Andreas Schrimpf

Cross-Sectional Tests of Conditional Asset Pricing Models: Evidence from the German Stock Market

We study the performance of conditional asset pricing models and multifactor models in explaining the German cross-section of stock returns. We focus on several variables, which (according to previous research) are associated with market expectations on future market excess returns or business cycle conditions. Our results suggest that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved when allowing for time-varying parameters of the stochastic discount factor. A conditional CAPM using the term spread explains the returns on our size and book-to-market sorted portfolios about as well as the Fama-French three-factor model and performs best in terms of the Hansen-Jagannathan distance. Structural break tests do not necessarily indicate parameter instability of conditional model specifications. Another major finding of the paper is that the Fama-French model - despite its generally good cross-sectional performance - is subject to model instability. Unconditional models, however, do a better job than conditional ones at capturing time-series predictability of the test portfolio returns.

Dividend Predictability around the World

We show that dividend-growth predictability by the dividend yield is the rule rather than the exception in global equity markets. Dividend predictability is weaker, however, in large and developed markets where dividends are smoothed more, the typical firm is large, and volatility is lower. Our findings suggest that the apparent lack of dividend predictability in the United States does not uniformly extend to other countries. Rather, cross-country patterns in dividend predictability are driven by differences in firm characteristics and the extent to which dividends are smoothed.

Information Flows in Foreign Exchange Markets: Dissecting Customer Currency Trades

We study the information content of order flow for future exchange rate movements based on a unique dataset covering a broad cross-section of currency pairs and distinguishing key customer types in currency markets. We sort currencies into portfolios based on lagged order flows, and find economically and statistically significant excess returns of up to 15% per annum for a strategy going long in currencies with recent buying pressure and going short in currencies with recent selling pressure. However, there is substantial heterogeneity across customer types: trading by corporate and private clients is generally not informative and tends to generate negative payoffs. Order flow by asset managers generates the largest portfolio return and forecasts permanent exchange rate changes. Flows by hedge funds also generate a positive portfolio return but only forecast transitory exchange rate movements. Furthermore, currency trading by hedge funds is significantly exposed to default, liquidity, and global volatility risk, which explains part of the forecast power of hedge fund flows for future currency returns. JEL Classification: F31, G12, G15.We study the information in order flows in the worlds largest over-the-counter market, the foreign exchange market. The analysis draws on a data set covering a broad cross-section of currencies and different customer segments of foreign exchange end-users. The results suggest that order flows are highly informative about future exchange rates and provide significant economic value. We also find that different customer groups can share risk with each other effectively through the intermediation of a large dealer, and differ markedly in their predictive ability, trading styles, and risk exposure.

International Stock Return Predictability Under Model Uncertainty

This paper examines return predictability when the investor is uncertain about the right state variables. A novel feature of the model averaging approach used in this paper is to account for finite-sample bias of the coefficients in the predictive regressions. Drawing on an extensive international dataset, we find that interest-rate related variables are usually among the most prominent predictive variables, whereas valuation ratios perform rather poorly. Yet, predictability of market excess returns weakens substantially, once model uncertainty is accounted for. We document notable differences in the degree of in-sample and out-of-sample predictability across different stock markets. Overall, these findings suggest that return predictability is neither a uniform, nor a universal feature across international capital markets.

International Diversification Benefits with Foreign Exchange Investment Styles

This paper studies portfolio choice with popular foreign exchange (FX) investment styles such as carry trades, FX momentum and FX value strategies. We go beyond the benefits from hedging to shed more light on the speculative component of currency investments. In particular, we are interested in the magnitude of diversification benefits due to the style-based management of the currency component of well-diversified international portfolios. Our results suggest that FX investment styles generate significant improvements in the asset allocation. These findings hold after taking into account transaction costs and when controlling for the FX risk inherent in the benchmark assets. Importantly, these results are also confirmed in an extensive out-of-sample experiment mimicking investor decisions in real-time. The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2189886

The Response of Tail Risk Perceptions to Unconventional Monetary Policy

We evaluate the response of perceived tail risks in financial markets to the implementation of unconventional monetary policy by the U.S. Federal Reserve. Using information from out-of-money equity index options, we find that perceived risks decline significantly in response to both policy announcements and actual asset purchases. The announcement effects are strongest specifically for downside risk measures rather than simple measures of volatility (e.g. the VIX). The impact of actual purchases is strongest when driven by simultaneous expansion and the duration extension of the Federal Reserves balance sheet. These effects of both announcements and purchases have been variable over time and particularly pronounced during the latest policy phases implemented in 2012, a period also coinciding with the Federal Reserves more extensive use of forward guidance about short-term rates.

Segmented Money Markets and Covered Interest Parity Arbitrage

We show that it is crucial to account for the heterogeneity in funding costs, both across banks and across currency areas, in order to understand recently documented deviations from Covered Interest Parity (CIP). When CIP arbitrage is implemented accounting for marginal funding costs and realistic risk-free investment instruments, the no-arbitrage relation holds fairly well for the majority of market participants. A narrow set of global high-rated banks, however, does enjoy riskless arbitrage opportunities. Such arbitrage opportunities emerge as an equilibrium outcome as FX swap dealers set prices to avoid inventory imbalances. Low-rated banks find it attractive to turn to the FX swap market to cover their U.S. dollar funding, while swap dealers elicit opposite (arbitrage) flows by high-rated banks. Such arbitrage opportunities are difficult to scale, with funding rates adjusting as soon as arbitrageurs increase their positions.

Evaluating Conditional Asset Pricing Models for the German Stock Market

We study the performance of conditional asset pricing models in explaining the German cross-section of stock returns. Our test assets are portfolios sorted by size and book-to-market as in the paper by Fama and French (1993). Our results show that the empirical performance of the Capital Asset Pricing Model (CAPM) can be improved substantially when allowing for time-varying parameters of the stochastic discount factor. A conditional CAPM with the term spread as a conditioning variable is able to explain the cross-section of German stock returns about as well as the Fama-French model. Structural break tests do not indicate parameter instability of the model - whereas the reverse is found for the Fama-French model. Unconditional model specifications however do a better job than conditional ones at capturing time-series predictability of the test portfolio returns.

Scarcity effects of QE: A transaction-level analysis in the Bund market

This paper investigates the scarcity effects of quantitative easing (QE) policies, drawing on intra-day transaction-level data for German government bonds, purchased under the Public Sector Purchase Program (PSPP) of the ECB/Eurosystem. This paper is the first to match high-frequency QE purchase data with high-frequency inter-dealer data. We find economically significant price impacts at high (minute-by-minute) and low (daily) frequencies, highlighting the relevance of scarcity effects in bond markets. Asset purchase policies are not without side effects, though, as the induced scarcity has an adverse impact on liquidity conditions as measured by bid-ask spreads and inter-dealer order book depth. We further show that the price impact varies greatly with market conditions: it is considerably higher during episodes of illiquidity and when yields are higher.

Monetary Shocks at High-Frequency and Their Changing FX Transmission Around the Globe

We show that the impact of monetary policy on exchange rates has been growing significantly in recent years. Our results are established by a high-frequency event study of how key fixed income instruments - Overnight-Index Swaps (OIS) and Bonds - respond jointly with exchange rates to news about monetary policy from seven major central banks. News affecting short-term maturity bonds tend to have the strongest impact, highlighting the relevance of communication regarding the path of future monetary policy for exchange rate movements. Overall, our findings suggest that the external channel of monetary transmission has been alive and well, even though many central banks have hit the effective lower bound in recent years.