Time series momentum and macroeconomic risk

Trend Following and Macroeconomic Risk

To examine the familiar tradeoff between risk and return in financial investments, we use a rolling two-stage stochastic program to compare mean-risk optimization models with time series momentum strategies. In a backtest of allocating investment between a market index and a risk-free asset, we generate scenarios of future return according to a momentum-based stochastic process model. A new hybrid approach, time series momentum strategy controlling downside risk (TSMDR), frequently dominates traditional approaches by generating trading signals according to a modified momentum measure while setting the risky asset position to control the conditional value-at-risk (CVaR) of return. For insight into the outperformance of TSMDR, we decompose each strategy into two aspects, the trading signal and the asset allocation model that determines the risky asset position. We find that 1) weighted moving average can better capture the trend of the stock market than time series momentum computed as past 12-month excess return, 2) mean-risk strategies generally provide better returns whereas risk parity strategies have less investment risk and 3) controlling CVaR limits the investment risk better than controlling variance does.

Time series momentum (TSMOM), which is found in various asset classes, offers investors several practical advantages over traditional cross-sectional momentum. However, recent studies raise questions about its general existence and urge researchers to extensively search for optimal combinations in time horizon, asset characteristics, and market conditions in which TSMOM may be profitable. With a comprehensive study covering 2.25 million monthly returns on over 20,000 US individual stocks from 1986 to 2017, we find that TSMOM profits are more prominent among stocks and during market states characterized by inferior information dissemination.

Optimality of Momentum and Reversal

Asset Price movements indicate financial health of an economy because of the serious affects these have on financial indicators. This study is carried out to see the behaviour of asset price movements in different time horizons in the presence of leading economic indicators. The objective of this study is to track asset price movements and the impact of economic indicators on asset prices in different time horizons. This study intends to find out the appropriate time horizon for predicting asset price buildup that can lead to a potential financial crisis. Uni-variate and Multi-variate Logit Regression Analysis is performed in this study to be applied in four different time horizons. Results show that Real Gross Domestic Product, Credit to private sector, Interest rates of Long and Short term, Gross Domestic Product-deflator, the Consumer Price Index, Real effective exchange rates and nominal effective exchange rates are the significant early warning indicators for predicting the future financial crisis in the economy of Pakistan in longer time horizon as they affect asset price buildup in the long time periods. This study shows that asset prices contain more information in long run and can be effectively used as a tool to predict financial crises due to asset price misalignments

Production-Based Asset Pricing and the Oil Market

The three essays in this dissertation study the impact of corporate liquidity on a firm's value, how corporate liquidity affects the probability of financial distress and equity returns, and whether corporate liquidity represents an idiosyncratic risk, or serves as a priced risk factor.;The first essay examines the relationship between corporate liquidity and equity returns for individual firms. It is found that firms holding more liquid assets have significantly higher equity returns. This positive relationship between corporate liquidity and equity returns is more pronounced among firms with financial constraints. In addition, firms expecting volatile cash flows stock more cash for precautionary purposes and their stock returns are higher relative to those generating stable cash flows. These empirical evidences indicate that the level of corporate liquidity may signal risks faced by companies. Furthermore, more liquid firms tend to have higher market beta, which suggests that corporate liquidity may serve as a risk factor. Finally, Fama-MacBeth two pass regression results show that corporate liquidity contains different information than what is included in other important firm characteristics like size and book-to-market equity ratio.;The second essay further explores the relationship between corporate liquidity and the expected return of stocks at the aggregate level. Asset pricing tests are performed to examine whether the constructed corporate liquidity factor, LMI (Liquid Minus Illiquid), is a risk factor and whether it is systematic and priced. Empirical evidences from multifactor asset pricing models suggest that LMI can still serve as an independent factor and is priced although it shares some common information with the three popular factors MKT, SMB and HML. Moreover, corporate liquidity beta is increased when the macroeconomic condition becomes less favorable, and the corporate liquidity beta is more sensitive to changes in macroeconomic conditions for firms with more corporate liquidity and financial constraints.;The third essay examines how a company's market value can be affected by residual cash, and whether corporate liquidity and negative residual cash can predict bankruptcy. It is shown that deviation from the target or optimal cash is value destructive, which provides support for the tradeoff theory. However, the impact of residual cash on market value of equity is not symmetric: positive residual cash tends to reduce firm value less than negative residual cash. In general, firms with negative residual cash are more likely to experience financial distress since they are smaller, less profitable, generate lower cash flows, and have higher leverage but weaker payoff

In this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing.

The daily relationship between U.S. asset prices and stock prices of American countries

We develop a representative agent model of a production economy in order to explain the joint dynamics of house prices and equity returns. In a model generating costly business cycle fluctuations, we find that restrictions on housing supply have important implications for asset pricing. Together with habit formation in the composite of consumption and leisure, building restrictions provide an explanation for the high volatility of house prices and contribute to the resolution of asset pricing puzzles.

Asset Pricing with Return Extrapolation

We study China stock market using the Consumption-based Capital Asset Pricing Model (CCAPM) of Lucas [Econometrica 46 (1978) 1429]. A cointegration test reveals no long-term relationship between equity prices and dividends in China. The applicability of the CCAPM seems weak in China. The highly volatile dividend growth rates nonetheless cannot rationalize the large equity premia (the equity premium puzzle) in China stock market. We find the mean model-implied risk-free rate is much higher than the historical figure in China.

Asset Pricing Anomalies and Macroeconomic Risk: Evidence from Australia

Macroeconomic Risks and Characteristic-Based Factor Models

This paper not only provides a theoretical model for the value-at-risk of active and passive trading strategies but also discusses the substantial implications relevant to risk management. Our results suggest that, first, passive strategies are riskier than active trading strategies based on historical returns, such as momentum and contrarian strategies. Second, momentum (contrarian) trading is riskier in a bull (bear) market. Third, the value-at-risk of momentum (contrarian) strategies has a positive relation to the absolute value of the return autocorrelation, as well as a positive (negative) relation with the state of the market. Further, momentum trading strategies give a superior risk-adjusted performance compared with other strategies in international stock markets.