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Volatility and Returns

This analysis addresses the intricate relationship between volatility and returns within financial frameworks, drawing from Eric Falkenstein's insights and other scholarly works. It critiques conventional theories that equate volatility with risk, highlighting discrepancies in various markets, from mutual funds to corporate bonds. The study spans historical data on returns across different assets, including stocks, bonds, and futures, while questioning the efficacy of traditional models like CAPM and the Fama-French. Ultimately, it posits that volatility does not necessarily correlate with expected returns, reshaping our understanding of risk.

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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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