Yexiao Xu

Risk and Return Revisited

0 ne time-honored rule in the field of finance is that risk and return are related. Often called the “no free lunch” principle, it asserts that over the long run it is not possible to achieve exceptional returns without accepting substantial risk. Any standard equilibrium model of asset pricing justifies ths relationship. Data from Ibbotson Associates confirm that since 1926, U.S. common stocks have provided a total return of 10.7% per year, about seven percentage points greater than the return from riskless Treasury bds.

Idiosyncratic Risk and Creative Destruction in Japan

The dramatic rise and fall of the Japanese equity market provides a unique opportunity to examine market-and firm-specific risks over different market conditions. The price behavior of Japanese equities in the 1990s is found to resemble that of U.S. equities during the Great Depression. Both show increasing market volatility and a prolonged large co-movement in equity prices. What is unique about the Japanese case is the surprising fall in firm-level volatility and turnover in Japanese stocks after its market crash in 1990. This large decrease in firm-level volatility may have impeded Japans capital formation process as it has become more difficult over the past decade for both investors and managers to separate high quality from low quality firms. Using data on firm performance fundamentals and corporate bankruptcies, we show that the fall in firm-level volatility and turnover in Japanese stocks could be attributed to the sharp increase in earnings homogeneity among Japanese firms and the lack of corporate restructuring.

Sell-side analyst research and stock comovement

We document that a stocks price around a recommendation or forecast covaries with prices of other stocks the issuing analyst covers. The effect of shared analyst coverage on stock price comovement extends beyond analyst activity days. A stocks daily returns covary with the returns of other stocks with which it shares analyst coverage. These links between stock price comovement and shared analyst coverage are consistent with the coverage-specific information we find in earnings forecasts; analysts who cover both stocks in a pair expect future earnings of the stocks to be more highly correlated than do analysts who cover only one stock from the pair. Collectively, our evidence indicates that analyst research produces coverage-specific spillovers that raise price comovement among stocks that share analyst coverage. The strength of these spillovers is comparable to spillovers from broad industry and market information in analyst research.

A comparison of semi-parametric and partially adaptive estimators of the censored regression model with possibly skewed and leptokurtic error distributions

Abstract Monte Carlo simulations are used to compare partially adaptive estimators (based on flexible pdfs) with the Tobit, CLAD, Heckman, and two semi-parametric estimators. The sample RMSE of the partially adaptive estimators tends to be smaller than for alternatives considered.

Some forecasting applications of partially adaptive estimators of ARIMA models

Abstract This paper investigates the relative forecasting performance of some partially adaptive estimators of ARIMA models based on flexible parametric error distributions which allow for kurtosis and skewness. These methods are used to obtain forecasts of some well-known data sets.

Identifying the Factor Structure of Equity Returns

A challenge for modern portfolio managers and security analysts is understanding the variables or factors that drive security returns. Statistical methods such as principal components analysis are useful but lack meaningful interpretations. Real economic factors comport with intuitive understanding but lack explanatory power. This study seeks to bridge the gap between these two approaches by interpreting “statistical factors” using economic factors. The authors examine the factor structure of equity portfolio returns widely used in a sample period from 1963 through 1999. They find there are three major factors for equity returns, which can be associated with 1) the market return; 2) market capitalization; and 3) the investment opportunity set. Higher–order factors can be uniquely identified with macroeconomic variables.

When Does Idiosyncratic Risk Really Matter

In contrast to the current literature, we provide new evidence supporting a positive relation between idiosyncratic risk and the expected future market return. Since a large part of the idiosyncratic risk can be diversified away easily, the conventional aggregate idiosyncratic risk measures can only be noisy proxies for the undiversified idiosyncratic risk, which may be priced according to Merton (1987). We thus propose a simple noise reduction method that includes two different noisy measures (dual-predictor) in the same predictive regression to reexamine the relation. We show that the noise effect tends to cancel out in our framework due to the highly correlated noise components of the two measures. In particular, our dual-predictor alone explains future market returns with an adjusted R^2 of 4%. Such a large predictive power is economically significant and robust to the inclusion of other popular predictors and to the choices of sample periods and additional market indices.

A New Test for the Detection of the Pricing Role of Aggregate Idiosyncratic Risk in the Predictive Regression

The standard test for the pricing role of aggregate idiosyncratic risk in the conventional predictive regression considers aggregate total idiosyncratic risk a reasonable proxy for its undiversified component, which should be priced as theory suggests. However, when the priced component is relatively small, the test has little statistical power to reject the null hypothesis that idiosyncratic risk does not matter, even when the priced component, albeit small, explains an economically large portion of future excess return variation. We propose a simple regression-based method that can, under certain conditions, substantially improve the power of the test when economically important alternative hypotheses are true, but sacrifices little in the size of the test for the improved power. Based on the new test, we strongly reject the proposition that idiosyncratic risk does not matter and uncover a significantly positive relationship between aggregate undiversified idiosyncratic risk and future market excess returns.

Effort and the Cycle: A Short Summary

One of the success stories of macroeconomic research over the last decade has been the development of real business cycle models. These models analyze business cycle movements as the systematic reactions of an economy to stochastic shocks, influencing, in particular, production (see [KP1] for the origin and [CP1] and the volume in which it is published, for the latest summary of this line of research). Crucial in all of these models is the description of the labor market: since cyclical movements in output are foremost movements in aggregate labor, any model that proposes to explain business cycles must explain the rather large cyclical movements in employment. In the benchmark real business cycle model of Hansen, see [Hal], these movements are explained as the result of indivisibilities in the labor market: agents are either employed or unemployed. They participate in a lottery for jobs: the “unlucky” agents are told to work, whereas the “lucky” ones are unemployed and can thus enjoy their additional leisure time. The device of the lottery ensures the desired high intertemporal substitutability of leisure in the social planners problem. Exogeneous, stochastic fluctuations in the aggregate productivity (the Solow residual) are then enough to drive the cycle and to explain the procyclicality of the average productivity of labor. Using standard Solow residual accounting, the size of these exogeneous shocks can be calibrated to actual data. The model then implies cyclical properties for all variables in the model, which compare favourably to their observed properties.