Corporate policies and asset prices

This thesis analyzes the interconnections between corporate policies and asset prices that arise under imperfect capital markets. The magnitude of financial frictions and uncertainty about their future value affect optimal decisions regarding investment, cash savings, financing, payout, and ultimately, valuations. Recognising these effects can help our understanding of return behaviour deemed anomalous under standard asset pricing theory. In turn, we can utilize price data for precise measurement of the frictions. The thesis is based on three papers. The first paper sheds further light on the documented link between earnings and price momentum. I provide evidence that both permanent and transitory shocks contribute to fluctuations in the earnings of momentum firms. I show, theoretically and empirically, that financial constraints can explain the surprisingly large price impact of transitory shocks for momentum firms. The second paper provides a mechanism for value and momentum premia that is driven by the valuation effects of optimal corporate policies under uncertain financing conditions. Time-series variation in the cost of issuing equity leads to a procyclical momentum premium and a countercyclical value premium, consistent with the data. The model can also explain the performance of the two premia during market rebounds as well as the time-series behaviour of their correlation. Finally, the goal of the third paper is to estimate the variation of equity floatation costs, both over time and in the cross-section, at a high level of granularity. Equity issuance is measured based on the daily variation in shares outstanding. This measure identifies issuance events and allows us to exploit data moments related to the quantity issued, its timing and the price reaction, all of which are highly informative of the costs. The estimated model is useful for quantifying the importance of the market timing motive for financing policy

Testing for convergence in stock markets: A non-linear factor approach

This paper applies the Phillips and Sul (2007) method to test for convergence in stock returns to an extensive dataset including monthly stock price indices for five EU countries (Germany, France, the Netherlands, Ireland and the UK) as well as the US over the period 1973-2008. We carry out the analysis on both sectors and individual industries within sectors. As a first step, we use the Stock and Watson (1998) procedure to filter the data in order to extract the long-run component of the series; then, following Phillips and Sul (2007), we estimate the relative transition parameters. In the case of sectoral indices we find convergence in the middle of the sample period, followed by divergence, and detect four (two large and two small) clusters. The analysis at a disaggregate, industry level again points to convergence in the middle of the sample, and subsequent divergence, but a much larger number of clusters is now found. Splitting the cross-section into two subgroups including Euro area countries, the UK and the US respectively, provides evidence of a global convergence/divergence process not obviously influenced by EU policies

Testing stock market convergence: a non-linear factor approach

This paper applies the Phillips and Sul (Econometrica 75(6):1771–1855, 2007) method to test for convergence in stock returns to an extensive dataset including monthly stock price indices for five EU countries (Germany, France, the Netherlands, Ireland and the UK) as well as the US between 1973 and 2008. We carry out the analysis on both sectors and individual industries within sectors. As a first step, we use the Stock and Watson (J Am Stat Assoc 93(441):349–358, 1998) procedure to filter the data in order to extract the long-run component of the series; then, following Phillips and Sul (Econometrica 75(6):1771–1855, 2007), we estimate the relative transition parameters. In the case of sectoral indices we find convergence in the middle of the sample period, followed by divergence, and detect four (two large and two small) clusters. The analysis at a disaggregate, industry level again points to convergence in the middle of the sample, and subsequent divergence, but a much larger number of clusters is now found. Splitting the cross-section into two subgroups including euro area countries, the UK and the US respectively, provides evidence of a global convergence/divergence process not obviously influenced by EU policies

1/N and long run optimal portfolios: results for mixed asset menus

Recent research [e.g., DeMiguel, Garlappi and Uppal, (2009), Rev. Fin. Studies] has cast doubts on the out-of-sample performance of optimizing portfolio strategies relative to naive, equally weighted ones. However, existing results concern the simple case in which an investor has a one-month horizon and meanvariance preferences. In this paper, we examine whether their result holds for longer investment horizons, when the asset menu includes bonds and real estate beyond stocks and cash, and when the investor is characterized by constant relative risk aversion preferences which are not locally mean-variance for long horizons. Our experiments indicates that power utility investors with horizons of one year and longer would have on average benefited, ex-post, from an optimizing strategy that exploits simple linear predictability in asset returns over the period January 1995 - December 2007. This result is insensitive to the degree of risk aversion, to the number of predictors being included in the forecasting model, and to the deduction of transaction costs from measured portfolio performance.Econometric models ; Asset pricing ; Rate of return

Essays in Asset Pricing and Volatility Risk

In the first chapter (``Good and Bad Uncertainty: Macroeconomic and Financial Market Implications\u27\u27 with Ivan Shaliastovich and Amir Yaron) we decompose aggregate uncertainty into `good\u27 and `bad\u27 volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. The market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia. In the second chapter (``A Tale of Two Volatilities: Sectoral Uncertainty, Growth, and Asset-Prices\u27\u27) I document several novel empirical facts: Technological volatility that originates from the consumption sector plays the ``traditional\u27\u27 role of depressing the real economy and stock prices, whereas volatility that originates from the investment sector boosts prices and growth; Investment (consumption) sector\u27s technological volatility has a positive (negative) market-price of risk; Investment sector\u27s technological volatility helps explain return spreads based on momentum, profitability, and Tobin\u27s Q. I show that a standard DSGE two-sector model fails to fully explain these findings, while a model that features monopolistic power for firms and sticky prices, can quantitatively explain the differential impact of sectoral volatilities on real and financial variables. In the third chapter (``From Private-Belief Formation to Aggregate-Vol Oscillation\u27\u27) I propose a model that relies on learning and informational asymmetry, for the endogenous amplification of the conditional volatility in macro aggregates and of cross-sectional dispersion during economic slowdowns. The model quantitatively matches the fluctuations in the conditional volatility of macroeconomic growth rates, while generating realistic real business-cycle moments. Consistently with the data, shifts in the correlation structure between firms are an important source of aggregate volatility fluctuations. Cross-firm correlations rise in downturns due to a higher weight that firms place on public information, which causes their beliefs and policies to comove more strongly

Asset Pricing Implications of Hiring Demographics

This paper documents that U.S. industries that shift their skilled workforce toward young employees exhibit higher expected equity returns. The young-minus-old (YMO) hiring return spread comoves negatively with value-minus-growth while being significantly positive on average. Exposure to the YMO spread accounts for a significant portion of annual momentum profits at the industry level. I find that an adjustment of the skilled workforce toward young employees is associated with greater productivity in new capital inputs of an industry. This motivates a risk-based explanation for the YMO spread, and its interaction with value and momentum. A model of investment and hiring where young and experienced employees are equipped with differential roles in production and investment can account for the empirical findings

Leraning, life-cycle and entrepreneurial investment

In this paper, present a calibrated model of life-cycle occupation and investment decisions where households choose between paid work and entrepreneurship and conditional on the latter how much of their savings to invest in their business. The returns to entrepreneurial activity are modeled through Bayesian learning. The model is able to reproduce the main stylized facts of entry in and exit out of self-employment over the life-cycle. It also suggests a partial explanation of the recent finding of Moskowitz and Vissing-Jørgensen (2002) that entrepreneurs seem not to require a premium for the extra risk of their private equity investment.Occupational choice, portfolio choice, entrepreneurship, firm dynamics, learning, private equity premium

Financial development and stock returns: A cross country analysis

We examine stock returns in a cross section of emerging and mature markets (49 countries) over 1980-99. Stock returns are found to be significantly related to the degree of financial development. In general, a deeper and higher quality banking system is associated with lower volatility of stock returns and a greater synchronization in the movements of domestic and world returns. International synchronization is also greater the more liquid the stock market.financial development; stock returns

1/N and Long Run Optimal Portfolios: Results for Mixed Asset Menus

Recent research [e.g., DeMiguel, Garlappi and Uppal, (2009a), Rev. Fin. Studies] has cast doubts on the out-of-sample performance of optimizing portfolio strategies relative to a naive, equally-weighted ones. However, most of the existing results concern the simple case in which an investor has a one-month horizon and mean-variance preferences. In this paper, we examine whether this finding holds for longer investment horizons, when the asset menu includes bonds and real estate beyond stocks and cash, and when the investor is characterized by constant relative risk aversion preferences which are not locally mean-variance for long horizons. Our experiments indicates that power utility investors with horizons of one year and longer would have on average benefited, ex-post, from an optimizing strategy that exploits simple linear predictability in asset returns over the period January 1995 - December 2007. This result is insensitive to the degree of risk aversion, to the number of predictors being included in the forecasting model, and to the deduction of transaction costs from measured portfolio performance.equally weighted portfolios; long investment horizon; real-time strategic asset allocation; public real estate vehicles; ex post performance; predictability; parameter uncertainty

The determinants of UK Equity Risk Premium

Equity Risk Premium (ERP) is the cornerstone in Financial Economics. It is a basic requirement in stock valuation, evaluation of portfolio performance and asset allocation. For the last decades, several studies have attempted to investigate the relationship between macroeconomic drivers of ERP. In this work, I empirically investigate the macroeconomic determinants of UK ERP. For this I parsimoniously cover a large body of literature stemming from ERP puzzle. I motivate the empirical investigation based on three mutually exclusive theoretical lenses. The thesis is organised in the journal paper format. In the first paper I review the literature on ERP over the past twenty-eight years. In particular, the aim of the paper is three fold. First, to review the methods and techniques, proposed by the literature to estimate ERP. Second, to review the literature that attempts to resolve the ERP puzzle, first coined by Mehra and Prescott (1985), by exploring five different types of modifications to the standard utility framework. And third, to review the literature that investigates and develops relationship between ERP and various macroeconomic and market factors in domestic and international context. I find that ERP puzzle is still a puzzle, within the universe of standard power utility framework and Consumption Capital Asset Pricing Model, a conclusion which is in line with Kocherlakota (1996) and Mehra (2003). In the second paper, I investigate the impact of structural monetary policy shocks on ex-post ERP. More specifically, the aim of this paper is to investigate the whether the response of UK ERP is different to the structural monetary policy shocks, before and after the implementation of Quantitative Easing in the UK. I find that monetary policy shocks negatively affect the ERP at aggregate level. However, at the sectoral level, the magnitude of the response is heterogeneous. Further, monetary policy shocks have a significant negative (positive) impact on the ERP before (after) the implementation of Quantitative Easing (QE). The empirical evidence provided in the paper sheds light on the equity market’s asymmetric response to the Bank of England’s monetary policy before and after the monetary stimulus. In the third paper I examine the impact of aggregate and disaggregate consumption shocks on the ex-post ERP of various FTSE indices and the 25 Fama-French style value-weighted portfolios, constructed on the basis of size and book-to-market characteristics. I extract consumption shocks using Structural Vector Autoregression (SVAR) and investigate its time-series and cross-sectional implications for ERP in the UK. These structural consumption shocks represent deviation of agent’s actual consumption path from its theoretically expected path. Aggregate consumption shocks seem to explain significant time variation in the ERP. At disaggregated level, when the actual consumption is less than expected, the ERP rises. Durable and Semi-durable consumption shocks have a greater impact on the ERP than non-durable consumption shocks. In the fourth and final paper I investigate the impact of short and long term market implied volatility on the UK ERP. I also examine the pricing implications of innovations to short and long term implied market volatility in the cross-section of stocks returns. I find that both the short and the long term implied volatility have significant negative impact on the aggregate ERP, while at sectoral level the impact is heterogeneous. I find both short and long term volatility is priced negatively indicating that (i) investors care both short and long term market implied volatility (ii) investors are ready to pay for insurance against these risks