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Investing Research Articles

Making Money with Options Based on Superior Volatility Forecasts

Are there systematic errors in market expectations about the future volatilities of individual stock prices? If so, what reliable strategy could a trader use to exploit these errors? In their August 2006 paper entitled “Option Returns and the Cross-Sectional Predictability of Implied Volatility”, Amit Goyal and Alessio Saretto examine the complete range of implied stock price volatilities for all U.S. equity options to devise an volatility forecasting model more efficient than that inherent in the market. They then test the model’s ability (out of sample) to identify outperforming options trading strategies that exploit this market inefficiency. Using daily data for all U.S. equity options over the period January 1996 to May 2005, they conclude that: Keep Reading

The Options Trading Landscape

How do individuals really trade in equity options? Do they mostly just buy speculative calls and protective puts? In their May 2006 paper entitled “Option Market Activity”, Josef Lakonishok, Inmoo Lee, Neil Pearson and Allen Poteshman examine actual option trading behaviors of firm proprietary traders (most sophisticated), customers of full-service brokers (including hedge funds?) and customers of discount brokers (least sophisticated). Using a unique dataset with detailed purchase-write and open-close transaction information for each equity option series listed by the Chicago Board Options Exchange (CBOE) from 1990 through 2001, they conclude that: Keep Reading

Are Individual Investors Entrepreneurs? If So…

Is success as an entrepreneur all luck, or is there a provable contribution from skill? Do winners win just because they are willing to roll the dice, or because they consistently bring innovative insights to the market? In their July 2006 paper entitled “Skill vs. Luck in Entrepreneurship and Venture Capital: Evidence from Serial Entrepreneurs”, Paul Gompers, Anna Kovner, Josh Lerner and David Scharfstein pit skill against luck by investigating the persistence of success among serial entrepreneurs. Focusing on the founders of companies listed by Venture Source as recipients of venture capital during the period 1975-2000, they conclude that: Keep Reading

Diminishing Returns from Hedge Funds? Or Not?

Has dramatic growth and proliferation of hedge funds used up all the alpha, or do opportunities for excess returns still abound? In their October 2006 paper entitled “Net Inflows and Time-Varying Alphas: The Case of Hedge Funds”, Andrea Beltratti and Claudio Morana investigate whether dramatic asset growth has eroded the performance of hedge fund managers. Their analysis encompasses the following categories of hedge funds: convertible arbitrage (CA – 8%), dedicated short bias (DSB – 1%), emerging markets (EM – 4%), equity market neutral (EMN – 7%), event driven (ED – 17%), fixed income arbitrage (FIA – 7%), global macro (GM – 11%), long/short equity (LSE – 32%), managed futures (MF – 5%). The percentages indicate the share of total hedge fund assets by category as of December 2005. Using quarterly fund net returns and asset flows and appropriate return benchmarks for each fund category over the period 1994-2005, they conclude that: Keep Reading

Predicting Stock Returns Using Accounting Fundamentals

Which accounting data is most important in predicting future stock returns? In their July 2006 paper entitled “How Do Accounting Variables Explain Stock Price Movements? Theory and Evidence”, Peter Chen and Guochang Zhang test the predictive power of a model that combines the discount rate with four indicators of company cash flow: (1) earnings yield; (2) capital investment; (3) changes in profitability; and, (4) changes in growth opportunities. Earnings yield indicates current cash flow generation, while the other three factors indicate future changes in cash flow generation. Using annual company-level accounting data and analyst growth forecasts for cash flow indicators (27,897 firm-year observations over the period 1983-2001) and the yield on 10-year Treasury notes for the discount rate, they conclude that: Keep Reading

An Equity Risk Premium Opus

What excess return have you gotten, do you expect, should you require, does the market imply for taking the risk of owning stocks? In his September 2006 paper entitled “Equity Premium: Historical, Expected, Required and Implied”, Pablo Fernandez addresses all these questions in a comprehensive overview/history and analysis of the equity risk premium in the U.S. and other countries. He begins with definitions of four perspectives on the equity premium, the first equal for all investors and the other three varying among investors: Keep Reading

Sell Risk to Growth Investors and Buy It from Value Investors?

Are value (growth) investors stolid conservatives (wild risk-takers)? If so, is there a way to trade on the difference in behavioral preferences? In their September 2006 paper entitled “Risk Aversion and Clientele Effects”, Douglas Blackburn, William Goetzmann and Andrey Ukhov compare the risk preferences of value and growth investors by examining: (1) option prices for pairs of value-growth indexes, and (2) funds flows for value and growth mutual funds. They further investigate whether any profitable options trading strategies devolve from the difference in risk preferences. Using recent data for five value-growth index pairs and for several value and growth mutual funds, they find that: Keep Reading

International Diversification with Small Stocks: A Two-fold Size Effect

Are there diversification and return advantages from getting off the beaten path (to small-capitalization stocks) when diversifying internationally? In their September 2006 paper entitled “International Diversification with Large- and Small-Cap Stocks”, Cheol Eun, Wei Huang and Sandy Lai compare the benefits of using large-capitalization and small-capitalization stocks to diversify across countries. Taking the perspective of a dollar-based investor, they examine diversification across ten countries with open capital markets (Australia, Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands, the United Kingdom and the United States). Using monthly size and return data for three market capitalization-based funds (large-cap, mid-cap and small-cap) for each country over the period 1980-1999, they conclude that: Keep Reading

Measuring Investor/Trader Risk Aversion

Does a willingness to pay more or less for options than indicated by recent actual levels of stock return volatility reflect the current level of investor/trader risk aversion? In other words, does the gap between option-implied and historical stock return volatilities provide a tradable measure of fearfulness? In the September 2006 draft of their paper entitled “Expected Stock Returns and Variance Risk Premia”, Tim Bollerslev, George Tauchen and Hao Zhou investigate the predictive power of the implied-historical volatility gap for future stock returns. Using monthly data for the S&P 500 index (VIX for implied volatility and a summation of five-minute squared returns for historical volatility) for the period 1990-2005, they find that: Keep Reading

The Timing (In)Ability of Mutual Fund Investors

Do mutual fund investors move their money into and out of the stock market at the right times, or the wrong times? In their August 2006 paper entitled “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability”, Geoffrey Friesen and Travis Sapp examine the flows of funds to/from individual mutual funds to measure the timing ability of fund investors. They define a “performance gap” between the time-weighted (buy-and-hold) return and the dollar-weighted (actual investor average) return as the measure of investor timing ability. Using monthly data for 7,125 mutual funds over the period 1991-2004, they find that: Keep Reading

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