Showing papers in "European Journal of Finance in 2004"
TL;DR: In this article, a new model is presented to support the selection of a portfolio of stocks based on the results of the fieldwork undertaken with fund managers and using direct rating, MACBETH and optimisation techniques.
Abstract: The paper presents a new model to support the selection of a portfolio of stocks based on the results of the fieldwork undertaken with fund managers and using direct rating, MACBETH and optimisation techniques. The model consists of defining a benchmark portfolio (in this case, the Dow Jones Eurostoxx50) and scoring its different stocks according to several expected return criteria. Based on this multicriteria value analysis, a procedure is proposed to suggest adjustments to the proportions of the stocks in the portfolio. Finally, the risk of this modified portfolio is taken into consideration in an optimization module that includes constraints concerning the limits of variation for the proportion of each stock.
66 citations
TL;DR: In this paper, the cross-sectional return-risk relations obtained with an unconditional specification for assets' betas were compared to those obtained when the estimated betas are based on an ARCH model.
Abstract: The seminal study by Fama and MacBeth in 1973 initiated a stream of papers testing for the cross-sectional relation between return and risk. The debate as to whether beta is a valid measure of risk was reanimated by Fama and French and subsequent studies. Rather than focusing on exogenous variables that have a larger explanatory power than an asset's beta in cross-sectional tests, the matrix of variances-covariances is assumed to follow a time varying ARCH process. Using monthly data from the UK market from February 1975 to December 1996, the cross-sectional return–risk relations obtained with an unconditional specification for assets’ betas are compared to those obtained when the estimated betas are based on an ARCH model. The approach taken by Pettengill, Sundaram and Mathur, which allows a negative cross sectional return–risk relation in periods in which the market portfolio yields a negative return relative to the risk free rate, was also investigated. These tests are also carried out on samples perta...
57 citations
TL;DR: In this article, a survey questionnaire was employed to determine how UK finance practitioners derive and review the cost of capital, and to ascertain whether the final figure varied with the choice of method.
Abstract: The aims of this study were to determine how UK finance practitioners derive and review the cost of capital, and to ascertain whether the final figure varied with the choice of method. To investigate behaviour in the real world a survey questionnaire was employed, eliciting responses from the finance directors of 193 UK quoted firms. The results suggest that the cost of capital calculation is subject to wide variation across firms, both with regard to the overall figure and the precise computation of its components. The intuitive appeal of the WACC and CAPM approaches appears to ensure their continued popularity in the real world. However, firms tend not to make all of the adjustments to the overall figure which academics might expect, only making simple adjustments for risk and the tax advantage to debt. The after-tax money cost of capital which is approximately 10%, is influenced by the choice of method, and firms do not appear to revise their overall cost figure rapidly in response to the environment. ...
52 citations
TL;DR: In this article, the authors show that the semideviation also explains the cross-section of Internet stock returns in emerging markets and that of industries in the emerging markets in general.
Abstract: Beta as a measure of risk has been under fire for many years. Although practitioners still widely use the CAPM to estimate the cost of equity of companies, they are aware of its problems and are looking for alternatives. A possible alternative is to estimate the cost of equity based on the semideviation, a well-known and intuitively plausible measure of downside risk. Complementing evidence reported elsewhere about the ability of the semideviation to explain the cross-section of returns in emerging markets and that of industries in emerging markets, this article reports results showing that the semideviation also explains the cross-section of Internet stock returns.
39 citations
TL;DR: In this paper, the authors examined the stock market reaction to 402 company investment announcements made by UK companies during the 1991-1996 period and found that the market reacted more favourably to investments that create future investment opportunities, than to investments which can be categorized as 'exercising' investment opportunities.
Abstract: This paper examines the stock market reaction to 402 company investment announcements made by UK companies during the 1991–1996 period. The market-adjusted abnormal returns are generally positive but small. Investment announcements are classified according to functional categories, and we find the level of abnormal returns to vary according to the type of capital investment being announced. In particular, we find the market to react more favourably to investments that ‘create’ future investment opportunities, than to investments which can be categorized as ‘exercising’ investment opportunities. The market reaction also varies with firm size, with large companies tending to experience smaller responses to announcements than do smaller firms. Chung et al. (1998) reported that the quality of a company's investment opportunities is the primary determinant of market reactions to capital expenditure decisions. The findings presented here lend some support to a role for investment opportunities in market valuati...
37 citations
TL;DR: In this paper, time series techniques are used to analyse the dynamic linkages and propagation of shocks among five European stock markets, and evidence is found in support of a unique cointegrating vector over each of the pre- and post-crash samples.
Abstract: Given the impact of the October 1987 crash pre-empting fears of a deep-seated financial collapse, there is now much scope for assessing its importance quantitatively. In this paper, time series techniques are used to analyse the dynamic linkages and propagation of shocks among five European stock markets. While we do not find any long-run relationship of stock markets over the entire sample ped, evidence is found in support of a unique cointegrating vector over each of the pre- and post-crash samples. Furthermore, the dynamic analysis reveals that the lead–lag relationships changed quite significantly over the sample following the crash.
31 citations
TL;DR: In this paper, the dynamic links between stock market indices are analyzed in a GARCH-M framework, using daily data from France, Germany, Italy and the USA, and it is shown that indices in the periods before and after the introduction of the Euro as a single currency display a very distinct behaviour.
Abstract: The dynamic links between stock market indices are analyzed in a GARCH-M framework, using daily data from France, Germany, Italy and the USA. It is shown that indices in the periods before and after the introduction of the Euro as a single currency display a very distinct behaviour. Consistent with the literature, in the earlier period price changes are found to have an impact the next day on other markets. In the latter period this type of co-movement disappeared within Europe. Feedback trading has been shown to induce (negative) autocorrelation in national stock markets. In this paper an international version of the feedback trading model is used to illustrate that the lead–lag relationships across countries and the strength of these links depend on the currency regime.
27 citations
TL;DR: In this article, the authors examined whether the adoption of stock option plans results in changes in shareholders' wealth, and whether the stock market reactions to ESOP announcements could be explained by the target group of ESOP and the dilution effect.
Abstract: This paper examines whether the adoption of stock option plans results in changes in shareholders’ wealth, and whether the stock market reactions to ESOP announcements could be explained by the target group of ESOP and the dilution effect. Short-horizon test methods are applied for this purpose. The sample consists of ESOP announcements of Finnish publicly quoted companies on the Helsinki Stock Exchange during the time period 1988–1998. The event study results show a slightly positive market reaction to announcements of ESOPs targeted to management and a negative market reaction in the case of ESOPs targeted to all employees. The results of regression analysis show that the ESOPs with limited dilution convey positive information to the stock market and the dilution effect has a negative impact on stock returns, especially in the case of ESOPs targeted to all employees.
27 citations
TL;DR: In this paper, the authors explored the relationship between daily market volatility and the arrival of public information in four different financial markets and found that significant effects of specific news categories on the volatility of US stocks, treasury bills, bonds and dollar were detected.
Abstract: This paper explores the relationship between daily market volatility and the arrival of public information in four different financial markets. Public information is measured as the daily number of economic news headlines, divided in six categories of news. Statistical analysis of the news data suggests the presence of particular seasonality effects, as well as a strong degree of autocorrelation. Over the period 1994–1998, significant effects of specific news categories on the volatility of US stocks, treasury bills, bonds and dollar were detected. However, the effects – in size and duration – vary by news category and by financial market. It is demonstrated that most of the volatility persistence, as observed by GARCH models, tends to disappear when news is included in the conditional variance equation.
26 citations
TL;DR: In this article, the authors examined the equity market price interaction between Australia and the European Union represented by the UK, Germany and France based on the Toda-Yamamoto causality test, which is bootstrapped with leveraged adjustments.
Abstract: The paper examines the equity market price interaction between Australia and the European Union – represented by the UK, Germany and France – based on the Toda–Yamamoto causality test, which is bootstrapped with leveraged adjustments. A new information criterion is used to choose the optimal lag order. Weekly MSCI data covering the period 1988 to 2001 is used, divided into two subperiods to allow for a structural break arising from the ERM crisis of 1992. Results show that, during the period before the ERM crisis, no significant causal links exist between Australia and any of three EU countries. During the period after the ERM crisis, Australia also had no causal links with Germany and France but it had with the UK, with causality running from the UK to Australia but not vice-versa. Thus, Australian investors may find the German and French, but not the UK, equity markets, attractive venues for their international diversification. German and French, but not British, investors may also obtain the same benef...
23 citations
TL;DR: In this paper, a new member of the ARCH-family, Orthogonal GARCH, has been suggested as a remedy to inherent estimation problems in multivariate ARCH modelling.
Abstract: In risk management, modelling large numbers of assets and their variances and covariances in a unified framework is often important. In such multivariate frameworks, it is difficult to incorporate GARCH models and thus a new member of the ARCH-family, Orthogonal GARCH, has been suggested as a remedy to inherent estimation problems in multivariate ARCH modelling. Orthogonal GARCH creates positive definite covariance matrices of any size but builds on assumptions that partly break down during stress scenarios. This article therefore assesses the stress performance of the model by looking at four Nordic stock indices and covariance matrix forecasts during the highly volatile years of 1997 and 1998. Overall, Orthogonal GARCH is found to perform significantly better than traditional historical variance and moving average methods. Out-of-sample evaluation measures include symmetric loss functions (RMSE), asymmetric loss functions, operational methods suggested by the Basle Committee on Banking Supervision, as w...
TL;DR: In this article, the statistical properties of the stock returns on the Istanbul Stock Exchange (ISE) for the January 1988 to December 1999 period and the evolution of the underlying stochastic structure over this time period were investigated.
Abstract: This study documents the statistical properties of the stock returns on the Istanbul Stock Exchange (ISE) for the January 1988 to December 1999 period and tries to assess the evolution of the underlying stochastic structure over this time period. It also investigates empirically the relative efficiency of the ISE to test whether the rapid development of this market over the last decade caused it to become a relatively more efficient market. This is accomplished through a number of parametric and non-parametric tests of the random walk hypothesis using daily, weekly and monthly observations of the value-weighted ISE-100 index series. The emphasis is more on the evolution of the price process than on static tests of a random walk model as such. The findings indicate that the price mechanism in the ISE has evolved into a more informationally efficient process in little more than a decade of existence.
TL;DR: In this article, a numerical method is presented for valuing vanilla American options on a single asset that is up to fourth-order accurate in the log of the asset price, and second order accurate in time.
Abstract: A numerical method is presented for valuing vanilla American options on a single asset that is up to fourth-order accurate in the log of the asset price, and second-order accurate in time. The method overcomes the standard difficulty encountered in developing high-order accurate finite difference schemes for valuing American options; that is, the lack of smoothness in the option price at the critical boundary. This is done by making special corrections to the right-hand side of the differnce equations near the boundary, so they retain their level of accuracy. These corrections are easily evaluated using estimates of the boundary location and jump in the gamma that occurs there, such as those developed by Carr and Eaguet. Results of numerical experiments are presented comparing the method with more standard finite difference methods.
TL;DR: In this article, a game-theoretic approach to the investigation of arbitrage opportunities based on combinations of exotic wagers for the same event is described, also known as a "lock" or "Dutch Book" situation.
Abstract: A game-theoretic approach to the investigation of arbitrage opportunities based on combinations of exotic wagers for the same event is described. This situation is also known as a ‘lock’ or ‘Dutch Book’. The technique is applied to recent totalizator data from Australian thoroughbred races. It appears that such opportunities appear fairly regularly, at least according to published final dividends for various bet types. The method is demonstrated in some detail on a particular example.
TL;DR: In this paper, the presence of liquidity premia in the relative pricing of assets traded on the Spanish government securities market was investigated and a classification of bonds into four different categories based on their degree of liquidity was proposed.
Abstract: This paper investigates the presence of liquidity premia in the relative pricing of assets traded on the Spanish government securities market. First, a classification of bonds into four different categories based on their degree of liquidity is proposed. Second, liquidity premia are estimated introducing liquidity parameters in the estimation of the zero-coupon yield curve. Results suggest the existence of a liquidity premium for post-benchmark bonds (both strippable and non-strippable). The size of this premium is relatively small. In the case of pre-benchmark bonds, the lack of liquidity does not seem to be priced. It is also shown that these pricing discrepancies are robust to the impact of taxes on bonds.
TL;DR: This paper showed that the expected return-win probability frontier is not monotonic as has been hitherto tacitly assumed and provided a consistent explanation for both the usual favourite-longshot bias and also for the few examples where a reverse bias has been observed.
Abstract: The traditional explanation for the usual favourite–longshot bias in gambling is that gamblers are risk-lovers. Conditions are derived under which the bias occurs and it is shown to be consistent with a utility function that has elasticity greater than one in a certain range. With a utility function that displays risk-aversion as well as risk-loving behaviour over its domain, it is demonstrated that the expected return–win probability frontier is not monotonic as has been hitherto tacitly assumed. This provides a consistent explanation for both the usual favourite–longshot bias and also for the few examples where a reverse bias has been observed. Pooled data supports the thesis that the frontier is not completely monotonic but does indeed have a turning point.
TL;DR: In this paper, the ambiguity is characterized using an instantaneous time-varying elasticity concept, and several bi-dimensional liquidity measures that cope with the ambiguity problem are constructed, and it is shown that these measures are superior since commonalities in overall liquidity cannot be fully explained by the common factors in one-dimensional proxies of liquidity.
Abstract: Variations in overall liquidity can be measured by simultaneous changes in both immediacy costs and depth. Liquidity changes, however, are ambiguous whenever both liquidity dimensions do not reinforce each other. In this paper, ambiguity is characterized using an instantaneous time-varying elasticity concept. Several bi-dimensional liquidity measures that cope with the ambiguity problem are constructed. First, it is shown that bi-dimensional measures are superior since commonalities in overall liquidity cannot be fully explained by the common factors in one-dimensional proxies of liquidity. Second, it is shown that an infinitesimal variation in either market volatility or trading activity augments the probability of observing an unambiguous liquidity adjustment. Ambiguity strongly depends on the expected (deterministic) component of volatility.
TL;DR: In this paper, the authors investigated whether personal tax could help explain the size of the historic equity premium in the UK measured before personal tax and found that personal tax accounts for a slightly higher proportion of the before-tax return on gilts than on equity.
Abstract: This paper investigates whether personal tax could help explain the size of the historic equity premium in the UK measured before personal tax. If there has been a higher tax burden on equity, some of the premium could be viewed as compensation for tax. It is estimated here that personal tax reduces the arithmetic mean nominal return on equity from 13.3% to 11.1% pa during the period 1919–1998, and the mean return on gilts from 7.1% to 5.6% pa. Thus, personal tax accounts for a slightly higher proportion of the before-tax return on gilts than on equity, implying that the equity premium is not a compensation for a higher tax burden on equity.
TL;DR: In this article, the consequences of legal restrictions on the volume of shares firms can repurchase are analyzed and the authors suggest that the imposition of a limit on the volumes of common stock favours the use of open market repurchases (OMRs) compared to other methods of repurchase such as TAs and Dutch auctions (DAs).
Abstract: This paper analyses the consequences of legal restrictions on the volume of shares firms can repurchase. Results suggest that the imposition of a limit on the volume of common stock favours the use of open market repurchases (OMRs) compared to other methods of repurchase such as tender offer repurchases (TORs) and Dutch auctions (DAs). The positive share abnormal returns around both announcements of open market buybacks and sellbacks in the full sample suggest that they are basically used to change the ownership structure of the firm in a consistent way with the convergence of interest hypothesis. The positive abnormal stock returns around open market repurchases, which are significantly different to the negative ones around sellbacks, when there are no changes in ownership structure also indicates the existence of a signalling and free cash flow effects.
TL;DR: In this paper, the authors compared the performance of experts, novices and simple statistical models over three time horizons on a task involving probabilistic forecasts of exchange rate movements, and found that experts performed better than a random walk forecaster, but worse than the random walk with constant drift and first-order autoregressive models.
Abstract: An experiment is reported which compares directional forecasting performance of experts, novices and simple statistical models over three time horizons on a task involving probabilistic forecasts of exchange rate movements. Probability-judgement accuracy analyses illustrated no clear overall performance differences between experts and novices, but significant differences between the groups on various important components of judgement suggested that the groups obtained their similar overall scores using different cognitive strategies. Striking horizon effects and expertize–horizon interactions were also observed. The subjects performed better than a random walk forecaster, but worse than the random walk with constant drift and first-order autoregressive models. Composite human judgement, however, not only improved on individual judgement but, also, surpassed the simple statistical models in many instances. Possible explanations are offered for these results, suggestions are made for future research, and pr...
TL;DR: The authors decomposes US and Euro area excess stock and bond return innovations into news factors using the Campbell-Schiller methodology and finds that stock return volatility is mostly due to volatility of future excess return news.
Abstract: This paper decomposes US and Euro area excess stock and bond return innovations into news factors using the Campbell–Schiller methodology. The results indicate that stock return volatility is mostly due to volatility of future excess return news. Inflation news plays a minor role although it is significantly correlated with excess return innovations. For the bond market too, it is future return news—not inflation news—that moves bond returns most. For finite investment horizons, however, asset market movements give a differential importance to the various news components. Results are comparable for the US and the Euro area, but differ in terms of magnitudes. In addition, sensitivities (‘betas’) to a set of state variables are estimated, yielding high interest rate betas and low money growth betas. Generally, inflation, unemployment and leading indicator betas are significant. Asset market exposures to oil and exchange rate changes are more significant for the Euro area than in the US.
TL;DR: In this paper, nonlinearity in the mean of a Finnish financial time series is investigated using the Smooth Transition Autoregression (STAR) model and a neural network, and linearity is tested for by a standard autocorrel.
Abstract: It is well documented that daily returns of several financial assets cannot be modelled by pure linear processes. It seems to be generally accepted that many economic variables follow nonlinear processes. The sources of nonlinearity can be divided in two classes: those where nonlinearities stem from the conditional variance and those where non-linearities enter through the conditional mean. Efforts in modelling the former have resulted in development of the ARCH-family models. There is, however, less evidence on nonlinearity in the mean of financial time series. One family of models that is applied in finance is the STAR. In this paper some nonlinear modelling techniques are applied to a Finnish financial time series, the daily Banking and Finance branch index on the Helsinki Stock Exchange. The techniques include a variance-nonlinear model from the ARCH family, a mean-nonlinear model, namely Smooth Transition Autoregression (STAR)-model and a neural network. Linearity is tested for by standard autocorrel...
TL;DR: In this paper, the authors present arbitrage and risk arbitrage betting strategies for Team Jai Alai in a sports betting game, where the arbitrage conditions are utility free and the risks are constructed according to the Kelly criterion/capital growth theory that maximizes asymptotically long run wealth almost surely.
Abstract: This paper presents arbitrage and risk arbitrage betting strategies for Team Jai Alai. This game is the setting for the analysis and most results generalize to other sports betting situations and some financial market applications. The arbitrage conditions are utility free while the risk arbitrage wagers are constructed according to the Kelly criterion/capital growth theory that maximizes asymptotically long-run wealth almost surely.
TL;DR: In this article, a real options model was constructed in which a firm has a privileged right to exercise an irreversible investment project with a stochastic payoff. But the model assumes that the investment costs are fully sunk, and a firm that exercises the investment option after debt is in place will then choose a better state to exercise this option as it issues more bonds.
Abstract: This article constructs a real options model in which a firm has a privileged right to exercise an irreversible investment project with a stochastic payoff. Supposing that the investment costs are fully sunk, a firm that exercises the investment option after debt is in place will then choose a better state to exercise this option as it issues more bonds. This debt-overhang phenomenon, however, benefits the firm since waiting is itself valuable. Accordingly, the firm will both exercise the investment option later and issue more bonds as compared with a firm that issues bonds upon exercising the investment option.
TL;DR: In this paper, the authors investigated the relationship between deposit insurance and bank market values in Denmark and found that the market values of large Danish banks exhibited a modest positive reaction to the announcement of insurance, but that small risky banks responded negatively.
Abstract: Previous studies of the relationship between deposit insurance and bank market values have usually been limited to consideration of minor changes in bank regulations, but the 1987 initiation of deposit insurance in Denmark permits examination of a potentially major policy shift. It is found that the market values of large Danish banks exhibited a modest positive reaction to the announcement of insurance, but that small risky banks responded negatively. These results partially contrast with those previously found for the USA, an outcome that seems likely to reflect the interaction of deposit insurance with the particular characteristics of the pre-existing Danish regulatory system.
Journal Article•
TL;DR: In this article, a new member of the ARCH family, Orthogonal GARCH, has been suggested as a remedy to inherent estimation problems in multivariate ARCH-modelling.
Abstract: In Risk Management, modelling large numbers of assets and their variances and covariances together in a unified framework is often important. In such multivariate frameworks, it is difficult to incorporate GARCH models and thus a new member of the ARCH-family, Orthogonal GARCH, has been suggested as a remedy to inherent estimation problems in multivariate ARCH-modelling. Orthogonal GARCH creates positive definite covariance matrices of any size but builds on assumptions that partly break down during stress scenarios. In this article, I therefore assess the stress performance of the model by looking at four Nordic Stock Indices and covariance matrix forecasts during the highly volatile years of 1997 and 1998. Overall, I find Orthogonal GARCH to perform significantly better than traditional historical variance and moving average methods. As out of sample evaluation measures, I use symmetric loss functions (RMSE), asymmetric loss functions, operational methods suggested by the Basle Committee on Banking Supervision, as well as a forecast evaluation methodology based on pricing of simulated "rainbow options".
TL;DR: In this article, the influence of heterogeneous time preferences on the term structure is studied in the framework of a continuous-time pure exchange economy, in which agents have, apart from differential time preferences, the same degree of relative risk aversion.
Abstract: The influence of heterogeneous time preferences on the term structure is studied in the framework of a continuous-time pure exchange economy, in which agents have, apart from differential time preferences, the same degree of relative risk aversion. A closed-form solution for the financial equilibrium is obtained. In equilibrium, one long-term bond and one short-term bond form a complete market. Agents use these bonds to finance their consumption plans. The long-term bond is bought by agents with a long habitat. The short rate is a weighted average of the short rates which prevail in homogeneous economies populated by one type of agent only. It is shown by example that heterogeneity of time preferences can produce additional humps in the yield curve.
TL;DR: In this article, the authors analyzed the predictability of a hypothetical market with freely negotiated prices on which there exists a censoring of one-period returns which are in excess of an arbitrary level (e.g., floor and ceiling).
Abstract: This paper analyses the predictability of a hypothetical market with freely negotiated prices on which exists a censoring of one-period returns which are in excess of an arbitrary level (‘floor’ and ‘ceiling’). It is shown that the expected value of returns (adjusted for drift) conditional on last period information regarding the censoring are equal to zero (and therefore the market is not predictable in mean) if there is no intertemporal spillover on the market. A simple simulation model is proposed and applied for the analysis of the effects of intertemporal and cross-spillovers resulting from quantity constraints. Statistical predictability tests are proposed, based on the corrected Student-t statistic of a regression of returns of some information concerning the previous censoring. An illustrative empirical analysis of six main time series of returns on the Warsaw Stock Exchange confirms their ex-ante, but not ex-post, predictability.
TL;DR: In this article, an empirical analysis of the potential for heuristic-based approaches to derive a divisional cost of equity from a firm's total cost of capital is presented. But, the analysis is limited to the case of a single firm.
Abstract: This note provides an empirical analysis of the potential for heuristic-based approaches to derive a divisional cost of equity from a firm's total cost of capital. Since an empirical relationship between fundamental information and systematic risk has previously been shown in other studies, idiosyncratic information on risk and performance ought to serve as a good proxy to calculate divisional adjustments. Two practically used, heuristic-based approaches are tested and a significant relationship is found between one of the measures and CAPM beta. This method may offer a plausible and comparatively uncomplicated method for adjusting a firm's total cost of capital for divisional use.
TL;DR: The authors examined the performance of Irish domiciled funds over the period 1988 to 2000 and found consistent evidence of poor micro forecasting/stock selection ability across the funds examined, with some evidence of positive timing ability in two of the models, while diagnostic tests reveal limited evidence of misspecification in the models used.
Abstract: This study examines the performance of Irish domiciled funds over the period 1988 to 2000 The study specifically examines whether Irish portfolio managers, particularly in light of the small and thinly traded domestic market, can effectively partake in micro or macro forecasting Four alternative models are used to jointly assess micro and macro forecasting, while a fifth non-parametric model is used to solely examine market timing effects The results reveal consistent evidence of poor micro forecasting/stock selection ability across the funds examined The macro forecasting results are more varied, with some evidence of positive timing ability in two of the models In addition, significant correlations are generally found between the funds micro and macro forecasting ability, while diagnostic tests reveal limited evidence of mis-specification in the models used