rational international investment

Rational International InvestmentRational International Investment

Campbell R. Harvey, Ph.D.,Professor,

Duke Universityhttp://www.duke.edu/~charvey

WHU Campus for Finance“Rationality of Stock Markets and Empirical Finance”

January 2003

The PlanThe Plan

• Returns, diversification and predictability• Long horizon vs. short horizon• Expected performance• Prospect theory or skewness preference?• Importance of GPRs• The stock markets play a role in the world economy

0% 5% 10% 15% 20% 25%

Volatility(May 1986 to June 2002)

One Year Treasury STRIP

Two Year STRIP

Five Year Treasury STRIP

Seven Year Treasury STRIP

Ten Year Treasury STRIP

Twenty Year Treasury STRIPThirty Year Treasury STRIP

MBS Credit

AggregateGovernment

Three Year Treasury STRIP

Wilshire Small Cap

Wilshire 5000Wilshire Large Cap

Wilshire Mid Cap

EAFE X-Japan

International Performance

The International Track RecordThe International Track Record

Source: Erb and Harvey (2002)

GermanyEAFE

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

land UK US

Expansion geometric mean Recession geometric mean

Average Annual Returns During U.S. Business Cycle Phases

Returns and DiversificationReturns and Diversification

Data from MSCI

Bahrai

Brazil

Colombia

Greece

Hungary

Indones

Nigeri

Pakist

Philippin

Poland

Russia

Saudi A

Slovak

South A

Sri Lan

Taiwan

Thailan

Turkey

Zimbab

Composite

Expansion geometric mean Recession geometric mean

Average Returns During U.S. Business Cycle Phases

AnnualReturnU.S. $

Data from IFC

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

UK USW

Expansion std.dev. Recession std.dev.

Average Annual Volatility During U.S. Business Cycle Phases

Data from MSCI

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

UK USW

Expansion correlation with US Recession correlation with US

Correlations During U.S. Business Cycle Phases

Data from MSCI

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

Expansion covariance with US Recession covariance with US

Covariances During U.S. Business Cycle Phases

Data from MSCI

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

US+ geometric mean US- geometric mean

Average Returns During U.S. Up and Down Markets

Data from MSCI

Bahrai

Brazil

Colombia

Greece

Hungary

Indones

Nigeri

Pakist

Philippin

Poland

Russia

Saudi A

Slovak

South A

Sri Lan

Taiwan

Thailan

Turkey

Zimbab

Composite

US+ geometric mean US- geometric mean

Average Returns During U.S. Up and Down Markets

AnnualReturnU.S. $

Data from IFC

US Business Cycle is PredictableUS Business Cycle is Predictable

US Yield Curve Inverts Before Last Six US Recessions(5-year US Treasury bond - 3-month US Treasury bill)

8 % Real annual GDP growth

Yield curve

RecessionCorrect 2 Recessions

Correct

RecessionCorrect Yield curve accurate

in recent forecast

RecessionCorrect

Annual GDP growthor Yield Curve

Data though 1/12/03

Evolution of Correlation with U.S.

19701972

19741976

19781980

19821984

19861988

19901992

19941996

19982000

Corr(WorldXUS, US) Corr(IFC,US)

Data from IFC and MSCI

Source: Goetzmann, Li and Rouwenhorst (2002)

1860 1880 1900 1920 1940 1960 1980 2000

Core Markets Total Available Markets

The Long HorizonThe Long Horizon

100 Years of Real Equity Returns

Australi

Belgiu

Denmark

France

German

Irelan

Netherl

South A

Sweden

Data from Dimson, Marsh and Stauton (2002)

100 Years of Real Equity Returns

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

U.S. equity World X-US equity

100 Years of Real Bond Returns

Australi

Beligum

Denmark

France

German

Irelan

Netherl

South A

Sweden

100 Years of Real Bond Returns

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

U.S. World X-US

What to ExpectWhat to Expect

Dividend Yields Correlated With Future Returns

1900 Yield 2000 Yield

Price Earnings Ratios

Dec-99 Dec-02

Data from MSCI. Japan divided by 10.

Price to Trailing Peak Earnings vs 5 Year Average CPI(overlapping annual data)

Source: Bloomberg, Standard & Poor’s

-10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

1996-2001

5 yr Average CPI

(1920- August 2002)

Current environment:Inflation: 2.3%P/E: 24.7x January 2003

Source: Goldman Sachs (2002)

• Ten-year risk premium around 3.5% and stable whereas one-year risk premium quite variable

6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-017-Jun-01 10-Sep-01 4-Dec-01 11-Mar-024-Jun-02 16-Sep-02 2-Dec-02

10-year premium 1-year premium

Source: Graham and Harvey (2003)

y = 0.794x + 0.0791

R2 = 0.167

-15.00%

-10.00%

-5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00%

Rolling Five Year Long Term Bond Return(June 1932 to June 2002)

U.S. Equity and Bond Returns are Positively Correlated

World Real Equity and Real Bond Returns are Positively Correlated

y = 0.6783x + 4.815

R2 = 0.3984

-40 -30 -20 -10 0 10 20

Ten Year Real Bond Return

Inflation Negatively Related to Real US Bill Returns

y = -0.7078x + 0.0294

R2 = 0.5373

-20.0%

-15.0%

-10.0%

-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Inflation

Inflation Negatively Related to Real US Intermediate Bond Returns

y = -0.9873x + 0.0545

R2 = 0.3639-20.0%

-15.0%

-10.0%

-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Inflation

Inflation Negatively Related to Real US Bond Returns

y = -1.3027x + 0.0664

R2 = 0.2767-30.0%

-20.0%

-10.0%

-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Inflation

Inflation Negatively Related to Real US Equity Returns

y = -1.1054x + 0.1299

R2 = 0.0546

-60.0%

-40.0%

-20.0%

-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Inflation

Inflation Negatively Related to Real International Bill Returns

y = -0.9226x + 4.7819

R2 = 0.8021

0 1 2 3 4 5 6 7 8 9 10

100 Year Inflation Rate

Inflation Negatively Related to Real International Bill Returns

y = -0.6731x + 3.9725

R2 = 0.6097

0 1 2 3 4 5 6 7 8 9 10

Inflation Negatively Related to Real International Equity Returns

y = -0.6333x + 8.3176

R2 = 0.4935

0 1 2 3 4 5 6 7 8 9 10

Inflation Negatively Related to Real International Equity Returns

y = -0.9226x + 4.7819

R2 = 0.8021

y = -0.6731x + 3.9725

R2 = 0.6097

y = -0.6333x + 8.3176

R2 = 0.4935

0 1 2 3 4 5 6 7 8 9 10

Real Bill Real Bond Real Equity

Rethinking RiskRethinking Risk

• Traditional models maximize expected returns for some level of volatility

• Is volatility a complete measure of risk?

• Much interest in prospect theory, downside risk, asymmetric volatility, semi-variance, extreme value analysis, regime-switching, jump processes, ...

• In prospect theory (Kahneman and Tversky)– Investor risk averse in the case of gains, as a

small certain gain is preferred to a probable risky gain

– Investor risk seeking in the case of losses, as a probable risky loss is preferred to a small certain loss

• So investors do not evaluate outcomes based on true probabilities

• Loss aversion is a special case– Investor has a greater incremental utility

penalty for losses than for an equally large gain– Overall, investor looks risk averse

• But, perhaps we can think of these situations in terms of preference for higher moments

• Most asset allocation work operates in two dimensions: mean and variance -- but skew is important for investors.

• Examples:

1. The $1 lottery ticket. The expected value is $0.45 (hence a -55%) expected return.– Why is price so high? – Lottery delivers positive skew, people like

positive skew and are willing to pay a premium

2. High implied vol in out of the money OEX put options.– Why is price so high? – Option limits downside (reduces negative

skew).– Investors are willing to pay a premium for

assets that reduce negative skew– Is this loss aversion or skewness preference?

3. Some stocks that trade with seemingly “too high” P/E multiples– Why is price so high? – Enormous upside potential (some of which is

not well understood)– Investors are willing to pay a premium for

assets that produce positive skew– [Note: Expected returns could be small or

negative!]

Variance

Skewness

Expected Return

Variance

Source: Harvey and Siddique (2000)

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

land UK US

Average Skewness in Developed Markets

Data from MSCI

Bahrai

Brazil

Colombia

ublicEgy

Greece

Nigeria

Pakist

Philipp

Poland

Russia

Arabia

Slovak

Africa

Sri Lan

Thaila

Average Skewness in Emerging Markets

Data from IFC

Australi

Austria

Finlan

France

Hong K

Irelan

Nether

Norway

Portugal

Switzer

land UK US

Average Excess Kurtosis in Developed Markets

Data from MSCI

Bahrai

Brazil

Colombia

ublicEgy

Greece

Nigeria

Pakist

Philipp

Poland

Russia

Arabia

Slovak

Africa

Sri Lan

Thaila

Average Excess Kurtosis in Emerging Markets

Data from IFC

Alternative VehiclesAlternative Vehicles

Alternate Asset Classes Often Involve Implicit or Explicit Options

-4-3-2-101234567

1 2 3 4 5

S&P 500Global Macro

Source: Agarwal and Naik (2002)

1 2 3 4 5

S&P 500Trend Followers

-4-3-2-101234567

1 2 3 4 5

S&P 500FI Arb

1 2 3 4 5

Delta(BAA-10yTBond)x10FI Arb

Panel B: PRAM Returns, 1990 - 1998

Market Return minus Risk-free Rate

-.2 -.16 -.12 -.08 -.04 0 .04 .08 .12 .16 .2

97109004

94069805

98079203

9402920892069409

93119010

961295109109

9606900692019702930791049309

98019306

93029205

9404960394129210

96109301951292029204

96059303

96019103

950697119305

96089505

980695099502

91059507

93089207

970691079101

970598029810

91029707

90059112

Source: Figure 5 from Mitchell & Pulvino (2000)

-15 -10 -5 0 5 10

Russell 3000 Index Returns

LOWESS fit

Skewness has potential to explain one of the unsolved anomalies in finance: the profitability of momentum trading

y = -5.3067x + 24.869

R2 = 0.5934

0 0.5 1 1.5 2 2.5 3

Momentum portfolios

•Harvey, Liechty, Liechty and Müller (2002) “Portfolio Selection with Higher Moments” provide a new approach to portfolio selection which accounts for:

Higher momentsEstimation errors in the inputs

The Evolution of World RiskThe Evolution of World Risk

• The U.S. has become much more risky– High sensitivity to some GPRs– Disagreement on strength of economy– Financial information less credible

The Evolution of World RiskThe Evolution of World Risk ICRG Political Risk

Data from PRS

Oct-01

Oct-02

Equally-weighted world G-7xUS Switzerland United States

Data from PRS

Oct-01

Oct-02

Equally-weighted world Japan Switzerland United States

Data from PRS

EW world Japan Germany Switzerland United States

Risk Ratings December 2002

Data from PRS

Luxembourg 94.5 Netherlands 88.5 Bahamas 84.5Finland 94.0 Singapore 88.5 Spain 83.0Ireland 92.5 Portugal 87.5 Hungary 82.5Switzerland 92.5 Australia 87.0 France 81.0Iceland 92.0 Belgium 87.0 Italy 81.0Sweden 91.5 Japan 87.0 Slovenia 81.0Denmark 91.0 United Kingdom 87.0 Brunei 80.5New Zealand 91.0 Malta 86.5 United States 80.0Austria 90.5 Canada 86.0 Bahrain 79.5Norway 90.0 Germany 86.0 Poland 79.5

Risk Ratings May 2001

Netherlands 96.5 Portugal 90.0 Chile 81.0Finland 95.0 Norway 90.0 Slovak Rep. 81.0Luxembourg 95.0 Singapore 89.5 Uruguay 81.0Denmark 93.5 Germany 88.0 Brunei 80.5Iceland 93.0 Japan 88.0 France 80.0Sweden 93.0 Australia 87.0 Qatar 80.0Switzerland 93.0 Belgium 87.0 U.A.E. 80.0United Kingdom 92.5 Malta 87.0 Hong Kong 79.5Canada 91.0 Bahamas 84.5 Poland 79.5Ireland 90.5 Costa Rica 83.5 Botswana 79.0New Zealand 90.5 Italy 83.0 Cyprus 79.0Austria 90.0 Spain 82.0 Czech Rep. 79.0United States 90.0 Slovenia 81.5 Greece 79.0

Data from PRS

R2 = 0.2976

0 10 20 30 40 50 60 70 80 90 100

II Rating

Higher risk means equity investors require a higher rate of return

Risk Ratings from Institutional Investor

• Equation implies an increase in the medium-term risk premium– This helps explain the recent decline in the

equity market– This helps explain the recent behavior of the

U.S. dollar– This helps explain the slow down in real

investment (hurdle rates are up)

• Efficiently functioning stock markets make a difference in the real economy– There is now substantial cross-country evidence

on the impact of stock market development on the real economy

Stock Markets and the Real EconomyStock Markets and the Real Economy

• Market integration has a fundamental influence on asset prices

Prices

High Expected Announcement Implementation Low ExpectedReturns of Liberalization Returns

Segmented Integrated

Asset Prices and Market Integration

Return to Integration

0.60Pre Post

Average Annual Geometric Returns

-0.10-0.050.000.050.100.150.200.250.300.350.400.45 Pre Post

Correlation with World

Implications

• Lower cost of capital

• More investment, employment

• More economic growth

Geert Bekaert, Campbell Harvey and Chris Lundblad, Does Financial Liberalization Spur Growth?

• Not just an emerging markets effect: Euro also increased integration

Findings

• Liberalization increases real growth by 1% per year for five years – which is a large number

• The liberalization effect is robust to– different definitions of liberalization dates– to business cycle or interest rate controls– allowing for intensity of liberalization

...and independent of capital account liberalization

Findings

• We control » macroeconomic reforms» financial development» other regulatory reforms

...and effect is intact

But is there a cost?

• Foreign speculators• Economic crises• Irrational contagion

• Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others)– One can always point to a particular country to support

this idea– What about looking at a broad cross section?

Geert Bekaert, Campbell Harvey and Chris Lundblad, Growth Volatility and Equity Market Liberalization, 2002.

• No evidence that GDP growth volatility increases after markets open up

Standard Deviation of GDP Growth Rates1980-2000

ARGBRA

CHLGRC

NGAPAK

PHLVEN

PRTTUR

NZLESP

Average

Pre-liberalization Post-liberalization

• Predictability arises naturally from business cycle fluctuations – it need not be confused with irrationality

• While the research is very important, the case has not yet been made for widespread application of behavioral models

• Stock markets, in general, play a positive role – not just for investors and corporations – but the economy

ConclusionsConclusions

• My articles on www.duke.edu/~charvey– The Drivers of Expected Returns in International Markets (2000)– Global Tactical Asset Allocation (2001) with Magnus Dahlquist– The Term Structure of Equity Risk Premia (2002) with Claude Erb– Characterizing Systematic Risk of Hedge Funds with Buy-and-Hold

and Option-Based Strategies, (2002) Vikas Agarwal and Naranyan Y. Naik

– Portfolio Selection with Higher Moments, with John Liechty, Merrill Liechty, and Peter Müller

– Does Financial Liberalization Spur Growth? with Geert Bekaert, and Chris Lundblad

– Growth Volatility and Equity Market Liberalization with Geert Bekaert, and Chris Lundblad

ReadingsReadings

rational international investment

real us bond returnssource

real us bill returnssource

real us equity returnssource

real bond returns

month us treasury bill

expectworld real equity

expecttenyear risk premium

long horizondata

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