The Journal of Financial Economics
We derive lower and upper bounds on the conditional expected excess market return that are related to risk-neutral volatility, skewness, and kurtosis indexes. The bounds can be calculated in real time using a cross section of option prices. The bounds require a no-arbitrage assumption, but do not depend on distributional assumptions about market returns or past observations. The bounds are highly volatile, positively skewed, and fat tailed. They imply that the term structure of expected excess holding period returns is decreasing during turbulent times and increasing during normal times, and that the expected excess market return is on average 5.2%.
We also derive closed-form expressions for any physical moment of the excess market return (e.g., mean, variance, skewness, kurtosis, etc.) when the functional form of the utility is specified. We provide closed-form expressions for the SDF obtained when a representative agent has CARA, CRRA, and HARA utilities. In these cases, we also derive closed-form expressions for physical moments of the excess market return. Bounds are not needed. Although we derive these closed-form expressions, our bounds are for the general case when the utility function and SDF are not known.
Best Paper in Asset Pricing: 2019 SFS Cavalcade Asia-Pacific
Winner: 2019 Chicago Quantitative Alliance Academic Paper Competition
This paper provides evidence that the market does not efficiently incorporate expected returns implied by analyst price targets into prices. I use a novel decomposition to extract information and bias components from these analyst-expected returns and develop an asset pricing framework that helps interpret price reactions to each component. A one-standard-deviation increase in the information (bias) component is associated with a five (one) percentage point increase in announcement-month returns. The positive reaction to bias implies the market does not fully debias analyst-expected returns before incorporating them into prices. Prices overreact to bias and reverse their initial reaction within three to six months. Prices underreact to information and returns drift an additional one percentage point beyond their initial reaction in the following 12 months. Announcement-window returns forecast future returns, which provides model-free evidence of underreaction, and that underreaction dominates overreaction. Trading against underreaction generates average monthly returns of 1.12% with a Sharpe ratio of 1.08, and the returns survive controlling for exposure to many standard factors.
Work in Progress
"Idiosyncratic Labor Income in a Production General Equilibrium Model" (with Miguel Palacios and Lawrence Schmidt)
We develop a highly tractable, general equilibrium model with production and incomplete markets. In the model, agents can invest in physical capital and human capital, where the latter investment technology is subject to uninsurable, idiosyncratic disaster risk. The quantity of both inputs is time-varying and endogenously determined in equilibrium, subject to aggregate adjustment costs. We demonstrate that the presence of uninsurable risk has first-order implications for the riskiness of human capital; in particular, the risk premium on human capital and the share of total wealth in human capital are considerably larger and smaller, respectively, relative to the complete markets benchmark. Moreover, the presence of state-dependent, idiosyncratic risk increases the equity risk premium and has important implications for agent's optimal investment behavior.
"Is There a Mutual Fund Manager Skill Premium?" (with Michael Barnett and Douglas Xu)
We estimate mutual fund manager skill as manager-level realized abnormal return alpha produced over a manager’s entire career. Given this measure, there is an economically and statistically significant manager skill premium of 20-30 basis points per month over the 1990-2014 period. The premium varies over time and across fund types. Sector-specific funds, small cap funds, and all funds during 1990-1999 sub-period have a manager skill premium of 20-130 basis points. There is no statistically significant premium for non-sector funds, large cap funds, or all funds during the 2000-2014 sub-period. Additionally, there is a premium of about 40 basis points for managers with positive alpha's, but no statistically significant premium for managers with negative alpha's. These results provide evidence that manager skill contributes more to abnormal returns for funds that invest in low-information-environment stocks. We use a theoretical model to demonstrate how this mechanism is consistent with our empirical results.