Idiosyncratic Volatility: Evidence from Asia

The traditional Capital Asset Pricing Model states that assets can earn only higher returns if they have a high beta. However, evidence shows that the single risk factor is not quite adequate for describing the cross-section of stock returns. The current consensus is that firm size and book-to-market equity factors are pervasive risk factors besides the overall market factor. Malkiel and Xu (1997 and 2000) further the debate in empirical asset pricing by stating that idiosyncratic volatility is useful in explaining the cross-sectional expected returns. In this paper we provide international evidence on the relationship between expected stock returns, overall market factor, firm size and idiosyncratic volatility. Our findings suggest that size and idiosyncratic volatility premium are real and pervasive. We find that small and high idiosyncratic volatility stocks generate superior returns and hence suggest that such firms carry risk premia. Our findings also suggest that idiosyncratic volatility is more powerful than the CAPM beta and the firm size effect. Our findings challenge the portfolio theory of Markowitz (1952) and the CAPM of Sharpe (1964), which advances the notion that it is rational for a utility maximizing investor to hold a well-diversified portfolio of investments to eliminate idiosyncratic risks.Idiosyncratic risk, Portfolio Theory, Capital Asset Pricing Model, Size effect and Beta.

ASSET PRICING IN THE ASIAN REGION

In this asset pricing study, three questions are addressed. First, does the multifactor model of Fama and French (1993) capture returns in Asian stock markets in a meaningful manner? Second, do small firms and high book-to-market equity firms carry a risk premia? Third, can competing hypotheses (such as survivorship bias, data-snooping and irrationality) explain the multifactor model results? The answers from this study are as follows: The multifactor model of Fama and French (1993) provides a parsimonious description of the cross-section of returns, with the relationship between firm size, book-to-market equity and average stock returns being robust for Asian markets over the 1990s. We find that small firms and high book-to-market equity firms carry a risk premia, providing opportunities for mean-variance efficient investors. Finally, our findings reject the claim that the results of multifactor model can be explained by competing hypotheses for the Asian experience.Multifactor asset pricing models, Asian region, size effect, book-to-market equity effect.

On the Value Premium in Malaysia

Davis, Fama and French (2000) report that the value premium in United States’ stocks is robust. Herein, we present out-of-sample evidence for Malaysia, finding that value stocks outperform growth stocks and document an arbitrage opportunity. We observe that the mean monthly returns are substantially higher for the two mimic portfolios (SMB and HML) when compared with the market portfolio. For the period 1991 through 1999, an investor generated 1.92% (annually) holding the market portfolio in Malaysia, compared with the two mimic portfolios, SMB and HML with returns of 17.70% and 17.69% respectively. We also observe that the standard deviations for the two mimic portfolios are significantly lower than the standard deviation of the market portfolio. Moreover, the findings presented in this study reject the notion of survivorship bias advanced by Kothari, Shanken and Sloan (1995) and the data-snooping hypothesis attributed to Black (1993) and Mackinlay (1995) as an explanation for the value premium.Asset pricing, multifactor models, value premium, arbitrage

Multifactor Models are Alive and Well

A large number of studies have investigated the cross-section of average returns on common stocks in the United States and have found little relationship with the estimated beta of the single-factor model. This paper tests the joint roles of an overall market factor, and factors related to firm size (market equity) and style (book equity to market equity) in the cross-section of average stock returns in Australia, as there is little evidence available on the asset pricing theory in markets outside the United States. This paper also tests the claim that the size and style effect is the result of seasonal phenomena. We report that the three-factor model largely explains the variation in stock returns in a meaningful pattern. We also observe that size and style factors do a good job throughout the sample period and reject the claim that these effects are due to seasonal phenomena. Our results document that the explanatory power of the three-factor model is not restricted to a limited set of portfolios. Moreover, our findings do not support the data-snooping hypothesis.Asset Pricing, Multifactor Models, Seasonality Premium, Size and Book-to-Market

Idiosyncratic Volatility Matter? New Zealand Evidence

Standard asset pricing models ignore idiosyncratic risk. In this study we examine if stock idiosyncratic or unique risk affects returns for New Zealand stocks using the factor portfolio mimicking approach of Fama and French (1993, 1996). We find evidence of a negative relationship between firm size and a stock’s idiosyncratic volatility. Small firms and firms with high idiosyncratic risk also generate positive risk premia after controlling for market returns. We find no evidence of seasonal effects that can explain our findings. Our study provides support for an asset-pricing model with multiple risk factors.Idiosyncratic volatility, Asset Pricing, Unique risk

IDIOSYNCRATIC RISK AND AUSTRALIAN EQUITY RETURNS

In this paper we investigate the relationship between portfolio returns and idiosyncratic risk for Australian stocks. We report that the portfolio with highest idiosyncratic volatility generates an average annual return of over 45%. We observe additionally that the outcome is consistent with an exponential growth process for stock prices. Further, consistent with Malkiel and Xu, we observe that a stock’s idiosyncratic volatility is inversely correlated with the size of the underlying firm. Thus, our model advances an interpretation of the Fama and French finding that portfolios of stocks of small firms offer superior risk-adjusted returns. Moreover, our findings challenge the portfolio theory of Markowitz (1959) and the asset-pricing model of Sharpe (1964).Idiosyncratic risk, Capital Asset Pricing Model, Size effect

Small Firm Effect, Liquidity and Security Returns: Australian Evidence

Standard asset pricing models ignore the costs of liquidity. In this study we advance the ongoing debate on empirical asset pricing and test if liquidity costs (as proxied by turnover rate, turnover ratio and bid-ask spread) affect stock returns for Australian stocks. Our tests use the factor portfolio mimicking approach of Fama and French (1993, 1996). We find small and less liquid firms generate positive risk premia after controlling for market returns and firm size. We find no evidence of any seasonal effects that can explain our multifactor asset pricing model findings. In summary, our study provides support for a broader asset-pricing model with multiple risk factors.Liquidity, Turnover, Asset Pricing, and Closing Bid-Ask Spread

Market Timing and Selectivity: Evidence from Australian Equity Superannuation Funds

In this performance evaluation study, two questions are addressed. First, do active fund managers possess macro and micro forecasting skills that deliver superior risk-adjusted returns? Second, what is the nature of market timing/stock selectivity trade off in the generation of alpha? The answers from this study are as follows: as an industry, managers delivered inferior returns for superannuation investors for the period 1991 through 1999. The study provides little evidence that the Australian funds management industry holds sufficient macro and/or micro forecasting abilities to generate positive alpha. While previous research has found that inferior market timing decisions are compensated for by superior stock selection skills, this study finds no substantive inverse relationship between timing and selectivity.Performance evaluation; Timing; Selectivity.

Do Momentum Strategies Work?: - Australian Evidence

This paper investigates the profitability of momentum investment strategy and the predictive power of trading volume for equities listed in the Australian Stock Exchange. Recent research finds that momentum and trading volume appear to predict subsequent returns in U.S. market and past volume helps to reconcile intermediate-horizon “under reaction” and long-horizon “overreaction” effects. However, bulk of the evidence on this important relationship between past returns and future returns is limited to U.S. portfolios. This study provides an out of sample evidence by examining the relationship between “trading volume” (measured by the turnover ratio) and “momentum” strategies in an Australian setting. We document a strong momentum effect for the Australian market during the period 1988 through 2002 and find that momentum plays an important role in providing information about stocks. We also find that past trading volume predicts both the magnitude and persistence of price momentum. In summary, our findings are consistent with the U.S. evidence.