Volume 16, No. 4, Fourth Quarter 2018

Explaining the High P/E Ratios: The Message from the Gordon Model

by: Heinz Zimmermann

Are the high valuation levels of equity prices, after controlling for the low interest rate level, driven by irrational exuberance and excessive growth expectations? The Gordon model helps for a consistent interpretation of commonly used valuation ratios. Overall, P/E ratios do not seem to be caused by irrational growth expectations, rather a decline can be observed over the past years. Discount rates are the major drivers of high valuation levels in Europe and particularly in Switzerland, while profitability is the major source in the US and Germany.

Time Aggregation of Sharpe Ratio A Better Extrapolation Rule

by: Ziemowit Bednarek, Pratish Patel and Cyrus Ramezani

The √T rule extrapolates a one-period Sharpe Ratio to T periods. But the rule ignores compounding. By considering compounding, Levy (1972) and others show that the Sharpe Ratio changes non-monotonically with horizon. We also theoretically and empirically show that the Sharpe Ratio term structure is hump-shaped and not upward sloping as the √T rule suggests. We offer a better extrapolation rule. Using bootstrapped Generalized method of Moments (GMM), we provide robust Sharpe Ratio estimates of several popular test assets. The empirical results reject the √T rule over a long horizon.

Trading Methods and Trading Costs for Agency Mortgage-Backed Securities

by: Pengjie Gao, Paul Schultz and Zhaogang Song

Investors can trade individual agency mortgage-backed securities (MBS) as specified pools (SPs), or trade them through TBA forward contracts. Sellers in the TBA market deliver the cheapest possible pool that fulfills the contracts, so they are traded on a cheapest to deliver basis. More valuable mortgage-backed securities are traded as SPs. We show that trading costs are far, far lower for TBA trades. Trading costs are lower for large trades, for trades with more active dealers, for trades of MBS with a large balance outstanding, and for trades where dealers act as brokers rather than commit capital.

Automation, Intermediation and the Flash Crash

by: Andrei Kirilenko, Albert S. Kyle, Mehrdad Samadi and Tugkan Tuzun

The Flash Crash of May 6, 2010, shook the confidence of market participants and raised questions about the market structure of electronic markets. In these markets, intraday intermediation has been increasingly provided by market participants without formal obligations to do so. We examine intraday intermediation in the E-mini S&P 500 stock index futures market before and during the Flash Crash. We also discuss the evolution of trading from human to electronic environments and the implications of our results for market design.

Illiquidity and Factor Returns: Exploring the Intersection Between Illiquidity, Small Cap and Popular Factors

by: Jason C. Hsu and Vivek Viswanathan

Factor returns are often reported as the average of factor returns among large stocks and the factor returns among small stocks. However, factor returns among small, illiquid stocks are significantly higher than those among larger, more liquid stocks, suggesting that the factor returns in the literature are exaggerated and cannot be implemented with substantial assets. Moreover, investors who are able to take greater liquidity risk can capture higher factor returns by investing in factors among small stocks.

The End of Theory

by: Richard Bookstaber • reviewed by: Savannah Smith

“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. 16, No. 4

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.

Risk, Reward, and Beyond: On the Behavioral Sensitivities of Mean–Variance Efficient Portfolios

by: Jürgen Vandenbroucke and Sanjiv Ranjan Das

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.