Gwangheon Hong

On the dual characteristics of closed-end country funds

Abstract In a mildly segmented world market, closed-end country fund (CECF) returns and premiums (or discounts) would be determined by factors due mainly to market segmentation and investor sentiment. The role of these two types of factors has been debated. We reexamine this issue by examining the relative importance of US market returns and foreign market returns in determining CECF returns. By employing time-series empirical methods, we find that CECF returns are more heavily influenced by their local (foreign) market returns than by US market returns, which implies that there remains a substantial diversification benefit from investing in CECFs.

Empirical Evidence on Corporate Risk-Shifting

We study empirically whether nonfinancial firms’ behavior is consistent with systematic risk‐shifting. We compare firms’ operating risk before and after a debt issue, under the assumption that if there is any risk‐shifting it is most likely to occur right after a debt issue. We document a significant increase in firms’ operating risk, even after adjusting for industry influences. The risk‐shifting is higher for firms with no subsequent debt issues, and for firms with lower credit ratings. Other determinants are earnings volatility, size of debt issue, and whether the bond is callable.

Correlations between Stock Returns and Bond Returns:Income and Substitution Effects

We attempt to better understand the varying correlations between stock and bond returns across countries and over sample periods using international data. The observation is that there are two forces that affect the correlation between stock and bond returns. The force that drives a positive correlation is identified as the income effect. The force that drives a negative correlation is identified as the substitution effect. In combination, the two effects help determine the actual correlation between stock and bond returns. We contribute to the literature by proposing an empirical method, the structural vector autoregression (VAR) identification method, to identify the two-income and substitution-effects and to measure the relative importance of the two effects that determine the actual net relation between the two asset returns. We further provide some evidence that the income and substitution effects are related to, among other things, the size of the financial market, the growth and volatility (risk) of the economy, and the business cycle over time. In addition, the framework of the income and substitution effects helps us better understand the automatic stabilizing effects of the dynamic optimal asset allocation during business cycles.

Are Real Estate Investment Trusts (REITs) an Inflation Hedge

Given the recent debate on the empirical validity of the inflation illusion hypothesis, recent implosion of REIT prices combined with potential inflationary pressure, and a significant role of the real estate market in the recent financial market meltdown, we examine whether the observed negative relations between REIT returns and inflation can be explained by the inflation illusion. We identify the mispricing component in the REIT prices based on present value models, both linear and loglinear, and then we investigate whether inflation can explain the mispricing component. We find some evidence of the inflation illusion hypothesis for the REIT return-inflation relation for the linear models with a constant interest rate in that the inflation rates explain some fraction of mispricing components and their effect on mispricing is negative. However, when we allow for time-varying interest rates, inflation does not explain the REIT mispricing component anymore. Further, when we take into account a potential asymmetric effect of positive and negative inflation on the mispricing components in REIT prices, which is an important implication of the inflation illusion hypothesis, we find that REIT prices are not easily compatible with the inflation illusion hypothesis. Therefore, we find only very limited evidence for the inflation illusion hypothesis. To see whether behavioral factors such as consumer sentiment can better explain the mispricing components in REIT prices, we use the consumer sentiment index in lieu of inflation in the regression of the mispricing components. We find that when we include both the inflation rate and the consumer sentiment index in the regression of the mispricing components, the consumer sentiments tend to explain the mispricing component while inflation loses its explanatory power. Therefore, we find some evidence that behavioral factors such as consumer sentiment could have contributed to the mispricing in the REIT prices.