Academic finance round-up

31Jul07

In what may become a recurring feature here at Abnormal Returns we take a look at a handful of articles from academic finance that have earned our attention. This is by no means a comprehensive look at the goings on in academic finance, merely a quick flyover.

With all the attention being paid to the subprime mortgage mess and the attendant CDO blow-ups, it is only appropriate that there are some articles that address this space. Francis A. Longstaff and Arvind Raja have a paper entitled “An Empirical Analysis of the Pricing of Collateralized Debt Obligations” that explores the nature of default risk priced into CDOs.

Yves Smith at naked capitalism points to a recent paper by Darrell Duffie that explores the notion of “credit risk transfer” which includes the world of CDOs and CLOs. This paper also touches on the assumptions behind credit default correlation estimates.

One stylized fact we have mentioned from time to time on this site is that the reduction in macroeconomic risk over the past two decades (or so) has lead to lower capital market risk. Notably in the form of lower volatility. We now have a worthy citation for you. Lettau, Ludvisgon and Wachter, “The Declining Equity Premium: What Role Does Macroeconomic Risk Play?” In it they show a high correlation between macroeconomic and capital markets volatility.

No mention of academic finance would complete without a mention of CXO Advisory Group. Steve LeCompte does yeoman’s work ferreting out academic research that is highly relevant to individual and institutional investors alike. In a recent post he examined a paper that in a nutshell shows that common technical analysis rules show little profitability in trading commodity futures.

While we are skeptical of the wholesale use of piggyback or coattail investing by individuals it is becoming an ever more popular investing theme. Mebane Faber at World Beta points to a handful of articles that examine the performance of stock picks based on the best performing equity mutual funds.

In a related article by Aneel Keswani and David Stolin entitled “Which Money Is Smart? Mutual Fund Buys and Sells of Individual and Institutional Investors” examine the idea of “smart money effect.” In their paper they find that the smart money effect is visible in both the US and the UK markets. That investors seem able to identify those funds that will outperform in the future.

Also on the topic of fund performance, Jonathan Berk and Ian Tonks in their paper “Return Persistence and Fund Flows of the Worst Performing Mutual Funds” note how poorly performing mutual funds continue in part due investor’s reluctance to remove their capital. (Originally found at SSRN.com)

We hope you enjoyed this academic finance round-up. While we are making no promises, we will look to post again on this topic as notable papers become known to us.

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