[ ] WHU_Rational.ppt

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[ ] WHU_Rational.ppt

  1. 1. Rational International Investment Campbell R. Harvey, Ph.D., Professor, Duke University http://www.duke.edu/~charvey WHU Campus for Finance “ Rationality of Stock Markets and Empirical Finance” January 2003
  2. 2. The Plan <ul><li>Returns, diversification and predictability </li></ul><ul><li>Long horizon vs. short horizon </li></ul><ul><li>Expected performance </li></ul><ul><li>Prospect theory or skewness preference? </li></ul><ul><li>Importance of GPRs </li></ul><ul><li>The stock markets play a role in the world economy </li></ul>
  3. 3. One Year Treasury STRIP Two Year STRIP Five Year Treasury STRIP Seven Year Treasury STRIP Ten Year Treasury STRIP Twenty Year Treasury STRIP Thirty Year Treasury STRIP MBS Credit Aggregate Government Three Year Treasury STRIP Wilshire Small Cap Wilshire 5000 Wilshire Large Cap Wilshire Mid Cap EAFE X-Japan International Performance The International Track Record Source: Erb and Harvey (2002) Germany EAFE
  4. 4. Returns and Diversification Data from MSCI
  5. 5. Returns and Diversification Data from IFC
  6. 6. Returns and Diversification Data from MSCI
  7. 7. Returns and Diversification Data from MSCI
  8. 8. Returns and Diversification Data from MSCI
  9. 9. Returns and Diversification Data from MSCI
  10. 10. Returns and Diversification Data from IFC
  11. 11. US Business Cycle is Predictable US Yield Curve Inverts Before Last Six US Recessions (5-year US Treasury bond - 3-month US Treasury bill) % Real annual GDP growth Yield curve Recession Correct 2 Recessions Correct Recession Correct Yield curve accurate in recent forecast Recession Correct Annual GDP growth or Yield Curve Data though 1/12/03
  12. 12. Returns and Diversification Data from IFC and MSCI
  13. 13. Acrobat Document Returns and Diversification Source: Goetzmann, Li and Rouwenhorst (2002)
  14. 14. Acrobat Document Returns and Diversification Source: Goetzmann, Li and Rouwenhorst (2002)
  15. 15. The Long Horizon Data from Dimson, Marsh and Stauton (2002)
  16. 16. The Long Horizon Data from Dimson, Marsh and Stauton (2002)
  17. 17. The Long Horizon Data from Dimson, Marsh and Stauton (2002)
  18. 18. The Long Horizon Data from Dimson, Marsh and Stauton (2002)
  19. 19. What to Expect Data from Dimson, Marsh and Stauton (2002)
  20. 20. What to Expect Data from MSCI. Japan divided by 10.
  21. 21. What to Expect Price to Trailing Peak Earnings vs 5 Year Average CPI (overlapping annual data) Price to Trailing Peak Earnings Source: Bloomberg, Standard & Poor’s Source: Goldman Sachs (2002) 0 5 10 15 20 25 30 35 - 10.0% - 5.0% 0.0% 5.0% 10.0% 15.0% 20.0% . 1996 - 2001 5 yr Average CPI (1920 - August 2002) Current environment: Inflation: 2.3% P/E: 24.7x January 2003
  22. 22. What to Expect <ul><li>Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable </li></ul>10-year premium 1-year premium Source: Graham and Harvey (2003)
  23. 23. What to Expect U.S. Equity and Bond Returns are Positively Correlated Source: Erb and Harvey (2002)
  24. 24. What to Expect World Real Equity and Real Bond Returns are Positively Correlated Source: Erb and Harvey (2002)
  25. 25. What to Expect Inflation Negatively Related to Real US Bill Returns Source: Erb and Harvey (2002)
  26. 26. What to Expect Inflation Negatively Related to Real US Intermediate Bond Returns Source: Erb and Harvey (2002)
  27. 27. What to Expect Inflation Negatively Related to Real US Bond Returns Source: Erb and Harvey (2002)
  28. 28. What to Expect Inflation Negatively Related to Real US Equity Returns Source: Erb and Harvey (2002)
  29. 29. What to Expect Inflation Negatively Related to Real International Bill Returns Source: Erb and Harvey (2002)
  30. 30. What to Expect Inflation Negatively Related to Real International Bill Returns Source: Erb and Harvey (2002)
  31. 31. What to Expect Inflation Negatively Related to Real International Equity Returns Source: Erb and Harvey (2002)
  32. 32. What to Expect Inflation Negatively Related to Real International Equity Returns Source: Erb and Harvey (2002)
  33. 33. Rethinking Risk <ul><li>Traditional models maximize expected returns for some level of volatility </li></ul><ul><li>Is volatility a complete measure of risk? </li></ul>
  34. 34. Rethinking Risk <ul><li>Much interest in prospect theory, downside risk, asymmetric volatility, semi-variance, extreme value analysis, regime-switching, jump processes, ... </li></ul>
  35. 35. Rethinking Risk <ul><li>In prospect theory (Kahneman and Tversky) </li></ul><ul><ul><li>Investor risk averse in the case of gains, as a small certain gain is preferred to a probable risky gain </li></ul></ul><ul><ul><li>Investor risk seeking in the case of losses, as a probable risky loss is preferred to a small certain loss </li></ul></ul><ul><li>So investors do not evaluate outcomes based on true probabilities </li></ul>
  36. 36. Rethinking Risk <ul><li>Loss aversion is a special case </li></ul><ul><ul><li>Investor has a greater incremental utility penalty for losses than for an equally large gain </li></ul></ul><ul><ul><li>Overall, investor looks risk averse </li></ul></ul>
  37. 37. Rethinking Risk <ul><li>But, perhaps we can think of these situations in terms of preference for higher moments </li></ul><ul><li>Most asset allocation work operates in two dimensions: mean and variance -- but skew is important for investors. </li></ul><ul><li>Examples: </li></ul>
  38. 38. Rethinking Risk <ul><li>1. The $1 lottery ticket . The expected value is $0.45 (hence a -55%) expected return. </li></ul><ul><ul><li>Why is price so high? </li></ul></ul><ul><ul><li>Lottery delivers positive skew, people like positive skew and are willing to pay a premium </li></ul></ul>
  39. 39. Rethinking Risk <ul><li>2. High implied vol in out of the money OEX put options . </li></ul><ul><ul><li>Why is price so high? </li></ul></ul><ul><ul><li>Option limits downside (reduces negative skew). </li></ul></ul><ul><ul><li>Investors are willing to pay a premium for assets that reduce negative skew </li></ul></ul><ul><ul><li>Is this loss aversion or skewness preference? </li></ul></ul>
  40. 40. Rethinking Risk <ul><li>3. Some stocks that trade with seemingly “too high” P/E multiples </li></ul><ul><ul><li>Why is price so high? </li></ul></ul><ul><ul><li>Enormous upside potential (some of which is not well understood) </li></ul></ul><ul><ul><li>Investors are willing to pay a premium for assets that produce positive skew </li></ul></ul><ul><ul><li>[Note: Expected returns could be small or negative!] </li></ul></ul>
  41. 41. Rethinking Risk Source: Harvey and Siddique (2000)
  42. 42. Rethinking Risk Data from MSCI
  43. 43. Rethinking Risk Data from IFC
  44. 44. Rethinking Risk Data from MSCI
  45. 45. Rethinking Risk Data from IFC
  46. 46. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Agarwal and Naik (2002)
  47. 47. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Agarwal and Naik (2002)
  48. 48. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Agarwal and Naik (2002)
  49. 49. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source: Agarwal and Naik (2002)
  50. 50. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options Source : Figure 5 from Mitchell & Pulvino (2000)
  51. 51. Alternative Vehicles Alternate Asset Classes Often Involve Implicit or Explicit Options -8 -6 -4 -2 0 2 4 6 -15 -10 -5 0 5 10 Russell 3000 Index Returns Event Driven Index Returns LOWESS fit Source: Agarwal and Naik (2002)
  52. 52. Rethinking Risk Skewness has potential to explain one of the unsolved anomalies in finance: the profitability of momentum trading Momentum portfolios
  53. 53. Rethinking Risk <ul><li>Harvey, Liechty, Liechty and M ü ller (2002) “Portfolio Selection with Higher Moments” provide a new approach to portfolio selection which accounts for: </li></ul><ul><ul><li>Higher moments </li></ul></ul><ul><ul><li>Estimation errors in the inputs </li></ul></ul>
  54. 54. The Evolution of World Risk <ul><li>The U.S. has become much more risky </li></ul><ul><ul><li>High sensitivity to some GPRs </li></ul></ul><ul><ul><li>Disagreement on strength of economy </li></ul></ul><ul><ul><li>Financial information less credible </li></ul></ul>
  55. 55. The Evolution of World Risk ICRG Political Risk Data from PRS
  56. 56. The Evolution of World Risk ICRG Political Risk Data from PRS
  57. 57. The Evolution of World Risk ICRG Political Risk Data from PRS
  58. 58. The Evolution of World Risk Risk Ratings December 2002 Data from PRS
  59. 59. The Evolution of World Risk Risk Ratings May 2001 Data from PRS
  60. 60. The Evolution of World Risk Higher risk means equity investors require a higher rate of return Risk Ratings from Institutional Investor
  61. 61. <ul><li>Equation implies an increase in the medium-term risk premium </li></ul><ul><ul><li>This helps explain the recent decline in the equity market </li></ul></ul><ul><ul><li>This helps explain the recent behavior of the U.S. dollar </li></ul></ul><ul><ul><li>This helps explain the slow down in real investment (hurdle rates are up) </li></ul></ul>The Evolution of World Risk
  62. 62. <ul><li>Efficiently functioning stock markets make a difference in the real economy </li></ul><ul><ul><li>There is now substantial cross-country evidence on the impact of stock market development on the real economy </li></ul></ul>Stock Markets and the Real Economy
  63. 63. <ul><li>Market integration has a fundamental influence on asset prices </li></ul>Stock Markets and the Real Economy
  64. 64. Stock Markets and the Real Economy Prices High Expected Announcement Implementation Low Expected Returns of Liberalization Returns P I P S Time Segmented Integrated Asset Prices and Market Integration Return to Integration
  65. 65. Average Annual Geometric Returns Stock Markets and the Real Economy
  66. 66. Correlation with World Stock Markets and the Real Economy
  67. 67. <ul><li>Implications </li></ul><ul><li>Lower cost of capital </li></ul><ul><li>More investment, employment </li></ul><ul><li>More economic growth </li></ul><ul><ul><li>Geert Bekaert, Campbell Harvey and Chris Lundblad, Does Financial Liberalization Spur Growth? </li></ul></ul><ul><li>Not just an emerging markets effect: Euro also increased integration </li></ul>Stock Markets and the Real Economy
  68. 68. <ul><li>Findings </li></ul><ul><li>Liberalization increases real growth by 1% per year for five years – which is a large number </li></ul><ul><li>The liberalization effect is robust to </li></ul><ul><ul><li>different definitions of liberalization dates </li></ul></ul><ul><ul><li>to business cycle or interest rate controls </li></ul></ul><ul><ul><li>allowing for intensity of liberalization </li></ul></ul><ul><li>...and independent of capital account liberalization </li></ul>Stock Markets and the Real Economy
  69. 69. <ul><li>Findings </li></ul><ul><li>We control </li></ul><ul><ul><li>macroeconomic reforms </li></ul></ul><ul><ul><li>financial development </li></ul></ul><ul><ul><li>other regulatory reforms </li></ul></ul><ul><li>...and effect is intact </li></ul>Stock Markets and the Real Economy
  70. 70. <ul><li>But is there a cost? </li></ul><ul><li>Foreign speculators </li></ul><ul><li>Economic crises </li></ul><ul><li>Irrational contagion </li></ul>Stock Markets and the Real Economy
  71. 71. <ul><li>But is there a cost? </li></ul><ul><li>Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others) </li></ul><ul><ul><li>One can always point to a particular country to support this idea </li></ul></ul><ul><ul><li>What about looking at a broad cross section? </li></ul></ul>Stock Markets and the Real Economy
  72. 72. <ul><li>But is there a cost? </li></ul><ul><li>Geert Bekaert, Campbell Harvey and Chris Lundblad, Growth Volatility and Equity Market Liberalization , 2002. </li></ul><ul><li>No evidence that GDP growth volatility increases after markets open up </li></ul>Stock Markets and the Real Economy
  73. 73. Stock Markets and the Real Economy
  74. 74. <ul><li>Predictability arises naturally from business cycle fluctuations – it need not be confused with irrationality </li></ul><ul><li>While the research is very important, the case has not yet been made for widespread application of behavioral models </li></ul><ul><li>Stock markets, in general, play a positive role – not just for investors and corporations – but the economy </li></ul>Conclusions
  75. 75. <ul><li>My articles on www.duke.edu/~charvey </li></ul><ul><ul><li>The Drivers of Expected Returns in International Markets (2000) </li></ul></ul><ul><ul><li>Global Tactical Asset Allocation (2001) with Magnus Dahlquist </li></ul></ul><ul><ul><li>The Term Structure of Equity Risk Premia (2002) with Claude Erb </li></ul></ul><ul><ul><li>Characterizing Systematic Risk of Hedge Funds with Buy-and-Hold and Option-Based Strategies , (2002) Vikas Agarwal and Naranyan Y. Naik </li></ul></ul><ul><ul><li>Portfolio Selection with Higher Moments , with John Liechty, Merrill Liechty, and Peter M ü ller </li></ul></ul><ul><ul><li>Does Financial Liberalization Spur Growth ? with Geert Bekaert, and Chris Lundblad </li></ul></ul><ul><ul><li>Growth Volatility and Equity Market Liberalization with Geert Bekaert, and Chris Lundblad </li></ul></ul>Readings

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