Andrea J. Heuson

Weak-Form and Semi-Strong-Form Stock Return Predictability Revisited

This paper makes indirect inference about the time variation in expected stock returns by comparing unconditional sample variances to estimates of expected conditional variances. The evidence reveals more predictability as more information is used, and there is no evidence that predictability has diminished in recent years. Semi-strong-form evidence suggests that time variation in expected returns remains economically important.

Intra–day Behavior of Treasury Sector Index Option Implied Volatilities around Macroeconomic Announcements

If option implied volatility is an unbiased, efficient forecast of future return volatility in the underlying asset, then we should be able to predict its path around macroeconomic announcements from responses in cash markets. Regressions show that volatilities rise the afternoon before announcements that move cash markets, and that post-announcement volatilities return to normal as rapidly as cash prices do. Although implied volatilities are predictable, the Treasury options market is efficient since informed traders do not earn arbitrage profits once we account for trading costs.

Term-Structure Factor Shifts and Economic News

For this article, daily changes in pure discount yields on U.S. risk-free securities were fit to a theoretically robust term-structure model to derive a set of orthogonal factors measuring the level, slope, and curvature of the yield curve. Changes in these factors at the release of unexpected economic news are reported. This methodology explicitly allows for commonalities in responses in the universe of spot rates, thus painting a rich picture of interest rate reactions to new information. The results have important implications for hedging volatility risk or seeking to profit from predicting volatility in bond prices. The argument that efficient markets respond quickly and completely to new information has been a cornerstone of empirical financial research for decades. Given the depth, breadth, and liquidity of the market for U.S. Treasury debt, Treasury yields react to the release of unexpected macroeconomic news in regularly scheduled announcements. Our research shows that reactions occur in a systematic way across the term structure and that an understanding of this phenomenon can enhance portfolio management strategies that are designed to hedge or profit from this predictable volatility. We studied adjustments in a set of orthogonal factors that represent shifts in the level, slope, and curvature of the term structure. The factors were estimated from daily zero-coupon yield changes and allowed for commonalities in responses across the universe of spot rates. Announcements for the following economic series were incorporated: the U.S. Consumer Price Index and Producer Price Index, nonfarm payroll, unemployment, retail sales, durable goods orders, housing starts, and industrial production. The generality of the analysis is important because it distinguished announcements that move the entire term structure in a parallel fashion from those that have incremental effects in the short range. Of the eight releases studied, the four that had the strongest systematic impact were announcements made at the beginning of each month—nonfarm payroll, industrial production, producer prices, and retail sales. Surprises in these four had a consistent, measurable impact on the term structure of zero-coupon yields that was felt equally across the entire maturity spectrum in most interest rate environments. Some announcements—most notably, nonfarm payroll—had incremental effects on the slope component as well as the level component. The underlying data were drawn from Treasury yields for 1982–2002—a long series that contains regimes of rising, falling, and neutral interest rates. This segmentation allowed us to discover that the responses to some surprises (specifically, nonfarm payroll and retail sales) occur later in the maturity structure in a falling-interest-rate environment than in a rising or neutral environment. Furthermore, in periods when the level of Treasury yields was adjusting to a new short-term equilibrium, we found that the market was sensitive to more types of announcements and that reactions to some announcements (notably, retail sales and housing starts) were significantly more pronounced. Taken as a whole, our findings indicate that traders believe increased demand from the producer sector initiates economic expansions, with a corresponding increase in the level of interest rates, whereas developments in the consumer sector sustain yield rallies. In addition, we suggest that announcement risk should be a systematic component of multifactor bond-pricing models and that it should be incorporated into trading strategies that seek to hedge against or profit from daily volatility in U.S. Treasury markets.

Fixed versus variable rate financing: The influence of borrower, lender, and market characteristics

Previous research has analyzed the problem faced by borrowers who must choose between fixed rate and variable rate loans when each loan carries different cost and risk characteristics and the borrowers face various income and employment prospects. In addition, the existing literature contains theoretical and empirical studies of how lenders react when given the ability to offer both fixed and variable rate financing. This article unifies the two strands of research to develop and test a model of the equilibrium proportion of variable rate lending. Results indicate that factors related to borrower, lender, and market characteristics are significant determinants of the equilibrium proportion of variable rate credit originated.

Institutional Disparities in the Pricing of Adjustable Rate Mortgage Loans

In recent years, commercial banks and savings and loan associations in South Florida have consistently offered initial adjustment period “teasers,” or subsidies, on their adjustable rate mortgage loans (ARMs). This study adopts the size of the initial subsidy as a proxy for a lenders willingness to offer ARM loans and develops an econometric model which relates the size of the teaser to a series of internal variables (other lending parameters), and external variables (financial market conditions).The results suggest that subsidization policies are not identical across institutions. Specifically, savings and loan associations seem to be less willing than commercial banks to accept the interest rate exposure inherent in ARM lending when future loan rates are constrained by adjustment limits. Consequently, the study argues that the character of a lenders existing assets influences its reactions to the risk/return properties of new assets.

Mortgage Delivery to the Secondary Market when Interest Rates are Falling

A borrower whose loan is committed to the securitization process has the ability and incentive to switch lenders if market rates drop during the loan origination period, which creates significant exposure for primary lenders. A simple secondary market contract innovation we call a mortgage rate drop guarantee (MRDG) could shift this risk to the securitizers who represent portfolio investors. Our simulation results indicate this shifting would have improved the risk/return distribution faced by originators without damaging the risk/return position of securitizers during our 1977–2010 sample period. Assuming conservative loan lives and origination periods, and competitive lending markets, the risk reduction features of MRDGs could also have generated significant interest savings for borrowers.

The After-Tax Yield to Maturity of a Premium Bond: Bias from a Simple Approximation

When finding the after-tax yield to maturity of a bond, it is customary to use the approximate relationship: after-tax yield = (1 - tax rate) × (before-tax yield). This paper provides a theoretical justification for this simplified formula by showing that, for premium bonds, it can be obtained from the complex implicit function defining the exact after-tax yield by using a first-order Taylor series approximation. Such simple approximations normally result in potentially large errors, and this is indeed what our simulation results show. Nevertheless, the approximation formulas error possesses the desirable properties that it is consistent in sign and bounded. Hence, the approximate formula, although easy to apply, should be used with caution.

Managing the Short‐Term Interest Rate Exposure Inherent in Adjustable Rate Mortgage Loans

This paper develops a model for determining the level of, and changes over time in, the short-term interest rate exposure contained in adjustable rate mortgage loans (ARMs). Results of the study indicate that movements in the underlying adjustment index can create both upward-movement or downward-movement interest rate risk for lenders whose ARMs carry rate adjustment limits. The model presented here is useful for designing hedging strategies for ARM loans, and for analyzing the impact of new originations on the interest rate exposure of the ARM portfolio. Copyright American Real Estate and Urban Economics Association.