A Multifactor, Nonlinear, Continuous-Time Model of Interest Rate Volatility

This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of thin air,' our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model's implications for the term structure of term premiums.

The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly

The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short-term interest rates, not to a breakdown of the link between fundamentals and exchange rates.

The Myth of Long-Horizon Predictability

The prevailing view in finance is that the evidence for long-horizon stock return predictability is significantly stronger than that for short horizons. We show that for persistent regressors, a characteristic of most of the predictive variables used in the literature, the estimators are almost perfectly correlated across horizons under the null hypothesis of no predictability. For example, for the persistence levels of dividend yields, the analytical correlation is 99% between the 1- and 2-year horizon estimators and 94% between the 1- and 5-year horizons, due to the combined effects of overlapping returns and the persistence of the predictive variable. Common sampling error across equations leads to ordinary least squares coefficient estimates and R2s that are roughly proportional to the horizon under the null hypothesis. This is the precise pattern found in the data. The asymptotic theory is corroborated, and the analysis extended by extensive simulation evidence. We perform joint tests across horizons for a variety of explanatory variables, and provide an alternative view of the existing evidence.

On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing

Previous research showed that the dividend price ratio process changed remarkably during the 1980's and 1990's, but that the total payout ratio (dividends plus repurchases over price) changed very little. We investigate implications of this difference for asset pricing models. In particular, the widely documented decline in the predictive power of dividends for excess stock returns in time series regressions in recent data is vastly overstated. Statistically and economically significant predictability is found at both short and long horizons when total payout yield is used instead of dividend yield. We also provide evidence that total payout yield has information in the cross-section for expected stock returns exceeding that of dividend yield and that the high minus low payout yield portfolio is a priced factor. The evidence throughout is shown to be robust to the method of measuring total payouts.

Do Asset Prices Reflect Fundamentals? Freshly Squeezed Evidence from the OJ Market

The behavioral finance literature cites the frozen concentrated orange juice (FCOJ) futures market as a prominent example of the failure of prices to reflect fundamentals. This paper reexamines the relation between FCOJ futures returns and fundamentals, focusing primarily on temperature. We show that when theory clearly identifies the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple, theoretically-motivated, nonlinear, state dependent model of the relation between FCOJ returns and temperature, we can explain approximately 50% of the return variation. This is important because while only 4.5% of the days in winter coincide with freezing temperatures, two-thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact that there is no relation the majority of the time is good news for the theory and for market efficiency, not bad news. In terms of residual FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The fact that, even in the comparatively simple setting of the FCOJ market, it is easy to erroneously conclude that fundamentals have little explanatory power for returns serves as an important warning to researchers who attempt to interpret the evidence in markets where both fundamentals and their relation to prices are more complex.

Behavioralize This! International Evidence on Autocorrelation Patterns of Stock Index and Futures Returns

This paper investigates the relation between returns on stock indices and their corresponding futures contracts in order to evaluate potential explanations for the pervasive yet anomalous evidence of positive, short-horizon portfolio autocorrelations. Using a simple theoretical framework, we generate empirical implications for both microstructure and behavioral models. These implications are then tested using futures data on 24 contracts across 15 countries. The major findings are (I) return autocorrelations of indices tend to be positive even though their corresponding futures contracts have autocorrelations close to zero, (ii) these autocorrelation differences between spot and futures markets are maintained even under conditions favorable for spot-futures arbitrage, and (iii) these autocorrelation differences are most prevalent during low volume periods. These results point us towards a market microstructure-based explanation for short-horizon autocorrelations and away from explanations based on current popular behavioral models.

An Explanation of the Forward Premium Puzzle: The Long and the Short of It

The forward premium anomaly, i.e., the empirical evidence that exchange rate changes are negatively related to interest rate differentials, is one of the most robust puzzles in financial economics. We add to this literature by recasting the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates. The differences using spot and maturity-matched forward rates are dramatic. As the maturity of the forward interest rate differential increases, the anomalous sign on the coefficient in the traditional specification is reversed, and the explanatory power increases. We present a simple model of interest rates, inflation, and exchange rates that explains this novel empirical evidence. The model is based on interest rate distortions due to Taylor rules and exchange rate determination involving not just purchasing power parity, but also effects due to real rate differentials and subsequent reversion of the exchange rate to fundamentals. We develop and test additional implications of this model. A key finding is that the effect of current interest rate differentials on exchange rates can be decomposed into two offsetting components, which, if used separately, greatly increase the explanatory power of regression models for exchange rates.hry 2451/25922hry 2451/2592

The Last Great Arbitrage: Exploiting the Buy-and-Hold Mutual Fund Investor

This paper demonstrates that an an institutional feature inherent in a multitude of mutual funds managing billions in assets generates fund NAVs that reflect stale prices. Since, in many cases, investors can trade at these NAVs with little or no transactions costs, there is an obvious trading opportunity. Simple, feasible strategies generate Sharpe ratios that are sometimes one hundred times greater than the Sharpe ratio of the underlying fund. These opportunities are especially prevalent in international funds that buy Japanese or European equities and in funds that invest in thinly traded securities in the U.S. When implemented, the gains from these strategies are matched by o setting losses incurred by buy-and-hold investors in these funds. In one particular example, we explore the consequences of trading between different Vanguard mutual funds, motivated via the rules inherent in University 403B plans. Compared to an equal-weighted buy-and-hold portfolio of international Vanguard funds with a 25% cumulative return, the strategy discussed in this paper produces a 139% return while being in the stock market less than 25% of the time

The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly

The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of shortterm interest rates, not to a breakdown of the link between fundamentals and exchange rates

THE VALUATION OF MUTUAL FUND CONTRACTS

Combining insights from the contingent claims and the asset-backed securities literatures, we study the economics of value creation in the asset management business. In particular, we provide a theoretical model and a closed form formula for the value of fund fees in the presence of the well known flow-performance relation, giving rise to interesting nonlinearities and volatility-related effects. The theoretical model sheds light on the role of fees, asset growth, asset and benchmark volatility, and the intensity of the flow-performance relation. To better understand the role of changing fund characteristics such as age and size on the fund value and fund risk, we estimate the empirical relation between returns and flows conditional on these characteristics for various asset classes. We study these effects using Monte Carlo simulations for various economically meaningful parameter values for specific asset classes. Measuring value as a fraction of assets under management, we find that both value and risk, systematic and idiosyncratic, decline in size and age. In addition, value is a complex, non-monotonic function of the fee charged on the fund