http://repub.eur.nl/res/aut/2900/ List of Publications en http://repub.eur.nl/static-eur/img/logo.png http://repub.eur.nl http://repub.eur.nl/res/pub/22283/ 2011-02-01T00:00:00Z Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates. http://repub.eur.nl/res/pub/21024/ 2010-10-01T00:00:00Z Abstract Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates. http://repub.eur.nl/res/pub/13885/ 2008-03-01T00:00:00Z Increasing correlation during turbulent market conditions implies a reduction in portfolio diversification benefits. We investigate the robustness of recent empirical results that indicate a breakdown in the correlation structure by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the increase in conditional correlation could be a result of assuming conditional normality for the return distribution. When assuming a popular alternative distribution – the bivariate Student-tr – we find significantly less support for an increase in conditional correlation and conclude that this is due to the presence of fat tails when assuming normality in the return distribution. http://repub.eur.nl/res/pub/10774/ 2007-12-07T00:00:00Z We review Irving Fisher’s seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are connected to individual episodes in which errors surrounding exchange rate expectations are persistent, but eventually transitory. We find considerable commonality in deviations from UIP and PPP, suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model, we find that deviations from UIP are almost entirely due to expectational errors in exchange rates, rather than attributable to the risk premium; a result consistent with those reported by Fisher a century ago. http://repub.eur.nl/res/pub/12677/ 2007-08-01T00:00:00Z Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper, we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favor of the Student’s t copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the Student’s t copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant. http://repub.eur.nl/res/pub/12668/ 2006-09-11T00:00:00Z Copulas offer financial risk managers a powerful tool to model the dependence between the different elements of a portfolio and are preferable to the traditional, correlation-based approach. In this paper we show the importance of selecting an accurate copula for risk management. We extend standard goodness-of-fit tests to copulas. Contrary to existing, indirect tests, these tests can be applied to any copula of any dimension and are based on a direct comparison of a given copula with observed data. For a portfolio consisting of stocks, bonds and real estate, these tests provide clear evidence in favor of the \\studt copula, and reject both the correlation-based Gaussian copula and the extreme value-based Gumbel copula. In comparison with the \\studt copula, we find that the Gaussian copula underestimates the probability of joint extreme downward movements, while the Gumbel copula overestimates this risk. Similarly we establish that the Gaussian copula is too optimistic on diversification benefits, while the Gumbel copula is too pessimistic. Moreover, these differences are significant. http://repub.eur.nl/res/pub/12613/ 2006-08-01T00:00:00Z Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton [Merton, R.C., 1969. Lifetime portfolio selection under uncertainty: The continuous time case. Review of Economics and Statistics 51, 247–257]-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to the crisis prone emerging markets. http://repub.eur.nl/res/pub/16938/ 2006-02-01T00:00:00Z Introduction [by way of abstract] Two decades ago exchange-rate economics seemed to be in total shambles. That, however, did not last long. Science proceeds by successive approximations and in the intervening years the foreign exchange market became one of the most heavily researched areas in economics. The first wave of findings to come out of this new research concerned the centuries-old theoretical construct of purchasing power parity, and, relatedly, the behavior of real exchange rates. Here the consensus gradually shifted from the widespread view that PPP had collapsed to the view that it was, in fact, a 'useful empirical first empirical approximation' in the long-run, as Lothian and Taylor (1996) put it. In an introduction to the JIMF conference issue on exchange-rate modeling published in 1998, one of us wrote (Koedijk, 1998)1: 'Ten years of data and estimation techniques later the outlook is less bleak. At least in the medium-run a predictable relationship between exchange rates and economic fundamentals has re-emerged and reintroduced tempered optimism in exchange rate economics.'... http://repub.eur.nl/res/pub/7173/ 2005-12-19T00:00:00Z This paper analyzes the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates. http://repub.eur.nl/res/pub/12671/ 2005-08-07T00:00:00Z Systemic crises can have grave consequences for investors in international equity markets, because it causes the risk-return trade-off to deteriorate severely for a longer period. In this paper we propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton (1969)-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises has a large impact on asset allocation decisions, while the costs of ignoring such crises are substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to emerging markets, being most prone to a crisis. An investor facing short selling constraints withdraws completely from equity markets if the likelihood of a crisis increases. http://repub.eur.nl/res/pub/1923/ 2005-02-01T00:00:00Z In this paper we present the results of an international survey among 313 CFOs on capital structure choice. We document several interesting insights on how theoretical concepts are being applied by professionals in the U.K., the Netherlands, Germany, and France and we directly compare our results with previous findings from the U.S. Our results emphasize the presence of pecking-order behavior. At the same time this behavior is not driven by asymmetric information considerations. The static trade-off theory is confirmed by the importance of a target debt ratio in general, but also specifically by tax effects and bankruptcy costs. Overall, we find remarkably low disparities across countries, despite the presence of significant institutional differences. We find that private firms differ in many respects from publicly listed firms, e.g. listed firms use their stock price for the timing of new issues. Finally, we do not find substantial evidence that agency problems are important in capital structure choice. http://repub.eur.nl/res/pub/1834/ 2004-12-22T00:00:00Z European banking regulation has been harmonized to a high degree over the last few decades. Nevertheless, the European banking industry remains fragmented as shown by the relatively high market shares of banks in their home countries. In this paper we concentrate on the integration process of European bank share prices. We develop a parsimonious model that is able to detect different integration (correlation) regimes. The model is applied to a set of 41 European banks that have a continuous share price listing over the period January 1990 – March 2003. Our main finding is that the correlation between larger banks in Europe has increased substantially over this period, whereas the correlation between smaller banks has become lower. A reason for this result could be that investors perceive that the activities of bigger banks get more integrated. Another reason may be that as a result of institutional and other larger investors turning their investment strategies towards a European sector-based approach, investors are tracking indices of the European banking sector. These indices are typically constructed from the stock prices of the larger banks. This would create an incentive for large banks to become more integrated with other large banks. http://repub.eur.nl/res/pub/16942/ 2004-11-01T00:00:00Z This paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973–2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the ‘‘synthetic’’ euro against several other major currencies over the period 1979–2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area. http://repub.eur.nl/res/pub/1442/ 2004-08-06T00:00:00Z This paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the “synthetic” euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area. http://repub.eur.nl/res/pub/1296/ 2004-06-04T00:00:00Z There exists a widespread consensus among mainstream academics and investors that socially responsible investing (SRI) leads to inferior, rather than superior, portfolio performance. Using Innovest’s well-established corporate ecoefficiency scores, we provide evidence to the contrary. We compose two equity portfolios that differ in eco-efficiency characteristics and find that our highranked portfolio provided substantially higher average returns compared to its low-ranked counterpart over the period 1995-2003. Using a wide range of performance attribution techniques to address common methodological concerns, we show that this performance differential cannot be explained by differences in market sensitivity, investment style, or industry-specific components. We finally investigate whether this eco-efficiency premium puzzle withstands the inclusion of transaction costs scenarios, and evaluate how excess returns can be earned in a practical setting via a best-in-class stock selection strategy. The results remain significant under all levels of transactions costs, thus suggesting that the incremental benefits of SRI can be substantial. http://repub.eur.nl/res/pub/1270/ 2004-04-17T00:00:00Z Systemic crises can largely affect asset allocations due to the rapid deterioration of the risk-return trade-off. We investigate the effects of systemic crises, interpreted as global simultaneous shocks to financial markets, by introducing an investor adopting a crisis ignorant or crisis conscious strategy. Including the possibility of a systemic crisis is a substantial improvement. Investments in risky assets fall, while allocations to countries less sensitive to a crisis grow relatively. An increasing probability of a crisis exacerbates these effects. The certainty equivalent costs of ignoring systemic crises are large, ranging from 0.65% per year unconditionally, to over 5% per month conditionally on a high probability for the occurrence of a crisis. http://repub.eur.nl/res/pub/1111/ 2004-01-16T00:00:00Z In this paper we present the results of an international survey among 313 CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. We extend previous results of Graham and Harvey (2001) by broadening their sample internationally, by including corporate governance, and by applying multivariate regression analysis. We document interesting insights on how theoretical concepts are applied by professionals in the U.K., the Netherlands, Germany, and France and compare these results with the U.S. We discover compelling variations between large and small firms across all markets. While large firms frequently use present value techniques and the capital asset pricing model when assessing the financial feasibility of an investment opportunity, CFOs of small firms still rely on the payback criterion. Regarding debt policy we document more subtle disparities across firms and national samples. We also find substantial variation in corporate governance structures, which turn out to be more oriented at shareholder wealth in the Anglo-Saxon countries. Corporate finance practice appears to be influenced mostly by firm size, to a lesser extent by shareholder orientation, while national differences are weak at best. http://repub.eur.nl/res/pub/16939/ 2004-01-01T00:00:00Z This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross-listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980–99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France. http://repub.eur.nl/res/pub/16940/ 2004-01-01T00:00:00Z In the past two decades, analysts have observed increasing integration of international financial markets. Barriers to international investment among developed economies have slowly but steadily diminished. Hence, global risk factors are increasingly important for portfolio selection and asset pricing. Recent empirical evidence indicates, specifically, that global factors - notably, exchange rates - affect the pricing of stocks in industrialized countries. These developments suggest that an international capital asset pricing model (ICAPM) should be used for computing a company's cost of equity capital. Practitioners, however, predominantly use the single-factor domestic CAPM for estimating the cost of capital. We examine to what extent global factors make a difference in practical cost-of-capital computations... http://repub.eur.nl/res/pub/923/ 2003-09-24T00:00:00Z In this study we propose the use of the Student's t dependence function to model dependence between asset returns when conducting stress tests. To properly include stress testing in a risk management system, it is important to have accurate information about the (joint) probabilities of extreme outcomes. Consequently, a model for the behavior of risk factors is necessary, specifying the marginal distributions and their dependence. Traditionally, dependence is described by a correlation matrix, implying the use of the dependence function inherent in the multivariate normal (Gaussian) distribution. Recent studies have cast serious doubt on the appropriateness of the Gaussian dependence function to model dependence between extreme negative returns. The student's t dependence function provides an attractive alternative. In this paper, we introduce four tests to analyze the empirical fit of both dependence functions. The empirical results indicate that probabilities assigned to stress tests are largely influenced by the choice of dependence function. The statistical tests reject the Gaussian dependence function, but do not reject the Student's t dependence function. http://repub.eur.nl/res/pub/16943/ 2002-11-01T00:00:00Z This paper analyzes to what extent international and domestic asset pricing models lead to a different estimate of the cost of capital for an individual firm under the maintained assumption of perfect international financial integration. We distinguish between (i) the multifactor Solnik–Sercu ICAPM including both the global market portfolio and exchange rate risk premia, and (ii) the single factor domestic CAPM. We use a sample of 3,293 stocks from nine countries in the period 1980–1999. The domestic CAPM yields a significantly different estimate of the cost of capital from the multifactor ICAPM for only five percent of the firms in our sample. We attribute the close correspondence between local and global pricing to strong country factors in individual stock returns, which are probably due to lack of real integration. Our results reinforce the home bias puzzle. http://repub.eur.nl/res/pub/248/ 2002-10-29T00:00:00Z We examine the consequences of transparency in an experimental multiple-dealer market with asymmetrically informed dealers. Five professional securities traders make a market for a single security. In each trading round, one of the dealers (the "insider") is told the security's true value. We vary both pre-trade and post-trade transparency by changing the way quote and trade information is published. The insider's profits are greatest when price efficiency is lowest. Price efficiency, in turn, is reduced by pre-trade transparency and increased by posttrade transparency. Market liquidity, measured by dealers' bid-ask spreads, is improved by pre-trade transparency and reduced by post-trade transparency. http://repub.eur.nl/res/pub/249/ 2002-10-29T00:00:00Z International financial markets are becoming integrated. Hence, global risk factor are increasingly important for portfolio selection and asset pricing. The recent empirical finance literature has confirmed that both the global market portfolio and exchange rate risk factors constitute important determinants of asset returns. We show, however, that global risk factors do not importantly affect estimates of the cost of equity capital for a remarkably wide variety of companies. We analyze almost 3,300 stocks from nine industrialized countries over the period 1980-1999. Incorporating global factors into cost of capital estimations leads to an adjustment of roughly 50 basis points per annum on average for the U.S. and 70 to 100 basis points for the other countries. Adjustments of this magnitude easily fall inside the margin of error associated with actual cost of capital computations. Specifically for U.S. companies, the amendment of the cost of capital estimate is generally very small. This suggests that global risk factors do not really matter for computing the cost of capital of U.S. firms. http://repub.eur.nl/res/pub/250/ 2002-10-29T00:00:00Z This paper analyzes the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross-listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1983) and Sercu (1980) including both the global market portfolio and exchange rate risk premia, and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross-listed stocks from nine countries in the period 1980-1999. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12 percent of the cross-listed companies. The size of the cost of capital differential is around 50 basis points for the U.S., 80 basis points for the U.K., and 100 basis points for France. http://repub.eur.nl/res/pub/12391/ 2000-01-01T00:00:00Z A safety-first investor maximizes expected return subject to a downside risk constraint. Arzac and Bawa [Arzac, E.R., Bawa, V.S., 1977. Portfolio choice and equilibrium in capital markets with safety-first investors. Journal of Financial Economics 4, 277–288.] use the Value at Risk as the downside risk measure. The paper by Gourieroux, Laurent and Scaillet estimates the optimal safety-first portfolio by a kernel-based method, we exploit the fact that returns are fat-tailed, and propose a semi-parametric method for modeling tail events. We also analyze a portfolio containing the two stocks used by Gourieroux et al. and discuss the merits of the safety-first approach. http://repub.eur.nl/res/pub/12403/ 1998-01-01T00:00:00Z The discrete time analogue of the continuous time Krugman target zone model is developed in order to capture the typical volatility clusters and fat-tailed distributed innovations of exchange rates. It is shown that under these more general stochastic conditions the S-shaped relation between exchange rate and fundamentals is preserved, but is less pronounced. The model is tested for its S-shape and stochastic properties. Two clearly distinct sets of EMS currencies are detected on the basis of the curvature features. One-step-ahead realignment probabilities are used as an alternative evaluation method. http://repub.eur.nl/res/pub/16944/ 1998-01-01T00:00:00Z In this paper we investigate purchasing power parity (PPP) in a panel with 17 countries for the period 1972 through 1996. The novel feature of our panel methodology is that results are invariant to the choice of a benchmark on numeraire currency. In the panel we allow individual country effects in the relation between prices and exchange rates. In this way we can identify the currency pairs for which PPP holds or does not hold. We conclude that there is substantive evidence for PPP, although not to the same extent for every currency. Evidence in favor of PPP is strongest for many exchange rates relative to the Dmark, and weakest for the Japanese yen. For this currency a trend-like variable, like productivity growth, is missing. http://repub.eur.nl/res/pub/12411/ 1995-01-01T00:00:00Z This paper compares foreign exchange market intervention in case there is no uncertainty about the extent of an imperfectly sustainable target zone and where there is uncertainty. A well-known example of the first case was the European Monetary System between 1979 and 1992. An example of the latter is the dirty floating of the dollar against the Dmark and yen after the so-called Louvre Accord in 1987. The analysis shows that the instantaneous effectiveness of intervention tends to be larger the more implicit the band policy is. Our empirical results which use Belgian and US intervention data support this claim. http://repub.eur.nl/res/pub/12453/ 1993-01-01T00:00:00Z M et behulp van recent ontwikkelde wisselkoersmodellen is het mogelijk hetgedrag van wisselkoersen in een wisselkoersstelsel als het EMS te bestuderen. Aan de hand van geschatte devaluatiekansen laten de auteurs zien dat het EMS tot 1987 voor veel munten ongeloofwaardig was. Na 1987 nam de geloofwaardigheid substantieel toe, totdat de recente valutacrises het stelsel omverwierpen. Er zijn tot nog toe weinig aanwijzingen dat de nieuwe opzet van het EMS met fluctuatiemarges van 15% niet houdbaar is. Ook het vasthouden van de gulden aan de 2,25% bandbreedte ten opzichte van de Duitse mark lijkt atteszins gerechtvaardigd. http://repub.eur.nl/res/pub/12423/ 1992-01-01T00:00:00Z In the literature on the empirical unconditional distribution of foreign exchange rate returns there is indication that the type of distribution function is related to the form of exchange rate regime. The analysis has been hampered by the nonnestedness of alternative distribution models. The paper investigates the issue by means of extremal analysis which allows for a unified treatment. In particular, we try to sort out whether apparent distributional differences are due to differences in techniques or in regimes. http://repub.eur.nl/res/pub/12434/ 1990-01-01T00:00:00Z In the literature on the empirical distribution of foreign exchange rates there is now consensus that exchange rate yields are fat-tailed. Three problems, however, persist: (1) Which class of distribution functions is most appropriate? (2) Are the parameters of the distribution invariant over subperiods? (3) What are the effects of aggregation over time on the distribution? In this paper we employ extreme value theory to shed new light on these questions. We apply the theoretical results to EMS data.