Abstract
We measure misvaluation using the discounted residual income model. As shown in the literature, this measure of stocks' misvaluation significantly explains their future cross-sectional returns. We measure the market-level misvaluation (market inefficiency) by the misvaluation spread: the difference in the misvaluation of the most overvalued and undervalued shares. We show that the misvaluation spread is a strong predictor of a misvaluation-based long–short portfolio’s returns, reinforcing the hypothesis that it proxies for the level of mispricing in the stock market. Using data on hedge fund returns, hedge fund industry assets under management, flows, and individual hedge fund holdings, we present evidence that hedge funds' trading reduces market-level misvaluation. Our results are robust across different time periods and are not driven by market liquidity. Moreover, we find that mutual funds do not have the price-correcting effect that hedge funds have.
Abstract
We develop new methods for calibrating subjective expectations regarding the return generating process (RGP) of financial assets. Using finance professionals’ expectations of average and extreme returns, volatilities, and probabilities of stocks beating bonds, we investigate the beliefs implied by these expectations of other key aspects of the RGP, namely stock-bond correlation, stock mean-reversion, and tails of the return distribution. Most subjects’ implicitly assumed beliefs are far beyond plausible, and tend to be driven by a high confidence of stocks outperforming bonds. The results are similar across a range of market conditions and subject expertise, from financial advisers to CIOs.
Abstract
This paper examines optimal international portfolio choice in a setting where equity market correlations increase during periods of distress and investors are averse to disappointing outcomes. I propose a model that captures the joint effect of these two phenomena and show that international diversification is still highly valuable in utility terms even during correlated downturns. However, the model can also lead to optimal home bias in the more favorable states of the economy. Effective risk aversion is heavily state-dependent and the results cannot thus be replicated by a standard expected utility model merely by increasing risk aversion.
Abstract
This paper examines the relation between hedge funds’ risk and the probability of failure before and after the financial crisis. Using a set of downside risk measures we show that before 2007 the relation between risk and the probability of failure is positive; higher risk leads to a higher propensity of failing. However, after 2007 this relation changes signs. In the more recent period less risky funds tend to fail more often. This relation remains even when we exclude the period of the great recession (2007-2010). Furthermore, our results hold for two different failure criteria: attrition and real failure.
Abstract
We propose a model for momentum based on institutional trading and risk sharing. An increase in a stock’s value makes its current holders wealthier, but at the same time they bear more aggregate risk causing them to demand a higher risk premium in the future. Expectations of higher future expected returns attract new investors further pushing up the prices causing the short-term momentum effect. Ownership becomes more dispersed and risk sharing improves. Correspondingly, a decrease in a stock’s value makes its current holders poorer. They, however, now bear less aggregate risk thus requiring a lower risk premium. Lower future expected returns cause investors to exit and ownership becomes more concentrated. We also empirically test, and verify, the model’s main predictions.
Abstract
We study the effect of corporate governance on the industry level trade gap, i.e., for a single trade transaction, the discrepancy in the value reported by the exporting industry and the one reported by the importing industry. First, we document the trade gap at the industry level and characterize which industry characteristics are related to under- or over- reporting of exports and under- or over- reporting of imports. Second, we investigate whether industries with better governance have lower incentives to misreport their exports or imports. Third, we explore the causes on why a better governance might change the incentives for misreporting. Finally, we show that a portfolio long in industries with good governance and low misreporting and short in industries with bad governance and high misreporting delivers an annual positive significant alpha.