Douglas W. Blackburn

Individual vs. Aggregate Preferences: The Case of a Small Fish in a Big Pond

We study the relationship between the risk preferences of individuals and the risk preferences of the aggregate economy. To emphasize the vast differences that can occur between individual and market preferences brought about through aggregation, we assume an economy consisting entirely of risk seekers. We show that such individuals can lead to an aggregate economy that is risk averse. The converse is also true. An aggregate economy that exhibits risk aversion does not imply an economy of individual risk averters. An economy demanding a risk premium can be formed from individuals who do not demand such compensation. Understanding the relationship between the preferences of individuals and the preferences of the aggregate economy is crucial for understanding the connection between the behavioral finance literature, which focuses on individual preferences, and the asset-pricing literature, which focuses on aggregate prices. We discuss empirical implications of these results. This paper was accepted by Wei Xiong, finance.

Is World Stock Market Co-Movement Changing?

We examine world stock market comovement for 23 countries over 30-years from 1981 to 2010 -- a period that includes major changes in international trade institutions, capital market regulations, and the advent of the internet era. Our analysis is based on a generalized factor model that allows for country, regional, and world factors. We show that the commonly used world Fama French factor model with the world value-weighted portfolio as a proxy for the world factor, has biased results. We develop a new methodology, the Weighted-Generalized Canonical Correlation (W-GCC) method, to identify the presence of a world factor that explains variation in the stock price movements across all countries. We show in simulation studies that our methodology is able to identify the country factor even when the world factor is weak in some countries. We test for changes in comovement allowing for a structural change. We find that stock price comovements with respect to the world factor are stable through the mid 1990s and then starts increasing from the mid 1990s through 2010. The world factor we identify is highly correlated with the world factor estimated using an out-of-sample data set of ten newly emerged countries and comovement of these country returns also increase from 2000 to 2010. The Chinese B stock market shows a dramatic increase in comovement over the time period but not the Chinese A stock market, suggesting that comovement is more likely driven by investment cash flows. Our results have important implications for the benefits of international portfolio diversification strategies and the convergence of the cost of capital across countries.

Frontier Stock Markets: Local vs Global Factors

We study the returns of stocks from twenty-one frontier markets divided into the four regions of Europe, Africa, Middle East and Asia from January 2006 to June 2016. Factor mimicking portfolios based on market capitalization (SMB), book-to-market equity (HML), and momentum (WML) are constructed and reveal large and significant returns associated with value and momentum in frontier markets. Different from the developed markets, value and momentum effects are observed in both large and small market cap stocks. Empirical asset pricing models are not able to explain the observed value and momentum return patterns. Local asset pricing models, which use factors constructed from frontier market returns, and global asset pricing models, which use factors derived from developed market returns, are rejected in nearly all cases; however, the local four-factor model strongly outperforms the local single-factor capital asset pricing model (CAPM) for all regions, and the local four-factor model is found to be vastly superior to all global models. Surprisingly, there is no difference in performance between the global one-factor CAPM and the global four-factor model in explaining frontier stock market returns. This evidence strongly suggests that frontier and developed markets are segmented.

Book-to-Market Decomposition, Net Share Issuance, and the Cross Section of Global Stock Returns

This paper provides global evidence supporting the hypothesis that expected return models are enhanced by the inclusion of variables that describe the evolution of book-to-market—changes in book value, changes in price, and net share issues. This conclusion is supported using data representing North America, Europe, Japan, and Asia. Results are highly consistent across all global regions and hold for small and big market capitalization subsets as well as in different subperiods. Variables measured over the past twelve months are more relevant than variables measured over the past thirty-six months, demonstrating that recent news is more important than old news.

Liquidity Discount Model and Spillover Effects

The recent global financial crisis reignited concerns over systemic risk in the financial industry as a new type of systemic risk emerged – the severe loss of asset value due to illiquidity. The crisis has sparked a large body of research and has led to a number of new quantitative indicators of systemic risk. Despite the successful empirical results, the proposed indicators are primarily empirically motivated and are not capable of differentiating liquidity risk from other types of risk such as market and credit. In this paper, we develop a liquidity model to measure the risk caused by liquidity distress in the financial market. The model is parsimonious and has a semi-closed form to compute a discount due to a lack of liquidity. The liquidity discount measure may be applied to particular firms or may be aggregated into a liquidity index. A key feature of the model is its ability to distinguish between and compute the probability of liquidity default and economic default (insolvency). The model is applied to the study of liquidity in the financial sector leading to new empirical results. First, during the financial crisis, the probability of liquidity default (20%) was more than two times greater than the probability of economic default (8%). Second, standard measures of expected shortfall greatly underestimated shortfalls by 10% during the financial crisis by ignoring the loss of asset value due to illiquidity. Third, shocks to systematic liquidity risk are long lasting and can persist for as long as nine months depending on the financial subsector, and fourth, the level of bank interconnectedness peaks during periods immediately preceding crises creating the perfect environment for an unexpected liquidity shock to rapidly permeate the financial sector leading to a liquidity-induced crisis.

The Magic Formula: Value, Profitability, and the Cross Section of Global Stock Returns

Buying profitable, undervalued stocks and shorting unprofitable, overvalued stocks yields significant return differentials in North America, Europe, Japan, and Asia. Using data from 1991-2016, we test Greenblatt’s (2006) “Magic Formula” (MF) and find that a modified MF which uses gross profits as a measure of profitability yields significant abnormal returns for all size groups and in all regions. Results from double sorts and Fama-MacBeth regressions show that MF explains the cross-section of returns in addition to size, book-to-market and momentum.