The Time-Variation of Risk and Return in the Foreign Exchange and Stock Markets

Recent empirical work indicates that, in a variety of financial markets, both conditional expectations and conditional variances of returns are time- varying. The purpose of this paper is to determine whether these joint fluctuations of conditional first and second moments are consistent with the Sharpe-Lintner-Mossin capital-asset-pricing model. We test the mean-variance model under several different assumptions about the time-variation of conditional second moments of returns, using weekly data from July 1974 to December 1986, that include returns on a portfolio composed of dollar, Deutsche mark, Sterling, and Swiss franc assets, together with the US stock market. The model is estimated constraining risk premia to depend on the time-varying conditional covariance matrix of the residuals of the expected returns equations. The results indicate that estimated conditional variances cannot explain the observed time-variation of risk premia. Furthermore, the constraints imposed by the static CAPH are always rejected.

Time-Series Tests of a Non-Expected-Utility Model of Asset Pricing

This paper provides two alternative estimation and testing procedures of a representative-agent model of asset pricing which relies on a particular parametrization of non-expected-utility preferences. The first is based on maximum-likelihood estimates, supplemented with an explicit model of time varying first and second moments (where the time-variation of second moments in modelled with an ARCH-Autoregressive Conditionally Heteroskedastic-process); the second is based on generalized-method-of moments estimates. We perform our tests on a data set that includes monthly observations of rates of return on US stock prices and US consumption of nondurables and services. Our results are directly comparable to a test of the dynamic capital asset pricing model performed by Hansen and Singleton (1983), and to a recent test of the model studied here performed by Epstein and Zin (1989).

A Multi-Country Comparison of Term Structure Forecasts at Long Horizons

This paper extends previous work on the information in the term structure at longer maturities to other countries besides the United states, using a newly constructed data set for 1 to 5 year interest rates from Britain, West Germany and Switzerland. Even with wide differences in inflation processes across these countries, there is we find strong evidence that the term structure does have significant forecasting ability for future changes in inflation, particularly so at long maturities. On the other hand, the ability of the term structure to forecast future changes in 1-year interest rates is somewhat weaker; only at the very longest horizon (5 years) is there significant forecasting ability for interest rate changes.

Re-emerging Markets

Recent research shows that emerging markets are distinguished by high returns and low covariances with global market factors. These are striking results because of their immediate implications for the international investor. One key issue is whether these results may be attributed to recent emergence. Most of today's emerging markets are actually re-emerging markets, i.e. markets that attracted international attention earlier in the century, and for various political, economic and institutional reasons experienced discontinuities in data sources. To analyze the effects of conditioning on recent emergence, we simulate a simple, general model of global markets in which markets are priced according to their exposure to a world factor; returns are only observed if the price level exceeds a threshold at the end of the observation period. The simulations reveal a number of new effects. In particular, we find that the brevity of a market history is related to the bias in annual returns as well as to the world beta. These patterns are confirmed by long-term histories of global capital markets and by recent empirical" evidence on emerging and submerged markets. Even though these results can also be explained by alternative theories, the common message is that basing investment decisions on the past performance of emerging markets is likely to lead to disappointing results.

Good and Bad Credit Contagion: Evidence from Credit Default Swaps,”

Abstract This study examines the information transfer effect of credit events across the industry, as captured in the Credit Default Swaps (CDS) and stock markets. Positive correlations across CDS spreads imply dominant contagion effects, whereas negative correlations indicate competition effects. We find strong evidence of dominant contagion effects for Chapter 11 bankruptcies and competition effect for Chapter 7 bankruptcies. We also introduce a purely unanticipated event, which is a large jump in a company's CDS spread, and find that this leads to the strongest evidence of credit contagion across the industry. These results have important implications for the construction of portfolios with credit-sensitive instruments. JEL Classifications: G14 (Market Efficiency), G18 (Policy and Regulation), G33 (Bankruptcy