Ian Garrett

Dividend Behaviour and Dividend Signaling

We analyze the dividend behaviour of the aggregate stock market. We propose a model that assumes managers minimize the costs of adjustment associated with being away from their target dividend payout. The target is expressed as a function of lagged stock prices and permanent earnings, generalizing previous models of dividend behaviour. We present a new method for measuring unobserved permanent earning based on the Kalman filter. Our specification of dividend behaviour is strongly supported by the data relative to both alternative models and over time. We find significant evidence of dividends conveying information regarding unexpected positive changes in current permanent earnigs. We also find that both the speed of adjustment of dividends to target dividends and tests of signaling are sensitive to the specification of the model.

Macroeconomic variables as common pervasive risk factors and the empirical content of the arbitrage pricing theory

Abstract In this paper we investigate the performance of the APT for securities traded on the London Stock Exchange. We analyze performance in terms of the presence of common pervasive factors across two different samples allowing for the fact that returns exhibit an approximate factor structure. Unlike most previous studies, we find that for two subsamples of assets it is possible to arrive at a unique return generating process in the sense that three factors relating to the money supply, inflation and excess returns on the stock market are priced and carry the same prices of risk in both samples.

Conflicts of Interest and the Performance of Venture Capital-backed IPOs: a preliminary look at the UK

We document the incidence of initial public offerings (IPOs) issued by UK companies with existing venture capital investors and sponsored (and underwritten) by issuing houses that are parents or affiliates of the venture capital backers. The effects on the performance of the stock offering of the resulting conflicts of interest between the venture capitalist-affiliated sponsors and the investors taking up the stock is examined. Contrary to the conflicts-of interest hypothesis, IPOs underwritten by VC affiliates perform better in the long-term than other IPOs. We also examine the role of the reputation of the financial firms involved in the IPO. The long-term performance of UK IPOs is found to be positively related to the reputation of the venture capital backers. In the short-term, IPO returns appear to be related to the prestige of the sponsor rather than the venture capitalist in that top fifteen underwriters are associated with lower short-returns. Although there is evidence of higher initial returns in IPOs where the sponsor and venture capitalist are affiliated, this is offset by an approximately equal reduction in initial returns if the venture capitalist is associated with an issuing house which may or may not act as the actual IPO sponsor. Thus, the net effect is that backing by venture capitalists with links to issuing houses reduces initial returns but only if those affiliates are in fact not employed as the actual sponsors to the offerings.

Can we explain the dynamics of the UK FTSE 100 stock and stock index futures markets

If stock and stock index futures markets are functioning properly price movements in these markets should best be described by a first order vector error correction model with the error correction term being the price differential between the two markets (the basis). Recent evidence suggests that there are more dynamics present than should be in effectively functioning markets. Using self-exciting threshold autoregressive (SETAR) models, this study analyses whether such dynamics can be related to different regimes within which the basis can fluctuate in a predictable manner without triggering arbitrage. These findings reveal that the basis shows strong evidence of autoregressive behaviour when its value is between the two thresholds but that the extra dynamics disappear once the basis moves above the upper threshold and their persistence is reduced, although not eradicated, once the basis moves below the lower threshold. This suggests that once nonlinearity associated with transactions costs is accounted for, stock and stock index futures markets function more effectively than is suggested by linear models of the pricing relationship.

An alternative approach to investigating lead-lag relationships between stock and stock index futures markets

In the absence of market frictions, the cost-of-carry model of stock index futures pricing predicts that returns on the underlying stock index and the associated stock index futures contract will be perfectly contemporaneously correlated. Evidence suggests, however, that this prediction is violated with clear evidence that the stock index futures market leads the stock market. It is argued that traditional tests, which assume that the underlying data generating process is constant, might be prone to overstate the lead-lag relationship. Using a new test for lead-lag relationships based on cross correlations and cross bicorrelations it is found that, contrary to results from using the traditional methodology, periods where the futures market leads the cash market are few and far between and when any lead-lag relationship is detected, it does not last long. Overall, the results are consistent with the prediction of the standard cost-of-carry model and market efficiency.

Common Stochastic Trends in Emerging Equity Markets

Evidence suggests that stock markets in industrialized economies are increasingly integrated with the presence of common trends amongst national stock market indices. This implies that in the long run there is little gain from diversifying portfolios internationally. We investigate the existence of common trends in the increasingly important emerging equity markets of the Latin American and Asia-Pacific regions. While we find evidence of common trends, we argue that this in itself does not rule out long-run benefits to diversification. Examination of the composition of the common trends reveals that some countries do not enter that regions common trend and returns in some countries do not react to movements in the common trend, a result that generalizes to the inclusion of both the USA and the UK. Thus, even though common trends are detected, their impact is very limited and therefore emerging equity markets offer benefits in terms of diversification, even in the long run. Copyright 1999 by Blackwell Publishers Ltd and The Victoria University of Manchester

Intraday and Interday Basis Dynamics: Evidence from the FTSE 100 Index Futures Market

We examine the intraday and interday dynamics of both the level of and changes in the FTSE (Financial Times-Stock Exchange) 100 index futures mispricing. Like numerous previous studies we find significant evidence of mean reversion and hence predictability in mispricing changes measured over high (minute-by-minute) and low (daily) frequencies. Contrary to other studies we show explicitly that for high-frequency data, this predictability is due not to microstructure effects but to arbitrage activity. Using a threshold autoregressive model that is consistent with arbitrage behavior, we show that such models imply first-order autocorrelation in mispricing changes similar in magnitude to that actually observed. For low-frequency data, we show that predictability is driven neither by arbitrage activity nor by microstructure effects. Rather, it is a statistical illusion that is the result of overdifferencing a trend-stationary series.

Dividend Growth, Cash Flow and Discount Rate News

Using a new variable based on a model of dividend smoothing, we find that dividend growth is highly predictable and that cash flow news contributes importantly to return variability. Cash flow betas derived from this predictability are central to explaining the size effect in the cross section of returns. However, they do not explain the value effect; this is explained by noise betas. We also find that the relative importance of cash flow news in explaining recent stock price run-ups and subsequent declines increases when cash flow news is estimated directly.

Calculating the equity cost of capital using the APT: the impact of the ERM

Abstract One of the expected benefits of membership of the Exchange Rate Mechanism (ERM) was a reduction in risk which should lead to a lower cost of capital and foster investment and growth. Using the APT, we investigate the behavior of the equity market risk premium for the London Stock Exchange prior to and during sterlings membership of the ERM. We find that prior to and during the first year of membership the equity market risk premium fell quite dramatically. However, when conflict between domestic and ERM policy requirements arose at the turn of 1991, the equity risk premium increased and continued to do so until sterlings exit, partially wiping out the benefits of membership of the ERM.

Testing for seasonal patterns in conditional return volatility: evidence from Asia-Pacific markets

Several previous studies have focused upon seasonal patterns in the unconditional volatility of intraday and daily returns data. But these investigations could be misleading without considering a fuller structural model of the time series properties of return volatility. The seasonal pattern in the volatility of five Asia-Pacific stock markets is investigated using the unconditional modified Levene statistic (Ho, Y. K. and Cheung, Y. L., 1994, Seasonal pattern in volatility in Asian stock markets, Applied Financial Economics, 4, 61-67) and by estimating the conditional variance of each market using an ARCH procedure.