Volume 8, No. 3, Third Quarter 2010

The Asset Growth Effect in Stock Returns

by: Michael J. Cooper, Huseyin Gulen and Michael J. Schill

We document a strong negative relationship between the growth of total firm assets and subsequent firm stock returns using a broad sample of U.S. stocks. Over the past 40 years, low asset growth stocks have maintained a return premium of 20% per year over high asset growth stocks. The asset growth return premium begins in January following the measurement year and persists for up to five years. The firm asset growth rate maintains an economically and statistically important ability to forecast returns in both large capitalization and small capitalization stocks. In the cross-section of stock returns, the asset growth rate maintains large explanatory power with respect to other previously documented determinants of the cross-section of returns (i.e., size, prior returns, book-to-market ratios). We conclude that risk-based explanations have some difficulty in explaining such a large and consistent return premium.

A Bayesian Approach to Stress Testing and Scenario Analysis

by: Riccardo Rebonato

I present a new approach to stress testing that combines the elicitation of subjective (marginal or conditional) probabilities of events with the specification of a simple causal structure among them. By so doing, stress events are placed in an approximate but coherent probabilistic framework. The approach only requires the risk manager to provide simple and cognitively resonant input probabilities. The techniques of linear programming and Bayesian nets then ensure the consistency of the subjective inputs and facilitate the derivation of the desired joint probabilities.

Do Informed Investors Cause Momentum?

by: James H. Scott and Jorge A. Murillo

We show that there will be expected momentum in stock returns if there are informed and uninformed investors, and if informed investors know the mean of the stocks future fundamental value. We use analysts estimates to construct a truncated valuation formula and find not only that stock prices mimic current changes in value, but anticipate future changes in value, as predicted by the theory. This relationship in price and value occurs in periods before and after the momentum ranking period. Although the theory does not predict price reversals, we find that reversals fundamental values are associated with price reversals.

The Libor/SABR Market Models: A Critical Review

by: Sanjay K. Nawalkha

This paper reviews the LIBOR market model (LMM) and the LMM-SABR model. While a plethora of interest rate models, such as fundamental models, single-plus models, double-plus models, and triple-plus models, can be used for valuation of plain vanilla derivatives, only a few models such as the LMM and the LMM-SABR have been proposed as models that can hedge plain vanilla derivatives as well as value complex interest rate derivatives. However, given that LMM and LMM-SABR models are triple-plus models, they are calibrated to market prices by allowing timeinhomogeneous volatilities, and by changing numerous model inputs period by period. Changing the model period by period and using time-inhomogeneous volatilities make risk-return analysis impossible under the physical measure. Further, this paper demonstrates that the LMM-SABR model is based on the highly questionable assumption of zero drifts for the volatility processes (under the forward rate specific measures), which has no economic justification, and can lead to explosive behavior for volatilities. We suggest high-dimensional affine and quadratic models that use fast analytical approximations (such as the Fourier inversion method and the cumulant expansion method) for pricing caps and swaptions, as alternatives to the LMM and the LMM-SABR model.

An Improved Implied Copula Model and Its Application to the Valuation of Bespoke CDO Tranches

by: John Hull and Alan White

In Hull and White (2006) we showed how CDO quotes can be used to imply a probability distribution for the hazard rate over the life of the CDO. This is known as the implied copula model. In this paper we develop a parametric version of the implied copula model and show how it can be used for valuing bespoke CDOs. A two-parameter version of the model is a simple and appealing alternative to the Gaussian copula model. One of the parameters in this model is used to match spreads. The other can be implied from tranche quotes and is much less variable across the capital structure than base correlation. Both homogeneous and heterogeneous versions of the model are presented and the differences between the results obtained from these two versions of the model are examined. Results are also presented for the situation where hazard rates are driven by more than one factor.

Momentum Stocks

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

This Time is Different: Eight Centuries of Financial Crisis

by: Carmen M. Reinhart and Kenneth S. Rogoff • reviewed by: Bruce Grantier

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Practitioner’s Digest • Vol. 8, No. 3

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.