Transcript www.efalken.com

Eric Falkenstein
 Tests are of any theory the framework allows
 There are an infinite number of theories allowed
 Framework is untestable
ri  rf   m  rm  rf    size  rsmall  rbig    value  rvalue  rgrowth 
Brealey and Myers Investments Book
Return
Volatility
17.30%
33.4%
Stocks
13%
20.2%
Corporate Bonds
6.0%
8.7%
Government Bonds
5.70%
9.4%
T-bills
3.90%
3.2%
Small Stocks
 My Dissertation (1994) page 53
 Theory that some liked volatility not an equilibrium
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theory
Pre ‘behavioral finance’ popularity
No fancy empirical test (didn’t use GMM)
Makes no sense—arbitrage
[I took equity risk premium as given]
Theory more important than data
 Burned by calendar effects
Ang,, Hodrick, Xing and Zhang (JoF 2009)
1980-2003
Use Fama French Model
ri    rf   m  rm  rf    size  rsmall  rbig    value  rvalue  rgrowth 
Beta-Low
Beta0.5
Beta1.0
AnnRet
10.8%
11.4%
11.4%
8.2%
4.5%
AnnStdev
13.1%
11.6%
17.4%
26.2%
33.9%
0.57
0.57
1.04
1.44
1.78
Beta
Beta1.5 Beta-High
Sophie Ni (2007)
Return from Bid-Ask midpoint to expiration
-36%??
 Moskowitz, and Vissing-Jorgensen (2002)
Penman, Richardson, and Tuna. 2007
Expected
Returns
Theory
rE
rD
Debt/Equity
 Beta and Returns Unremarkable
 Russ Wermers JoF 2000 piece (persistence, turnover)
 Burton Malkiel JoF 1995 piece (persistence, alpha)
 Carhart JoF 1997 (persistence, momentum)
 Beta irrelevant
 The biggest criticism is not adverse statements, but
neglect
rAUD  ryen  % change in yen+riskprem?
% change in currency unpredictable
Return in AUD=Return in Yen+Appreciation in
Yen/AUD
5.5%  0.3%  5.2%
5.5%  0.3% 1.4%
1990-2008 Dollar Annualized Returns, Standard Deviations
Morgan Stanley Capital International (MSCI)
MSCI Emerging Markets Index: 7.3%, 35%
MSCI World (Developed) Index: 4.4%, 19%
 Dimson, Marsh, Staunton (2005)
 17 Countries, 1900-2005, Annual Data
 No Return Premium to High Yield Bonds over
Investment Grade
 Merrill High Yield Master II (HOAO) Merrill BBB-AA
Index (COCO)
 20 HY Funds, 12 IG funds
 1% premium from 0.25 to 3 years
 No premium from 5 to 30 years
 Volatility, Covariance, increasing linearly
 Futures return from roll
 Harvey and Erb (2007) copper, heating oil, and live
cattle were on average in backwardization,
 corn, wheat, silver, gold, and coffee were in contango
 What covariance, volatility has to do with this ???
 Campbell, Hilscher, and Szilagyi (2006) Find high
distress firms have lower returns
 Source: Author. Data from Moody’s, S&P, Compustat
 Longshot bias
 Horse Track:
 1-10 odd horses 3% average return on investment
 100-1 odd horses have -86% average return
 Bias not there in smaller odds, as in baseball
 Devany and Walls (1999), 2015 movies from 1984-96
 Steve Sharpe and Gene Amromin (2005). People have
higher expected returns when they have lower
expected volatilities
 Most studies find no positive aggregate
volatility/return correlation over time
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
E rm  rf  a m2  b mf
a, b  0
 IPO has a lot of Uncertainty
 Jay Ritter (see his website). 1980-2008.
 IPO Returns -3.7% annually below size-matched firms
for first 5 years
 Deither, Malloy, and Scherbina (2002). Table 2. Data
from 1983-2000.
 Data ‘strongly reject the interpretation of dispersion
in analysts’ forecasts as a measure of risk’
 Turnover of stock a proxy for disagreement
 Highly correlated with beta
 Equity
 Beta
 Volatility
 Equity options
 Distressed stock returns
 Analyst Disagreement
 Trading Volume
 IPOs
 Leverage and stock returns
 Lotteries
 Horse racing
 Equity
 Over time
 Across Countries
 BBB to B bond returns
 Futures
 Currencies
 Private Investments
 Movies
 Mutual Funds
 Low Odds Sport Bets
 Initial story was about total volatility
 Total volatility flat or negatively correlated with return
 Beta flat or negatively correlated with return
 unrelated to risk.
 Volatility, Beta Uncorrelated, negatively correlated,
with ‘true’ betas ???