Howard Chan

An investigation into the role of liquidity in asset pricing: Australian evidence

Employing a cross-sectional regression framework, we explore whether liquidity (as proxied by share turnover) is priced in an Australian setting, using monthly data over the period 1990 to 1999. We find that turnover is negatively related to stock returns and its importance persists even after controlling for book-to-market, size, stock beta and momentum. This finding is robust to seasonality effects and to potential nonlinearities.

Are the Fama-French Factors Proxying Default Risk?

In this paper we investigate the contention that the Fama-French (1993) models ability to explain cross-sectional variation in equity returns occurs because the Fama-French factors, SMB and HML, are proxying for default risk. To assess the default risk hypothesis, we augment the CAPM and the Fama-French model with a default factor and run system regressions of the default enhanced models using the GMM approach. Our key findings are that: 1) default risk is not priced in equity returns; and, 2) the Fama-French factors are not proxying for default risk. Although our findings suggest that SMB and HML are not proxying for default risk, our analysis indicates that the Fama-French factors are capturing some form of priced risk However, what type of risk the Fama-French factors are capturing remains an open question.

A multifactor model of gold industry stock returns: evidence from the Australian equity market

The empirical literature suggests that several different variables are potentially important in explaining the return on gold stocks beyond that of a market factor. The primary aim of this paper is to examine the empirical performance of a specification which incorporates into one multifactor model three such variables - gold prices, interest rates and foreign exchange rates. This paper applies this model to the return of gold stocks in the Australian equity market over the period 1979 to 1992. Contrary to other studies which have examined incomplete specifications relative to this framework, we find that the only variables of significant explanatory power are the market and gold price factors. Consequently, this has important implications for studies which examine the pricing behaviour of gold industry stocks.

Investigating the Performance of Alternative Default-Risk Models: Option-Based Versus Accounting-Based Approaches

In this paper we evaluate the performance of three alternate default-risk models, seeking to find that measure which performs best, using a comprehensive sample drawn from the Australian equities market. The first two models are option-based models and are derived from Mertons (1974) insight that equity can be viewed as a call option on a firms assets. In the first model, equity is modelled as a standard call option. In the second model, equity is modelled as a path-dependent barrier option. The third model is created using accounting ratios and is similar to Altmans (1968) Z-Score. To assess which of the models is superior, we consider variations of each model and then rely on prediction-oriented tests that focus on whether a firm subsequently defaults. Our results show that the option-based models clearly outperform their accounting ratio counterparts. Furthermore, our analysis suggests that the option-based models are very successful at ranking firms by default probability. It is noteworthy that the performances of the option-based models are difficult to distinguish from each other.

The value of liquidity: Evidence from the derivatives market

Abstract This paper documents the systematic overpricing of warrants relative to options. Models are developed in order to explain the cross-sectional variation in the relative pricing of these securities. Results indicate that relative pricing differences (RELDIFF) are related to various proxies of liquidity including days-to-maturity, relative trading volume and the mandated presence of market makers in the options market. The identity of warrant-issuers is also found to be significant in explaining relative pricing, possibly reflecting disparate levels of credit risk or it may be a manifestation of the different characteristics relating to the underlying shares upon which the warrants are issued. The paper also documents the impact that the change from floor trading to electronic trading had on the price formation process in the Australian Options Market.

Short-term contrarian investing—is it profitable? … Yes and No

In this paper we investigate short-term contrarian investment strategies in the Australian stock market using weekly data of those stocks comprising the All Ordinaries Index during the period 1994–2001. We find both the (Rev. Financ. Stud. 3 (1990) 175) equal-weighted strategy and a new value-weighted strategy yield statistically significant short-term contrarian profits. Importantly, these observed profits could not be fully explained by measurement errors such as bid–ask bounce or by risk, seasonality or volume. Profits are largely related to firm size with overreaction to firm specific information being the primary source of short-term contrarian profits in Australia. However, when a ‘practical’ short-term contrarian strategy including reasonable transaction costs is implemented, all profits vanish. Thus, while the contrarian approach is not viable as a stand-alone strategy, we argue that it may in fact be value-enhancing when employed as an overlay strategy, particularly in the context of managed funds.

Management earnings forecasts in a continuous disclosure environment

Purpose – The purpose of this paper is to assess management earnings forecasts in a continuous disclosure environment.Design/methodology/approach – A large sample of hand checked Australian management earnings forecasts are examined. These data are analysed using a series of logistic regressions. Hypotheses are proposed and tested based on Skinners litigation cost hypothesis. Increases in non‐routine management earnings forecasts post‐2000; and increases in the proportion of such forecasts that contain bad news are predicted. The relationship between forecast specificity and forecast news content is investigated.Findings – It was found that, post‐2000, legislative changes and increased enforcement action by ASIC were followed by increased disclosure of non‐routine management earnings forecasts. For routine forecasts, no significant increase in forecast disclosure is observed. This result is consistent with Skinner as is the finding that the increased disclosure is only apparent for bad news non‐routine f...

Factors or characteristics? That is the question

Daniel and Titman (1997) contend that the Fama‐French three‐factor model’s ability to explain cross‐sectional variation in expected returns is a result of characteristics that firms have in common rather than any risk‐based explanation. The primary aim of the current paper is to provide out‐of‐sample tests of the characteristics versus risk factor argument. The main focus of our tests is to examine the intercept terms in Fama‐French regressions, wherein test portfolios are formed by a three‐way sorting procedure on book‐to‐market, size and factor loadings. Our main test focuses on ‘characteristic‐balanced’ portfolio returns of high minus low factor loading portfolios, for different size and book‐to‐market groups. The Fama‐French model predicts that these regression intercepts should be zero while the characteristics model predicts that they should be negative. Generally, despite the short sample period employed, our findings support a risk‐factor interpretation as opposed to a characteristics interpretati...

Additions to and Deletions from an Open-Ended Market Index: Evidence from the Australian All Ordinaries

The shares of companies added to (deleted from) closed-end indices such as the S&P 500 experience significant positive (negative) abnormal returns. We examine companies added to or deleted from an open-ended market index where changes occur regularly and can be predicted in advance. Our results are broadly consistent with those for closed-end indices and are robust to benchmarks used to control for market, size and industry effects. Analysis of daily returns and volume shows significant effects around the change date. By construction, companies entering the index outperform index benchmarks prior to inclusion. After controlling for selection bias, additions outperformed over the 4 months prior to inclusion.

Fund Size, Transaction Costs and Performance: Size Matters!

Recent studies find evidence that small funds outperform large funds. This fund size effect is commonly hypothesized to be caused by transaction costs. Due to the lack of transactions data, prior studies have investigated the transaction costs theory indirectly. Our study, however, analyses the daily transactions of active Australian equity managers and finds aggregate market impact costs incurred by large managers are significantly greater than those incurred by small managers. Furthermore, we show large managers exhibit preferences for trade package formation and portfolio characteristics consistent with transaction cost intimidation. We analyse the interaction between transaction cost intimidation and the fund size effect, and document that large managers pursuing a highly active trading strategy suffer more from fund size, than large funds following a more passive strategy. This suggests the fund size effect is related to transaction costs, as trading activity is a good proxy for expected market impact. Finally, based on a simulation experiment, we find that transaction cost intimidation is at least as important as the increase in market impact costs due to fund size.