Doron E. Avramov
Professor of Finance |
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Curriculum Vitae (pdf)
Notes for PhD (Doctoral) Students
Research:
Working
papers (comments welcome):
Cross-Sectional
Asset Pricing Puzzles: An Equilibrium Perspective (with Scott
Cederburg and Satadru Hore)
Abstract:
This
paper proposes an intertemporal asset pricing model that resolves the negative
cross-sectional relations between expected stock return and dispersion,
idiosyncratic volatility (IV), and credit risk. All three puzzling effects
naturally emerge in the cross section of an economy characterized by recursive
preferences and persistent dividend and consumption growth rates. The
equilibrium cross section of expected return is driven by time-varying exposure
to an economic growth factor. The three effects are emerge through the
interaction of firm cash flow timing and investor aversion to shocks in
economic growth. Specifically, low expected growth firms derive their values
primarily from short-run cash flows. Such firms exhibit high dispersion, IV,
and credit risk due to their high price sensitivity to idiosyncratic shocks.
However, they have low exposure to economic growth shocks thereby exhibiting
low growth beta and expected return. In contrast, firms with values weighted
towards long-run cash flows have greater exposure to aggregate risk and are
relatively insensitive to idiosyncratic cash flow shocks. Thus they are
characterized by high expected return coupled with low dispersion, IV, and
credit risk levels.
Hedge Fund Predictabilty Under
the Magnifying Glass: The Economic Value of Forecasting Individual Fund Returns
(with Laurent Barras
and Robert
Kosowski)
Abstract:
The recent financial crises
has highlighted the need to search for suitable models forecasting hedge fund
performance. This paper develops and applies a framework in which to assess
return predictability on a fund by fund basis. Using a comprehensive sample of
hedge funds during the 1994-2008 period, we identify the fraction of funds in
each style that are truly predictable, positively or negatively, by macro
variables. Out-of-sample, exploring predictability can be difficult as
estimation risk and model uncertainty lead to imprecise fund forecast.
Moreover, in our multi-fund setting, investors face tradeoff between
unconditional and predictable performance, as strongly predictable funds may
exhibit low unconditional mean. Nevertheless, a strategy that combines
forecasts across predictors circumvents all these challenges and delivers
superior performance. We highlight the statistical and economic drivers of this
performance, especially in periods when predictor values strongly depart from
their long run means. Finally, we use such period - the 2008 crises - as a
natural out of sample experiment to validate the robustness of our findings.
The World Price of Credit
Risk (with
Tarun Chordia, Gergana
Jostova, and Alexander Philipov)
Global
asset-pricing models have failed to capture the cross section of average
country equity returns. Emerging markets have displayed strikingly large and
robust positive pricing errors. Country-level characteristics have played a
significant role in pricing international equities, suggesting that financial markets
may not be fully integrated. This paper offers a risk-based explanation that
resolves such deviations from global asset pricing. A world credit risk factor
fully explains the positive pricing errors in emerging market equities.
Moreover, in the presence of this credit risk factor, country-level
characteristics no longer play a role in pricing global equities. Factor models
that account for the world credit risk factor uniformly outperform competing
specifications, in both the time-series and cross-section, which exclude this
factor. Over the 1989-2009 period, the risk premium for systematic credit risk
exposure is 83 basis points per month and its importance has increased
dramatically in recent years.
Momentum,
Information Uncertainty, and Leverage – an Explanation Based on Recursive
Preferences (with Satadru Hore)
Abstract:
Momentum payoffs concentrate
in high information uncertainty and high credit risk firms and are virtually
nonexistent otherwise. This paper rationalizes such momentum concentrations in
consumption based equilibrium asset pricing. In our paradigm, dividend growth
is mean reverting, expected dividend growth is persistent, the representative
agent is endowed with stochastic differential utility of Duffie and Epstein
(1992), and dividend streams are used for both consumption and debt repayment
per Abel (1999). Employing reasonable risk aversion levels we are able to
produce the observational momentum effects. Momentum profitability is large in
the interaction between high levered and risky cash flow firms. It rapidly
deteriorates and ultimately disappears as leverage or cash flow risk
diminishes.
Publications and papers accepted for publication
Anomalies and
Financial Distress (with Tarun Chordia, Gergana Jostova,
and Alexander
Philipov) Forthcoming Journal of Financial Economics Presentation File
Winner of Best Paper Award: FMA Asia
Stock
Return Predictability and Model Uncertainty Journal of Financial
Economics 64 (2002), 423 – 458.
Abstract:
We
use Bayesian model averaging to analyze the sample evidence on return
predictability in the presence of model uncertainty. The analysis reveals
in-sample and out-of-sample predictability, and shows that the out-of-sample
performance of the Bayesian approach is superior to that of model selection
criteria. We find that term and market premia are robust predictors. Moreover,
small-cap value stocks appear more predictable than large-cap growth stocks. We
also investigate the implications of model uncertainty from investment
management perspectives. We show that model uncertainty is more important than
estimation risk, and investors who discard model uncertainty face large utility
losses.
Stock Return
Predictability and Asset Pricing Models Review of Financial Studies
17 (2004), 699-738.
Abstract:
This
paper develops an asset allocation framework that incorporates prior beliefs
about the extent of stock return predictability explained by asset pricing
models. We find that when prior beliefs allow even minor deviations from pricing
model implications, the resulting asset allocations depart considerably from
and substantially outperform allocations dictated by either the underlying
models or the sample evidence on return predictability. Under a wide range of
beliefs about model pricing abilities, asset allocations based on conditional
models outperform their unconditional counterparts that exclude return
predictability.
Investing in Mutual Funds when Returns are Predictable
(with Russ Wermers) Journal
of Financial Economics 81 (2006),
339-377. Discussion of
this paper in The New York Times, November 20 2005: “The Manager Is in a Slump (or
Maybe It’s Just a Phase)” by Mark Hulbert. Discussion of
this paper also appears in “Haaretz”
an Israeli-based newspaper (for Hebrew readers).
Abstract:
This paper analyzes investments in
Asset Pricing Models and Financial Market Anomalies
(with Tarun
Chordia)
Abstract:
This paper derives and implements a
framework in which to test whether conditional asset pricing models, applied to
single securities, can explain the size, value, turnover, and momentum effects
in expected stock returns. In this framework individual stock betas vary with
firm level size and book-to-market as well as with macroeconomic variables. The
evidence shows that under the extensively studied constant beta framework, none
of the models under consideration capture any of the size, value, turnover, and
past return effects, even when returns are risk-adjusted by size, value,
liquidity, and momentum factors. In contrast, when beta is allowed to vary, the
size and book to market effects are often explained, but the explanatory power
of turnover and past return remains robust. The past return or momentum effect
is related to model mispricing that varies with macroeconomic variables,
whereas turnover shows no business cycle patterns.
Predicting Stock Returns (with Tarun Chordia) Journal
of Financial Economics 82
(2006), 387-415.
Abstract:
This paper
studies whether incorporating business cycle predictors benefits a real time optimizing
investor who must allocate funds across 3,123 NYSE-AMEX stocks and cash.
Realized returns are positive when adjusted by the Fama-French and momentum
factors as well as by the size, book-to-market, and past return
characteristics. The investor optimally holds small-cap, growth, and momentum
stocks and loads less (more) heavily on momentum (small-cap) stocks during
recessions. Returns on individual stocks are predictable out-of-sample due to
alpha variation, whereas the equity premium predictability, the major focus of
previous work, is questionable.
An Exact Bayes
Test of Asset Pricing Models with Application to International Markets (with John Chao) Journal
of Business 79 (2006), 293-323.
Abstract:
This paper develops and
implements an exact finite-sample test of asset pricing models with time
varying risk premia using posterior probabilities. The strength of our approach
is that it allows multiple conditional asset pricing specifications, both
nested and non-nested, to be tested and compared simultaneously. We apply our
procedure to international equity markets by testing and comparing the
international CAPM and conditional ICAPM versions of Fama and French (1998).
The empirical evidence suggests that the best performing model is the ICAPM
with the value premium constructed based on global earnings-to-price ratio.
Liquidity and Autocorrelation in Individual Stock Returns
(with Tarun
Chordia and Amit
Goyal) Journal of Finance 61 (2006), 2365-2394.
Abstract:
This paper documents a strong relationship
between short-run reversals and stock return illiquidity, even after
controlling for trading volume. The largest reversals and the potential contrarian
trading strategy profits occur in the high turnover, low liquidity stocks, as
the price pressures caused by non-informational demands for immediacy are
accommodated. Thus, the high frequency negative autocorrelations are more
likely to result from stresses in the market for liquidity. The contrarian
trading strategy profits are smaller than the likely transactions costs because
the high turnover, low liquidity stocks face high transaction and large market
impact costs. This lack of profitability and the fact that the overall findings
are consistent with rational equilibrium paradigms suggest that the violation
of the efficient market hypothesis due to short-term reversals is not so
egregious after all.
The Impact of Trades on Daily Volatility (with Tarun Chordia
and Amit Goyal) Review of Financial Studies 19 (2006), 1241-1277.
Abstract:
This paper proposes a trading-based
explanation for the asymmetric effect in daily volatility of individual stock
returns. Previous studies propose two major hypotheses for this phenomenon:
leverage effect and time varying expected returns. However, leverage has no
impact on asymmetric volatility at the daily frequency and, moreover, we
observe asymmetric volatility for stocks with no leverage. Also, expected
returns may vary with the business cycle, i.e., at a lower than daily
frequency. Trading activity of contrarian and herding investors has a robust
effect on the relationship between daily volatility and lagged return.
Consistent with the predictions of the rational expectations models,
non-informational liquidity driven (herding) trades increase volatility
following stock price declines and informed (contrarian) trades reduce
volatility following stock price increases. The results are robust to different
measures of volatility and trading activity.
Understanding Changes in Corporate Credit Risk (with Gergana Jostova and Alexander Philipov) Financial
Analysts Journal 63
(2007), 90-105.
Abstract:
This paper provides new evidence on the
empirical success of structural models in explaining corporate credit risk
changes. A parsimonious set of common factors and firm-level fundamentals,
inspired by structural models, explains more than 54% (67%) of the variation in
credit spread changes for medium (low) grade bonds. No dominant latent factor
is present in the unexplained variation. While our set of variables has lower
explanatory power among high-grade bonds, it does capture most of the
systematic variation of credit spread changes in that category as well. It also
subsumes the explanatory power of the Fama and French (1993) factors among all
grade classes.
Momentum and credit rating (with Tarun Chordia, Gergana Jostova, and Alexander Philipov) Journal of Finance 62 (2007), 2503-2520.
Abstract:
This
paper establishes a robust link between momentum and credit rating. Momentum
profitability is large and significant among low-grade firms, but it is
nonexistent among high-grade firms. The momentum payoffs documented in the
literature are generated by low-grade firms that account for less than four
percent of the overall market capitalization of rated firms. The momentum
payoff differential across credit rating groups is unexplained by firm size,
firm age, analyst forecast dispersion, leverage, return volatility, and cash
flow volatility.
Dispersion in analyst's earnings forecasts and credit
rating (with Tarun Chordia, Gergana Jostova, and Alexander Philipov) Journal of Financial Economics 91 (2009), 83-101
Abstract:
This paper shows that the puzzling negative
cross-sectional relation between dispersion in analysts' earnings forecasts and
future stock returns is a manifestation of the credit risk effect. In
particular, the profitability of dispersion based trading strategies is
concentrated in a small number of the worst-rated firms and is significant only
during periods of deteriorating credit conditions. In such periods, the
negative dispersion-return relation emerges as low-rated firms experience
substantial price drop along with considerable increase in forecast
dispersion. Moreover, even
for this small universe of worst-rated firms, the dispersion-return relation is
nonexistent when either the dispersion measure or return is adjusted by credit
risk. The results are robust to
previously proposed explanations for the dispersion effect such as short-sale
constraints, illiquidity, and leverage.
Credit ratings and the cross-section of stock
returns (with Tarun Chordia, Gergana Jostova, and Alexander Philipov) Journal of Financial Markets 12 (2009), 469-499
Abstract:
Low
credit risk firms realize higher returns than high credit risk firms. This
effect is puzzling because investors pay a premium for bearing credit risk.
This paper shows that the credit risk effect exists only in periods around
credit rating downgrades. Around downgrades, low rated firms experience
considerable negative returns, precipitated by substantial deterioration in
their operating and financial performance, large negative earnings surprises
and analyst forecast revisions, and strong institutional selling. In contrast,
returns do not differ across credit risk groups in stable or improving credit
conditions. Remarkably, the credit risk effect is driven by the lowest rated
stocks which account for less than 4% of the total market cap, suggesting that
there is no pervasive distress factor in the cross section of returns.
Bayesian Portfolio
Analysis (with Guofu Zhou) Annual
Review of Financial Economics
2
(2010), 25-47.
Abstract:
This paper reviews the literature on Bayesian portfolio analysis. Information about events, macro conditions, asset pricing theories, and security-driving forces can serve as useful priors in selecting optimal portfolios. Moreover, parameter uncertainty and model uncertainty are practical problems encountered by all investors. The Bayesian framework neatly accounts for these uncertainties, whereas standard statistical models often ignore them. We review Bayesian portfolio studies when asset returns are assumed both independently and identically distributed as well as predictable through time. We cover a range of applications, from investing in single assets and equity portfolios to mutual and hedge funds. We also outline existing challenges for future work.
Hedge Funds,
Managerial Skills, and Macroeconomic Variables (with Robert Kosowski, Narayan
Naik, and Melvyn Teo)
Winner of the Best Paper Award at the 2007 European Finance Association.
Winner of the Best Paper Award at the 2008 Inquire
Abstract:
This paper
evaluates hedge fund performance through portfolio strategies that incorporate
predictability based on macroeconomic variables. Incorporating predictability
substantially improves out-of-sample performance for the entire universe of
hedge funds as well as for various investment styles. While we also allow for
predictability in fund risk loadings and benchmark returns, the major source of
investment profitability is predictability in managerial skills. In particular,
long-only strategies that incorporate predictability in managerial skills
outperform their Fung and Hsieh (2004) benchmarks by over 17 percent per year.
The economic value of predictability obtains for different rebalancing horizons
and alternative benchmark models. It is also robust to adjustments for backfill
bias, incubation bias, illiquidity, fund termination, and style composition.