High Sharpe Ratios

Paper Session

Saturday, Jan. 7, 2017 8:00 AM – 10:00 AM

Sheraton Grand Chicago, Sheraton Ballroom IV
Hosted By: American Finance Association
  • Chair: Alexi Savov, New York University

How should investors respond to increases in volatility?

Alan Moreira
,
Yale University
Tyler Muir
,
Yale University

Abstract

They should reduce their equity position. We study the portfolio problem of a long-horizon investor that allocates between a risk-less and a risky asset in an environment where both volatility and expected returns are time-varying. We find that investors, regardless of their horizon, should substantially decrease risk exposure after an increase in volatility. Ignoring variation in volatility leads to large utility losses (on the order of 35\% of lifetime utility). The utility benefits of volatility timing are larger than those coming from expected return timing (i.e., from return predictability) for all investment horizons we consider, particularly when parameter uncertainty is taken into account. We approximate the optimal volatility timing portfolio and find that a simple two fund strategy holds: all investors choose constant weights on a buy-and-hold portfolio and a volatility timing portfolio that scales the risky-asset exposure by the inverse of expected variance. We then show robustness to cases where the degree of mean-reversion in stock returns co-moves with volatility over time.

Deviations from Covered Interest Rate Parity

Wenxin Du
,
Federal Reserve Board
Alexander Tepper
,
Columbia University
Adrien Verdelhan
,
Massachusetts Institute of Technology

Abstract

We find that deviations from the covered interest rate parity condition (CIP) imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. Furthermore, these deviations are higher at quarter ends, lower after taking into account balance sheet costs of wholesale dollar funding, co-move other near risk-free fixed income spreads, and are highly correlated with nominal interest rates. These empirical findings point to key frictions in financial intermediation and their interactions with international imbalances in the new regulatory environment during the post-Global Financial Crisis period.

A First Glimpse Into the Short Side of Hedge Funds

Jaewon Choi
,
University of Illinois-Urbana-Champaign
Neil Pearson
,
University of Illinois-Urbana-Champaign
Shastri Sandy
,
Brattle Group

Abstract

We provide direct evidence about the profitability of hedge fund short trades in equities. We identify the opening and closing of equity short sales (and long side trades) by hedge funds and other institutional investors by combining data on the detailed transactions and holdings of the investors. Hedge fund short sales covered within five trading days are highly profitable, earning an average abnormal return of 14 bps per day, but short positions kept open longer than five days are not profitable. In contrast, non-hedge fund institutional investors do not make profits but rather tend to suffer losses on their short trades. Additional evidence suggests that some of the profitability of short trades is due to information and some stems from liquidity provision in both opening and covering trades, and that short selling profitability is persistent.
Discussant(s)
John Campbell
,
Harvard University
Pierre Collin-Dufresne
,
Swiss Federal Institute of Technology-Lausanne
Itamar Drechsler
,
New York University
JEL Classifications
  • G1 - Asset Markets and Pricing