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Finance Discussion Paper Series

The Distribution of Cross Sectional Momentum Returns DP-2017-001

Oh Kang Kwon, Stephen Satchell

The cross sectional momentum (CSM) strategy, considered in Jegadeesh and Titman (1993), is a trading strategy in which assets with highest past returns are equally weighted and held long while assets with lowest returns are also equally weighted but held short. Although anomalous returns from such momentum strategies, indicating persistence or reversal in the relative performance of underlying assets, have been the subject of numerous empirical studies, very little appears to be known about the distributional properties of the CSM returns. Most of the known results in this regard, such as those obtained in Lo and MacKinlay (1990), Jegadeesh and Titman (1993), Lewellen (2002), and Moskowitz et al. (2012), are limited to expected values and the first order autocorrelations in the returns of alternative momentum strategies in which the assets are weighted not equally, but instead in proportion to their returns over the ranking period. In this paper, we derive the density of CSM returns in analytic form, along with moments of all orders, under a reasonably general set of assumptions on the underlying asset returns. In particular, if the asset returns over the ranking and holding periods are independent then the density of the CSM returns is shown to be a mixture of univariate normals. We also obtain the density and the moments of equally weighted long only portfolios consisting of assets from an arbitrary return percentile band that we refer to as quantile portfolios.


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Investigating Price Discovery Using a VAR-GARCH(1,1) Model of Order Flow and Stock Returns DP-2016-001

Daniel Maroney, Stephen Satchell

The VAR-GARCH(1,1) price discovery model developed and tested with ASX data represents an extension of both the Chordia, Roll and Subrahmanyam (2005) and Hasbrouck (1991) models. The VAR-GARCH(1,1) price discovery model functions in accordance with the explanation for price discovery described by Chordia, Roll and Subrahmanyam (2005). This model allows the causal relationships between order flow and stock returns to be assessed, and for important aspects of the price discovery process to be measured. Both these analyses and the model itself represent contributions to the literature. This study also introduces an active trader order flow variable for five-minute intervals using broker identification data from the ASX, which enables the brokers who executed each trade to be identified, including whether they were retail or institutional brokers. The findings highlight that active trader order flow, including institutional order flow, has a positive causal relationship with stock returns. In addition, they show that active retail order flow has a negative causal relationship with stock returns.


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A Simple Overnight - Intraday Volatility Estimator DP-2015-002

Robert Krause, Stephen Satchell

This paper provides a highly efficient overnight/intraday volatility estimator that is both numerically simple and relatively tractable to analyse. Because of these properties, it is envisaged that it will be very useful in providing volatility estimates in many contexts.


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An Equilibrium Model Of Market Efficiency With Bayesian Learning: Explicit Modes Of Convergence To Rational Expectations Equilibrium In The Presence Of Noise Traders DP-2015-001

Omri Ross, Stephen Satchell, Mike Tehranchi

A simple discrete-time financial market model is introduced. The market participants consist of a collection of noise traders as well as a distinguished agent who uses the price information as it arrives to update her demand for the assets. It is shown that the distinguished agent's demand converges, both almost surely and in mean square, to a demand consistent with the rational expectations hypothesis, and the rate of convergence is calculated explicitly. Furthermore, the convergence of the standardised deviations from this limit is established. The rate of convergence, and hence the efficiency of this market, is an increasing function of both the risk-free interest rate and the relative number of noise traders in the market. An efficient market, therefore, measured in terms of a high proportion of informed traders, seems incompatible with the notion that efficient markets converge quickly.

Keywords: Market eciency, asymptotic rationality, Bayesian updating, mode of convergence.

JEL Classification Code: G14, D53, C62

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Liquidity Costs, Idiosyncratic Risk and the Cross Section of Stock Returns DP-2014-010

Reza Bradrania, Maurice Peat, Stephen Satchel

This study considers liquidity costs as an explanation for the idiosyncratic volatility premium documented in the literature. Liquidity costs may affect the estimation of idiosyncratic volatility through microstructure-induced noise. We eliminate the microstructure influences from stock returns and re-estimate idiosyncratic volatility and show that the liquidity level can explain the pricing ability of idiosyncratic volatility reported in the literature for value-weighted portfolios. This differs from the previous literature where liquidity explanations for the idiosyncratic volatility premium on value-weighted portfolios have been rejected. Moreover, our results from equally-weighted portfolios indicate that idiosyncratic volatility cannot predict returns ahead either before or after correcting for microstructure-induced bias. This suggests the evidence on the pricing of idiosyncratic risk is unproven, at least for the data considered in this study and in terms of explanations based on microstructure and liquidity arguments.

Keywords: Liquidity, Asset pricing, Idiosyncratic volatility, Expected returns

Version: 2014

The Impact of Hedge Funds on Asset Market DP-2014-009

Mathias Kruttli, Andrew J. Patton and Tarun Ramadorai

This paper provides empirical evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, and show that it has strong in- and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We construct a simple equilibrium model based on liquidity provision by hedge funds to noise traders to rationalize our findings, and empirically verify auxiliary predictions of the model.


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Taking the Art out of Smart Beta DP-2014-008

Cherry Muijsson, Ed Fishwick, Stephen Satchell

The reasons for out-performance in smart-beta portfolios remain mysterious. We extend previous literature on the link between portfolio performance and macroe-conomic factors by exploring the response of a smart beta portfolio to interest rate movements. The implications for fund managers heavily invested in low risk strate-gies where the immediate risk lies in the future rise in interest rates are worth considering. In particular, low beta funds appear to go up when interest rates fall more than when interest rates rise. We focus on the case of US equity investment based on the CAPM. We and that the anomaly is partially explained by interest rate sign changes due to macroeconomic policy rather than mismeasurement in the term structure, and observe heterogeneous impacts for low and high beta portfolios.


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Corporate Acquisitions of CEO Traders DP-2014-007

Henry Leung, Jeffrey Tse, P. Joakim Westerholm

This paper investigates whether the personal trading decisions of CEOs are related to their corporate acquisition decisions. We find that the personal trading performance of CEOs is significantly and positively related to the short-term market reaction to their mergers and CEOs exhibiting greater turnover on their personal common equity portfolios undertake acquisitions more frequently. Hence a CEOs' risk aversion, confidence and capability are consistent across their personal and corporate investment decisions. Our findings are consistent with existing theoretical framework and empirical studies of trading and acquisition behavior Benos (1998); Odean (1999); Hirshleifer and Luo (2001); Aktas, DeBodt and Roll (2009); Frijns, Gilbert, Lehnert and Tourani-Rad (2013).

Keywords: CEO, risk aversion, overcon dence

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Modelling the crash risk of the Australian Dollar carry trade DP-2014-005

Suk-Joong Kim

This paper investigates the nature and the determinants of the Australian dollar (AUD) carry trades using a Markov regime shifting model over the period 2 Jan 1999 to 31 Dec 2012. We find that the AUD has been used, except for a number of short periods notably surrounding the outbreak of the GFC, as an investment currency in a carry trade regime. We also investigate the determinants of the AUD carry trade regime probabilities. For daily horizon, prior to September 2008, carry trade regime probabilities are significantly lower in response to higher realized volatility of the USD/AUD exchange rate, number of trades, unexpected inflation and unexpected unemployment announcements. They are significantly higher when order flows are positive (more buyer than seller initialed trades of AUD) and when RBA policy interest rate unexpectedly increase. At weekly horizon, realized skewness and net long futures position on the AUD contributed to the carry trade regime probabilities. On the other hand, post-September 2008 period shows a breakdown on the relationship between carry trade regime probabilities and the determinants.

Keywords: AUD carry trade, Regime shifting, News, Order flows, Speculative positions

JEL Classification Code: E44; F31; G15

Version: February 2014  » Full text PDF 303.2 KB

The Four Horsemen: Heavy-tails, Negative Skew, Volatility Clustering, Asymmetric Dependence DP-2014-004

David Allen, Stephen Satchell

In the wake of the worst financial crisis since the Great Depression, there has been a proliferation of new risk management and portfolio construction approaches. These approaches endeavour to capture the stylised facts of financial asset returns: heavy tails, negative skew, volatility clustering and asymmetric dependence. Many approaches capture two or three characteristics, while capturing all four in a scalable framework remains elusive. We propose a novel approach that captures all four stylised characteristics using EGARCH, the skewed-t copula and extreme-value theory. Using eight data sets we show the approach is superior to eight benchmark models in both a VaR forecasting and a dynamic portfolio rebalancing framework. The approach generates significant economic value relative to the 1/N rule and the Gaussian approach. We also find that accounting for asymmetric dependence leads to a consistent improvement in VaR prediction and out-of sample portfolio performance including lower drawdowns.


Version: December 4th, 2013  » Full text PDF 3.9 MB

Theoretical Decompositions of the Cross-Sectional Dispersion of Stock Returns DP-2014-003

Andrew Grant, Steve Satchell

We present theoretical decompositions of cross-sectional return dispersion, assuming either a one-factor model, or a constant parameter model. This allows us to calculate expected return dispersion, based on dispersions in alpha and beta, and their cross-sectional correlation. We find that expected dispersion matches up reasonably well with actual realised dispersion - periods of high expected dispersion correspond to periods of high realised dispersion. Using U.S. equity portfolio data, we find that approximately 80% of expected dispersion is determined by extreme returns in the market.

Keywords: Cross-Sectional Volatility, Decomposition, Predictability

JEL Classification Code: G11, G17

Version: January, 2014  » Full text PDF 665.9 KB

Evaluating and Predicting the Failure Probabilities of Hedge Funds DP-2014-002

Hee Soo Lee, Juan Yao

Hedge funds have the most sophisticated risk management practices; however, hedge funds also appear to have a short lifetime relative to other managed funds. In this study, we investigate the failure probabilities of hedge funds particularly the failures due to financial distress. We forecast the failure probabilities of hedge funds using both a proportional hazard model and a logistic model. By utilizing a signal detection model and a relative operating characteristic curve as the prediction accuracy metrics, we found that both of the models have predictive power in the out-of-sample test. The proportional hazard model, in particular, has stronger predictive power, on average.

Keywords: Hedge fund; failure probability prediction; proportional hazard model; logit model; signal detection model; relative operating characteristic curve

JEL Classification Code: G33, G14, G17

Version: December, 2013  » Full text PDF 788.5 KB

Cluster PIN: A new estimation method for the probability of informed trading DP-2014-001

Quan Gan, David Johnstone, Wang Chun Wei

We present a new method for estimating the probability of informed trading (PIN). This method, called Cluster PIN (CPIN), is based on cluster analysis used in machine learning. CPIN does not require maximum likelihood estimation and thus avoids the computational issues that have been associated with some previous PIN estimation routines. We _nd that CPIN is more than 700 times faster than the best existing estimation method, and has comparable accuracy. A further practical advantage is that CPIN can be used to identify initial parameter conditions for existing maximum likelihood estimation methods. This hybrid of CPIN and maximum likelihood estimation yields the best practical combination of estimation speed and accuracy.

Keywords: PIN, CPIN, Market microstructure, Cluster analysis, Mixture model, Skellam distribution

JEL classification: C13, C38, C46, D53, G12, G14

Version: December 1, 2013  » Full text PDF 3.5 MB

Towards a Set of Design Principles for Executive Compensation Contracts DP-2013-003

Yaowen Shan, Terry Walter

Executive compensation has been controversial for several decades. Recent controversies over executive pay have sparked outrage from some sectors and calls for increased regulation and reform. Yet others argue that knee-jerk reactions to perceived abuses of pay can lead to a host of unintended and inefficient outcomes. This paper argues that much of this controversy is due to executives being rewarded via contracts that have weaknesses in design. We argue that few stakeholders in firms would object to generous compensation for managers whose performance results in abnormally high long-term shareholder wealth creation. We set out a set of design principles, developed from a review of the extensive theoretical, regulatory and empirical literature, that we suggest should be the fundamental building blocks for designing executive remuneration systems in public firms, especially where ownership and control is separated. Our purpose is to generate broad debate and discussion leading to a consensus as to the principles that should be present in all executive compensation contracts such that the interests of shareholders and managers are aligned.


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Waiting Costs and Limit Order Book Liquidity: Evidence from the Ex-Dividend Deadline in Australia DP-2013-002

Andrew Ainsworth, Adrian D. Lee

Recently developed theoretical models suggest a link between order aggressiveness, spreads and waiting time. We directly test these models using an experimental setting where waiting time is likely to be important for traders, namely the ex-dividend day. Consistent with theoretical predictions, we show that order placement is more aggressive before stocks begin trading ex-dividend and that spreads decline. Stocks with higher expected costs of delaying execution experience larger declines in order aggressiveness from the cum-day to the ex-day. Waiting costs also impact effective bid-ask spreads, which fall on the cum-day before rising on the ex-day.

Keywords: order aggressiveness, liquidity, bid-ask spread, ex-dividend day

JEL classification: G14

Version: November 26, 2013  » Full text PDF 395.8 KB

The Estimation of Psychic Returns for Cultural Assets DP-2013-001

Nandini Srivastava, Rachel Pownall, Stephen Satchell

This paper presents procedures for evaluating psychic returns to cultural assets. Measuring the psychic return of art investments is an important issue in cultural economics. We focus on the psychic returns of art relative to equity using British data from 1895 to 2011. However, our arguments are entirely general. We take into account the substantial costs involved in art investment and also discuss the existing estimates of the psychic returns to art in the literature which are typically between 10 per cent to 30 per cent. Applying utility based models and equilibrium based models, we construct new estimates of psychic returns based on plausible portfolio weights and also trace the linkages of psychic returns of art to other markets by an examination of trade flows.


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