Final Report Summary - EXTRETEXPRET (Extreme Returns and Expected Returns in International Stock Markets)
The fundamental objective of the project is investigating the relation between expected equity market returns and extreme equity market returns in an international context in order to create new implications with respect to risk management, portfolio allocation and security pricing. Extreme returns are important because they capture dimensions of equity market dynamics that are ignored by traditional asset pricing models. Highly negative returns are related with the concept of downside risk whereas highly positive returns are a means to capture the preferences of investors for positively skewed return distributions. In order to achieve the project’s objective, both firm-level and market-level data for equity returns and potential determinants of stock market movements have been collected from more than 50 countries. State-of-the-art econometric techniques have been used to analyze whether extreme returns are determinants of stock market returns.
The first part of the project investigates the relation between downside risk and expected returns on the aggregate stock market in an international context. Nonparametric and parametric value at risk are used as measures of downside risk to determine the existence of a risk-return tradeoff. For emerging markets, fixed-effects panel data regressions provide evidence for a significantly positive relationship between monthly expected market returns and downside risk. This result is robust after controlling for aggregate dividend yield and price-to-fundamental ratios. The relationship between expected returns and downside risk is weaker for developed markets and vanishes when control variables are included in the specification.
The second part of project investigates whether equity indices of 24 emerging and 28 developed markets compensate their investors equally after taking risk into account and examines the predictive power of reward-to-risk ratios for expected market returns. Again, special emphasis is placed on downside risk by calculating both nonparametric and parametric value at risk. When all 52 markets are ranked based on their alternative reward-to-risk ratios, almost all of the countries in the top quartile are emerging markets whereas almost all of the countries in the bottom quartile are developed markets. The pooled means of the reward-to-risk ratios are significantly higher for emerging markets compared to those of developed markets. The analysis also reveals that there is a significantly positive relation between various reward-to-risk metrics and expected market returns. Both portfolio analysis and cross-sectional regressions are utilized to examine this relation.
The importance of downside risk for equity returns especially in emerging markets and the fact that emerging markets have been historically more generous in rewarding investors after adjusting for risk has implications regarding the investment behaviors of financial market participants.
The first part of the project investigates the relation between downside risk and expected returns on the aggregate stock market in an international context. Nonparametric and parametric value at risk are used as measures of downside risk to determine the existence of a risk-return tradeoff. For emerging markets, fixed-effects panel data regressions provide evidence for a significantly positive relationship between monthly expected market returns and downside risk. This result is robust after controlling for aggregate dividend yield and price-to-fundamental ratios. The relationship between expected returns and downside risk is weaker for developed markets and vanishes when control variables are included in the specification.
The second part of project investigates whether equity indices of 24 emerging and 28 developed markets compensate their investors equally after taking risk into account and examines the predictive power of reward-to-risk ratios for expected market returns. Again, special emphasis is placed on downside risk by calculating both nonparametric and parametric value at risk. When all 52 markets are ranked based on their alternative reward-to-risk ratios, almost all of the countries in the top quartile are emerging markets whereas almost all of the countries in the bottom quartile are developed markets. The pooled means of the reward-to-risk ratios are significantly higher for emerging markets compared to those of developed markets. The analysis also reveals that there is a significantly positive relation between various reward-to-risk metrics and expected market returns. Both portfolio analysis and cross-sectional regressions are utilized to examine this relation.
The importance of downside risk for equity returns especially in emerging markets and the fact that emerging markets have been historically more generous in rewarding investors after adjusting for risk has implications regarding the investment behaviors of financial market participants.