a month. In an extended period from 1964 until 2018, this difference is important in generating strong in- and out-of-sample predictability and performs better than the historical risk premium and other commonly-used predictors for short- and long-term horizons.

Why do individuals not participate in the stock market?

We use a representative survey to study economic and non-economic factors that affect stock market participation. We find that many individuals suffer from inertia in the sense that they do not want to take the time and effort to invest in stocks. Inertia also explains stock market participation in addition to earlier documented factors such as actual and perceived financial literacy, trust, and the personal equity risk premium (PERP). A high percentage of non-investors (66%) assert that they will never invest in stocks. We find that inertia affects this assertion both directly and indirectly through factors such as age and gender.

What do we know about the idiosyncratic risk of clean energy equities?

The COVID-19 pandemic stimulated the need to invest in clean energy firms for better returns and climate risk mitigation. This study provides a detailed overview of the impact of idiosyncratic risk (IVOL) on excess returns of 95 clean energy stocks. Overall, investors in clean energy stocks are guided by the pessimist group of investors who underprice the high IVOL stocks and demand high-risk premiums to diversify the firm-specific risk. Further, during the COVID-19 period, there is no significant relationship between clean energy excess stock returns and IVOL. During this period, clean energy stocks were exposed to higher information asymmetry, limiting the arbitrage opportunities and producing a weaker return-IVOL relation indicating that clean energy stocks reflect the properties of technology stocks. IVOL has a low level of persistence which may be helpful in forecasting. This study offers valuable insights for regulators and investors from the investment decisions, asset pricing, and diversification perspective.

Fundamental, Stock Market, and Macroeconomic Factors on Equity Premium – Evidence from Indonesia Stock Exchange

Purpose: The equity premium influences investors' investing decisions, as well as their savings, spending habits, and portfolio allocation between risk-free and risky assets. Researchers have used different economic variables as potential predictors of the equity premium. However, research on determinants of equity risk premiums in emerging markets is less studied. This study aims at investigating the influence of fundamental (debt/equity ratio, dividend pay-out ratio), stock market (beta, stocks price volatility, liquidity), and macroeconomics factors (inflation and exchange rate) on the equity premium in Indonesia. Methodology: Data was collected from a 213 sample of stocks listed in the Indonesia Stock Market for January 2007 to December 2014. Data panel regression was performed to evaluate the impact of fundamental and stock market factors, measured in 16 semesters. Time-series regression was conducted to assess the impact of macro-economic factors, measured monthly. Findings: We find that debt ratio, dividend ratio, beta, stock prices volatility, and exchange rate are positively related to the equity premium while inflation had a negative relationship. Stocks liquidity did not play a significant role in explaining the equity premium. Originality/Value: This study offers insights for investors to determine reasonable returns based on information about the significant determinants in the Indonesia Stock Market.

RISK DISTRIBUTION AMONG UNCORRELATED RISK FACTORS: DIVERSIFIED RISK PARITY

This paper aims to distribute the risk among equity risk, interest rate risk and inflation risk, in a portfolio to prevent a risk concentrated portfolio by employing diversified risk parity (DRP) strategy. Principal component analysis and minimum linear torsion models are used to obtain DRP strategies which are compared with other risk based models and tested on five different asset classes whose prices are collected between January 1988 and December 2017. For attaining a thorough analysis, we include mean-variance optimization whose results are compared with both risk-based and DRP strategies in the out-of-sample testing using Sharpe ratio and uncorrelated risk factors. The results demonstrate that DRP strategies have better performance than other models. Specifically, DRP based on the minimum linear torsion model yields the highest Sharpe and risk diversification ratios. Thus, this strategy may guide the investors to construct risk diversified portfolios, especially, during financial crises.

Evaluating Large Bank Risk Using Stock Market Measures in the Basel III Period

AbstractThere is a puzzle in the literature which seems to indicate that high capital levels introduced by Basel III increase bank risk. This paper attempts to solve this puzzle by investigating whether the risk of the eight U.S. global systemically important banks (GSIBs) increased in the Basel III period from previous periods. This paper uses case studies of the eight U.S. GSIBs to evaluate whether Basel III has changed their risk perceived by the market. Basel III has reduced the systematic risk of equity of U.S. GSIBs perceived by the stock market, and it does not explain the decline in return on equity (ROE) which may indicate some increase in large bank financial risk. The paper breaks down stock market measures into drivers which capture systematic risk of equity and other drivers which capture financial risk, and it finds new evidence which solves the puzzle in the literature on large bank risk. The findings of the paper help investors, creditors and regulators to have a clear understanding of the market perception of large bank risk. The paper provides new methods and evidence which could help regulators to assess the impact of Basel III on bank risk perceived by the market.

Venture capital as innovative source of financing equity capital after the financial crisis in Spain

The global financial crisis affected the supply of funds to finance equity capital, thus calling for innovative risk capital financing methods. The paper explores the sources of venture capital (VC henceforth) fundraising and determines the relationship between VC fundraising, stock market returns, and market capitalization in Spain. The study uses time-series data of VC fundraising and stock market variables from 1989 to 2020 in a vector error correction model analysis after performing cointegration. The paper reports short-run and long-run causal relations between VC fundraising, stock market returns, and market capitalization when VC fundraising and stock market returns are used as dependent variables. However, such relations do not exist when the model is dependent on market capitalization. Our results show that the VC market raises funds from diversified (geographical and institutional) sources. Our findings support the risk diversification theory of VC financing. The paper provides implications for using alternative innovative ways of financing equity risk capital to spur economic growth.

Corporate managers, price noise and the investment factor

This study investigates the impact of flows between bond and equity funds on investment factors over the period 1984–2015. It determines contemporaneous mispricing effects and a statistical reversal relation between these flows and both legs of the investment factor. The statistical reversal relationship between previous flows and the investment factor is economically significant. A one-standard-deviation shock to flows causes a 0.29% decrease in investment factor returns, which are reversed within 5 months. A trading strategy based on signals from past flows and the investment factor outperforms the market by 0.68% in the months following positive flows and produces significant alphas after accounting for well-known equity risk factors. The findings are interpreted as evidence in favor of a behavioral explanation, in which sentiment influences actual managerial decisions. When retail investors and managers are swept up in market euphoria, retail investors shift their holdings from bond to equity mutual funds, and high-investment firms invest more aggressively. Market-level euphoria has a different impact on high- and low-investment firms, and thus the investment factor can be influenced. Hence, the mispricing occurs during these periods, and the reversal relationship is especially pronounced for a high-investment portfolio versus a low-investment portfolio. As a result, during the months following periods of positive flows, the investment factor outperforms the market factor. Interestingly, this study’s measure of flows, which serves as a proxy for market-level euphoria, outperforms other measures of investor sentiment.

Forecasting equity risk premium: A new method based on wavelet de‐noising

AbstractForecasting equity risk premium is notoriously difficult due to a mass of data noise in the raw series and the absence of clear tendency. Using the monthly S&amp;P 500 excess returns from 1927:01 to 2018:12, we first de‐noise the in‐sample original returns series via wavelet method to capture the basic trend of equity risk premium, and then propose forecasting models to obtain one‐step forward out‐of‐sample predicted values based on the de‐noised returns. Our new models can provide substantially superior out‐of‐sample performance compared with other competing models and the historical average. Sizeable economic gains can be realized by a mean–variance investor if they allocate their asset through the new approach. Our findings are robust under different settings from both statistical and economic perspectives.

Stranded fossil-fuel assets translate to major losses for investors in advanced economies

The distribution of ownership of transition risk associated with stranded fossil-fuel assets remains poorly understood. We calculate that global stranded assets as present value of future lost profits in the upstream oil and gas sector exceed US$1 trillion under plausible changes in expectations about the effects of climate policy. We trace the equity risk ownership from 43,439 oil and gas production assets through a global equity network of 1.8 million companies to their ultimate owners. Most of the market risk falls on private investors, overwhelmingly in OECD countries, including substantial exposure through pension funds and financial markets. The ownership distribution reveals an international net transfer of more than 15% of global stranded asset risk to OECD-based investors. Rich country stakeholders therefore have a major stake in how the transition in oil and gas production is managed, as ongoing supporters of the fossil-fuel economy and potentially exposed owners of stranded assets.

Expected Stock Returns When Interest Rates Are Low

The equity risk premium is generally considered to be a reward that investors earn on top of the prevailing risk-free return, implying that, all else equal, total expected stock returns should increase with the level of the risk-free return. We examine whether this notion is true using long-term historical data. Our statistical tests strongly reject the hypothesis that a higher risk-free return implies higher total average stock returns. Instead, expected stock returns appear to be unrelated (or perhaps even inversely related) to the level of the risk-free return. Thus, the equity risk premium tends to be higher when the risk-free return is low and vice versa. This result appears to stem from the operating performance of firms. Our findings challenge the conventional wisdom about expected stock returns and have important implications for asset allocation decisions, in particular when risk-free rates are at extreme levels.