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Volatility and Returns

Volatility and Returns. Eric Falkenstein. Standard Theory is a Framework. Tests are of any theory the framework allows There are an infinite number of theories allowed Framework is untestable. Volatility Often Used as a Risk Shorthand. Brealey and Myers Investments Book.

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Volatility and Returns

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  1. Volatility and Returns Eric Falkenstein

  2. Standard Theory is a Framework • Tests are of any theory the framework allows • There are an infinite number of theories allowed • Framework is untestable

  3. Volatility Often Used as a Risk Shorthand Brealey and Myers Investments Book

  4. Total Volatility and Returns • My Dissertation (1994) page 53

  5. Motivation: Mutual Funds Have Incentive Towards Volatility

  6. Paradigms of Science • Theory that some liked volatility not an equilibrium theory • Pre ‘behavioral finance’ popularity • No fancy empirical test (didn’t use GMM) • Makes no sense—arbitrage • [I took equity risk premium as given] • Theory more important than data • Burned by calendar effects

  7. Minimum Variance Portfolios Ang,, Hodrick, Xing and Zhang (JoF 2009) 1980-2003 Use Fama French Model

  8. Beta and Returns: 1962-2008

  9. Call Options Sophie Ni (2007) Return from Bid-Ask midpoint to expiration -36%??

  10. Small Businesses • Moskowitz, and Vissing-Jorgensen (2002)

  11. Leverage and Returns Penman, Richardson, and Tuna. 2007 Expected Returns Theory rE rD Debt/Equity

  12. Mutual Funds • Beta and Returns Unremarkable • Russ Wermers JoF 2000 piece (persistence, turnover) • Burton Malkiel JoF 1995 piece (persistence, alpha) • Carhart JoF 1997 (persistence, momentum) • Beta irrelevant • The biggest criticism is not adverse statements, but neglect

  13. Currencies: Uncovered Interest Rate Parity % change in currency unpredictable Return in AUD=Return in Yen+Appreciation in Yen/AUD

  14. World Country Returns 1990-2008 Dollar Annualized Returns, Standard Deviations Morgan Stanley Capital International (MSCI) MSCI Emerging Markets Index: 7.3%, 35% MSCI World (Developed) Index: 4.4%, 19%

  15. World Country Returns • Dimson, Marsh, Staunton (2005) • 17 Countries, 1900-2005, Annual Data

  16. Corporate Bonds • No Return Premium to High Yield Bonds over Investment Grade • Merrill High Yield Master II (HOAO) Merrill BBB-AA Index (COCO) • 20 HY Funds, 12 IG funds

  17. Treasury Yield Curve • 1% premium from 0.25 to 3 years • No premium from 5 to 30 years • Volatility, Covariance, increasing linearly

  18. Futures • Futures return from roll • Harvey and Erb (2007) copper, heating oil, and live cattle were on average in backwardization, • corn, wheat, silver, gold, and coffee were in contango • What covariance, volatility has to do with this ???

  19. Distress Risk • Campbell, Hilscher, and Szilagyi (2006) Find high distress firms have lower returns • Source: Author. Data from Moody’s, S&P, Compustat

  20. Sports Books • Longshot bias • Horse Track: • 1-10 odd horses 3% average return on investment • 100-1 odd horses have -86% average return • Bias not there in smaller odds, as in baseball

  21. Movie Returns by Rating • Devany and Walls (1999), 2015 movies from 1984-96

  22. Total Volatility over Time • Steve Sharpe and Gene Amromin (2005). People have higher expected returns when they have lower expected volatilities • Most studies find no positive aggregate volatility/return correlation over time

  23. Initial Public Offerings (IPOs) • IPO has a lot of Uncertainty • Jay Ritter (see his website). 1980-2008. • IPO Returns -3.7% annually below size-matched firms for first 5 years

  24. Analyst Disagreement • Deither, Malloy, and Scherbina (2002). Table 2. Data from 1983-2000. • Data ‘strongly reject the interpretation of dispersion in analysts’ forecasts as a measure of risk’

  25. Trading Volume • Turnover of stock a proxy for disagreement • Highly correlated with beta

  26. Negative Volatility-Return Relation • Equity • Beta • Volatility • Equity options • Distressed stock returns • Analyst Disagreement • Trading Volume • IPOs • Leverage and stock returns • Lotteries • Horse racing

  27. Absent Volatility-Return Relation • Equity • Over time • Across Countries • BBB to B bond returns • Futures • Currencies • Private Investments • Movies • Mutual Funds • Low Odds Sport Bets

  28. 'Risk' Orthogonal to Volatility • Initial story was about total volatility • Total volatility flat or negatively correlated with return • Beta flat or negatively correlated with return • unrelated to risk. • Volatility, Beta Uncorrelated, negatively correlated, with ‘true’ betas ???

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