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Finance Discussion Paper Series


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

Reza Bradrania, Maurice Peat, Stephen Satchell

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

JEL classification: G14

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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.

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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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Version:   » Full text PDF 2.5 MB



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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Version:   » Full text PDF 619.4 KB