Trading Strategies and Financial Models. Alexander Barinov

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1 Trading Strategies and Financial Models Alexander Barinov This version: July 2014 c 2014 Alexander Barinov

2 Contents 1 Topics in Market Efficiency EMH and Expected Returns Random Walk Hypothesis and Expected Returns Predictable Expected Returns Are Consistent with the EMH EMH Is About Abnormal Returns EMH, Trading Costs, and Limits to Arbitrage EMH and Trading Costs Limits to Arbitrage: Definition The Difference between Trading Costs and Limits to Arbitrage EMH, Competition, and Information Production People Making the Market Efficient Will Be Rewarded EMH Is Similar to Perfect Competition EMH: Conclusion Trading Costs Price impact Order Book Example Hiding in the Volume

3 4 CONTENTS Determinants of Price Impact Recent Trends in Price Impact Measuring Price Impact Bid-Ask Spread The Market Maker Example Determinants of Bid-Ask Spread Bid-Ask Spread as a Trading Cost Measuring the Bid-Ask Spread Short Sales Uses of Shorting Short Sales as an Insurance Zero-Investment Portfolios Alpha as a Trading Strategy Return Short-Sale Constraints and Mispricing The Winner s Curse The Miller (JF 1977) Story Determinants of Shorting Fees Short-Sale Constraints and Uncertainty Predictability of Risk Predictability Basics Why Expected Return Is Predictable? Treasury Bills, Inflation, and Expected Market Return

4 CONTENTS Default Premium and Expected Market Return Term Premium and Expected Market Return Dividend Yield and Expected Market Return Long-Run Predictability Caveats Long-Run Predictability in an Efficient Market Long-Run Predictability in an Irrational Market Long-Run Predictability and Statistical Caveats Expected and Unexpected Higher Expected Return Means Lower Current Return Back to Inflation and Expected Return Why Macro Variables Should Be Lagged Change Stands for News High Expected Returns During Recessions? Yes! Conditional CAPM Conditional CAPM: Theory Risk According to the CAPM Risk According to the Conditional CAPM How Important is the Risk Captured by the Conditional CAPM Conditional CAPM in the Data First Look at the Value Effect Empirical Setup Interpreting the Results Conditional CAPM Works, but Not by Enough

5 6 CONTENTS 6 Consumption CAPM and Intertemporal CAPM Consumption CAPM Risk According to Consumption CAPM Consumption CAPM in Real-Life Examples Intertemporal CAPM ICAPM Hunts for Consumption Proxies ICAPM Controls for Shifting Wealth from Good to Bad Periods ICAPM Example: Inflation Risk ICAPM Is Broader than Conditional CAPM ICAPM and the Value Effect: An Example VIX and the Business Cycle Change in VIX as an ICAPM Factor Factor-Mimicking Portfolio ICAPM and Multifactor Models Fama-French Model as APT Fama-French Model as ICAPM Introduction to Anomalies Anomaly: Definition First Possible Explanation: Rational Stories Ad-hoc CCAPM/ICAPM and Other Ways to Link Anomalies to Risk Three Views on the Fama-French Model Second Possible Explanation: Behavioral Stories

6 CONTENTS Limits to Arbitrage Speculation and Noise Traders Third Possible Explanation: Are Anomalies Real? Conclusion Value Effect Definition Rational Stories Investment Story Volatility Risk Story Other Risk-Based Stories Behavioral Stories Value Effect and Size Value Effect and Idiosyncratic Volatility Value Effect and Institutional Ownership Value Effect and Earnings Announcements Is the Value Effect Real? Trading Costs Story Value Effect Out-of-Sample Momentum Definitions Price Momentum Short-Term Reversal

7 8 CONTENTS Long-Term Reversal Post-Earnings Announcement Drift Earnings Momentum Rational Stories Initial Remarks Momentum Returns and the Business Cycle Momentum Risk and the Business Cycle Earnings Momentum Factor Behavioral Stories Momentum for Small, Young, and Volatile Stocks Momentum for High Turnover Stocks Momentum for Micro Caps Momentum for Growth Firms Momentum and Reversal during Bull and Bear Markets Momentum and Earnings Announcements Is Momentum Real? Trading Cost Story: Summary of the Evidence Trading Cost Story: Example Momentum Out of Sample New Issues Puzzle Definition How Stock Is Issued The Degree of the Underperformance

8 CONTENTS New Issues Puzzle in Multi-Factor Models New Issues Puzzle in Event Time Related Puzzles Risk-Based Stories Firm-Type Stories: New Issues and the Small Growth Anomaly Firm-Type Stories: Volatility Risk Story Firm-Type Stories: New Issues and Investment Factor Risk-Shift Stories: New Issues and Leverage Risk-Shift Stories: New Issues and Turnover Behavioral Stories Basic Behavioral Story Behavioral Story and Different Types of Issues Behavioral Stories, Size, and Market-to-Book New Issues and Earnings Management New Issues Puzzle: Measurement Issues Calendar-Time vs. Event-Time Pseudo Market-Timing Uncertainty Effects Definitions Idiosyncratic Volatility and Expected Returns Idiosyncratic Volatility Discount Analyst Disagreement Effect Turnover Effect

9 10 CONTENTS Turnover Variability Effect Risk-Based Stories Johnson (JF 2004) Model Extending the Johnson Model: Volatility Risk Extending the Johnson Model: Cross-Section Volatility Risk Explains the Uncertainty Effects Mispricing Stories Miller (JF 1977) Story Is Not Behavioral Residual Institutional Ownership and Uncertainty Effects Probability to Be on Special Uncertainty Effects, Short-Sale Constraints, and Volatility Risk Credit Rating and Uncertainty Effects Are Uncertainty Effects Real? Idiosyncratic Volatility Discount at NYSE Lagged and Expected Idiosyncratic Volatility Idiosyncratic Volatility Discount and Short-Term Reversal Analyst Disagreement Effect and Liquidity Uncertainty Effects Around the World Seasonality in Stock Returns January Effect Turn-of-the-Year Effect Small Firms in January Small Growth Firms in January

10 CONTENTS The Other January Effect Monday Effect Weekend Risk and Volatility Monday Effect: Discovery and Disappearance Monday Effect and the Bid-Ask Bounce Monday Effect for Options Where Did the Monday Effect Go? Monday Effect for Puts? Monday Effect and the Delta Robustness of the Monday Effect Monday Effect and Limits to Arbitrage Distress Risk Puzzle Definition Default Risk as a Covariance Distressed Firms and Default Risk O-Score and Z-Score O-Score, Z-Score, and Returns Risk-Based Stories Risk-Shifting Around Bankruptcy Leverage and Self-Selection Johnson (JF 2004) Model Behavioral Stories Distress Risk Puzzle and Market-to-Book

11 12 CONTENTS O-score, MB, and Earnings Announcements Credit Rating Effect Credit Rating Effect in Recessions Credit Rating Effect and Downgrades Credit Rating Effect in Cross-Section Credit Rating Effect and Analyst Disagreement Measurement Issues Errors-in-Variables Cannot Explain Anomalies Equity as a Call Option on the Assets O-Score and R&D Expenses Accrual Anomaly Definition What Are Accruals? Accrual Anomaly How to Measure Accruals? Discretionary Accruals What Drives the Accrual Anomaly? Risk-Based Stories Accrual Anomaly and Value Effect Accrual Anomaly and Investment Factor Predicting Accrual Anomaly Behavioral Stories Accrual Anomaly in Cross-Section

12 CONTENTS Accrual Anomaly and Earnings Announcements Topics in Performance Measurement Alpha and Appraisal Ratio Alpha Appraisal Ratio Alpha or Appraisal Ratio? Zero-Investment Portfolios Set the Risk-Free Rate to Zero Numerical Example Topics in Performance Evaluation What the Manager Does That You Cannot? Multifactor Models and Performance Evaluation R-square and Portfolio Manager s Activity Carhart Model Alpha and Management Fees Who Gets the Alpha? Persistence of Performance What Drives the Alpha? Mutual Fund Flows An Example of Performance Measurement and Evaluation Four Ways to Measure Risk An Example of the Analyst Disagreement Effect

13 14 CONTENTS Applying the Carhart Model The Conditional CAPM Take on Risk The ICAPM Take on Risk The Downfall of Levered ETFs Levered ETFs: Definition and History Constant Leverage Trap Constant Leverage Trap and Pseudo Market Timing Constant Leverage and Trading Costs Constant Leverage Trap Is Not the Only Reason Levered ETFs Underperform Controlling for Trading Costs Explains the Underperformance of Levered ETFs A New Measure of Trading Costs Liquidity and Expected Returns Liquidity: A Special Characteristic Different Holding Periods and Clientele Effects Theory: Bid-Ask Spread and Expected Returns Example 1: Two Stocks, Two Investors Example 2: Three Stocks, Three Investors Amihud and Mendelson: Many Stocks, Many Investors Price Impact and Expected Returns The Amihud Measure and Expected Returns

14 CONTENTS Example 3: Two Stocks, Two Investors Example 4: Three Stocks, Two Investors Example 5: Two Stocks, Three Investors Liquidity Risk Liquidity as a State Variable Forming a Liquidity Risk Factor Three Dimensions of Liquidity Risk Pastor-Stambaugh Factor Examples with Liquidity Risk Factors Introduction to Behavioral Finance The Starting Point and the Road Ahead Mispricing and Limits to Arbitrage What We Need to Do Noise Traders and Covariances: Theory Starting Point: Those Who Create Mispricing Should Go Broke How Those Who Create Mispricing Avoid Going Broke Characteristic and Covariances: A New Take Noise Traders and Covariances: Evidence Index Additions and Deletions Betas and Infrequent Trading Measuring Investor Sentiment Sentiment and Anomalies

15 16 CONTENTS 22 Overview of Select Behavioral Theories Psychological Biases and Momentum Conservatism Bias and Representativeness Heuristic Conservatism Bias and Representativeness Heuristic in One Model Overconfidence and Self-Attribution Overconfidence and Self-Attribution in One Model Prospect Theory Equity Premium Puzzle Mental Accounting and Equity Premium Prospect Theory and Skewness Preference Asset Pricer s Take on Behavioral Finance Eugene Fama on Behavioral Finance Aggregation and Data Mining

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