The Price of Predictability: Estimating Inconsistency Premiums in Social Interactions

For financial decision-making, people trade off the expected value (return) and the variance (risk) of an option, preferring higher returns to lower ones and lower risks to higher ones. To make decision-makers indifferent between a risky and risk-free option, the expected value of the risky option must exceed the value of the risk-free option by a certain amount—the risk premium. Previous psychological research suggests that similar to risk aversion, people dislike inconsistency in an interaction partner’s behavior. In eight experiments (total N = 2,412) we pitted this inconsistency aversion against the expected returns from interacting with an inconsistent partner. We identified the additional expected return of interacting with an inconsistent partner that must be granted to make decision-makers prefer a more profitable, but inconsistent partner to a consistent, but less profitable one. We locate this inconsistency premium at around 31% of the expected value of the risk-free option.

Download Full-text

How leverage can improve performance

SHS Web of Conferences ◽

10.1051/shsconf/20208301031 ◽

2020 ◽

Vol 83 ◽

pp. 01031

Author(s):

Miroslav Kmeťko ◽

Eduard Hyránek

Keyword(s):

Risk Premium ◽

Expected Returns ◽

Tax Rates ◽

Expected Return ◽

Tax Rate ◽

Equity Ratio ◽

Risk Free Rate ◽

The Cost ◽

Managed Portfolios ◽

The Impact

One of the best-known Capital Asset Pricing Model (CAP/M) provides us with a methodology for measuring the relationship between the risk premium and the impact of leverage on expected returns. However, this model is not used only to value the cost of capital but also to evaluate the performance of managed portfolios. We will test how the expected return changes in percent by changing the debt-equity ratio and the tax rate based on following assumptions: market return 7%, risk-free rate of return 1% and beta 1.2. These assumptions will be constant and we will change the debt-equity ratio and tax rate. Based on these results, it is clear that the change in profitability varies, in relation to the change of the DE ratio by one tenth. As for changes I n tax rates, changes in expected profitability are not entirely in direct proportion to these changes.

Download Full-text

Cross-Section of Expected Returns Based on Equity Duration

Journal of Derivatives and Quantitative Studies ◽

10.1108/jdqs-03-2019-b0003 ◽

2019 ◽

Vol 27 (3) ◽

pp. 297-327

Author(s):

Sungjeh Moon ◽

Joonhyuk Song

Keyword(s):

Cross Section ◽

Risk Premium ◽

Factor Model ◽

Explanatory Power ◽

Significant Risk ◽

Significant Risk Factor ◽

Expected Returns ◽

Expected Return ◽

Cross Sectional ◽

Risk Premiums

We analyze the cross-sectional expected return of KOSPI stocks using equity duration. From 1991 to 2018, we calculate equity durations for the KOSPI listed stocks (including de-listed stocks) and find that the shorter the equity duration, the higher the risk premium. Using the 4-factor model with equity duration added to the benchmark 3-factor model, the explanatory power of the 4-factor model is superior to that of the existing benchmark model in accounting for risk premiums. This is an unusual finding that is not readily explainable by the traditional CAPM or the Fama-French 3-factor model. This can be interpreted that the equity duration is a separate and significant risk factor dissociated from the HML of the 3-factor model.

Download Full-text

Predictability and the Cross-Section of Expected Returns: A Challenge for Asset Pricing Models

Management Science ◽

10.1287/mnsc.2020.3859 ◽

2021 ◽

Author(s):

Christian Schlag ◽

Michael Semenischev ◽

Julian Thimme

Keyword(s):

Cross Section ◽

Risk Premium ◽

Empirical Test ◽

Expected Returns ◽

State Variables ◽

Expected Return ◽

Long Run ◽

The Cross ◽

Long Run Risks ◽

Macro Finance

Many modern macro finance models imply that excess returns on arbitrary assets are predictable via the price-dividend ratio and the variance risk premium of the aggregate stock market. We propose a simple empirical test for the ability of such a model to explain the cross-section of expected returns by sorting stocks based on the sensitivity of expected returns to these quantities. Models with only one uncertainty-related state variable, like the habit model or the long-run risks model, cannot pass this test. However, even extensions with more state variables mostly fail. We derive conditions under which models would be able to produce expected return patterns in line with the data and discuss various examples. This paper was accepted by David Simchi-Levi, finance.

Download Full-text

Risk, Uncertainty, and Expected Returns

Journal of Financial and Quantitative Analysis ◽

10.1017/s0022109016000417 ◽

2016 ◽

Vol 51 (3) ◽

pp. 707-735 ◽

Cited By ~ 69

Author(s):

Turan G. Bali ◽

Hao Zhou

Keyword(s):

Stock Returns ◽

Risk Premium ◽

Risk Premia ◽

Expected Returns ◽

Cross Sectional ◽

Asset Pricing Model ◽

Variance Risk Premium ◽

Equity Portfolios ◽

Variance Risk ◽

Highly Correlated

AbstractA conditional asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premia. The empirical results from the size, book-to-market, momentum, and industry portfolios indicate that the conditional covariances of equity portfolios with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant annualized 8% premium relative to portfolios that are minimally correlated with VRP.

Download Full-text

Buying CSR with employees’ pensions? The effect of social responsible investments on Norwegian SMEs’ choice of pension fund management

International Journal of Bank Marketing ◽

10.1108/ijbm-10-2015-0162 ◽

2017 ◽

Vol 35 (1) ◽

pp. 56-74 ◽

Cited By ~ 4

Author(s):

Harald Biong ◽

Ragnhild Silkoset

Keyword(s):

Pension Fund ◽

Pension Funds ◽

Decision Makers ◽

Expected Returns ◽

Fund Management ◽

Socially Responsible ◽

Expected Return ◽

Content Type ◽

Management Fees ◽

Pension Fund Management

Purpose Employees often expect an emphasis on financial aspects to be predominant when their employers choose a fund management company for the investment of employees’ pension fund deposits. By contrast, in an attempt to appear as socially responsible company managers may emphasize social responsibility (SR) in pension fund choices. The purpose of this paper is to examine to what extent managers for small- and medium-sized companies emphasize SR vs expected returns when choosing investment managers for their employees’ pension funds. Design/methodology/approach A conjoint experiment among 276 Norwegian SMEs’ decision makers examines their trade-offs between social and financial goals in their choice of employees’ pension management. Furthermore, the study examines how the companies’ decision makers’ characteristics influence their pension fund management choices. Findings The findings show that the employers placed the greatest weight to suppliers providing funds adhering to socially responsible investment (SRI) practices, followed by the suppliers’ corporate brand credibility, the funds’ expected return, and the suppliers’ management fees. Second, employers with investment expertise emphasized expected returns and downplayed SR in their choice, whereas employers with stated CSR-strategies downplayed expected return and emphasized SR. Originality/value Choice of supplier to manage employees’ pension funds relates to a general discussion on whether companies should do well – maximizing value, or do good, – maximizing corporate SR. In this study, doing well means maximizing expected returns and minimizing costs of the pension investments, whereas doing good means emphasizing SRI in this choice. Unfortunately, the employees might pay a price for their companies’ ethicality as moral considerations may conflict with maximizing the employees’ pension fund value.

Download Full-text

The Autonomy-validity Dilemma in Mechanical Prediction Procedures: The Quest for a Compromise

10.31234/osf.io/6cnxd ◽

2021 ◽

Author(s):

Marvin Neumann ◽

Susan Niessen ◽

Jorge Tendeiro ◽

Rob Meijer

Keyword(s):

Predictive Validity ◽

Psychological Research ◽

Decision Makers ◽

First Year ◽

Total N ◽

University Admission ◽

Application Data ◽

Mechanical Prediction ◽

The Mind ◽

Combining Information

A robust finding in psychological research is that combining information with a mechanical rule results in more valid predictions than combining information holistically in the mind. Nevertheless, information is typically combined holistically in practice, resulting in suboptimal predictions and decisions. Earlier research showed that decision makers are more likely to use mechanical prediction procedures when they retain autonomy in the decision-making process. However, it remains largely unknown how different autonomy-enhancing features affect predictive validity. Therefore, in two pre-registered studies (total N = 342), we investigated if and how prediction procedures can be designed such that they satisfy decision-makers’ autonomy needs and acceptance without reducing predictive validity. Based on archival application data from a university admission procedure, participants predicted applicants’ first-year GPA and chance of dropout. The results of Bayesian analyses showed that participants preferred prediction procedures in which they retained autonomy by choosing consistent predictor weights of a mechanical rule or by holistically adjusting the predictions of an optimal regression model. In general, these prediction procedures resulted in slightly higher predictive validity compared to fully holistic prediction. Providing participants with predictor validity information slightly increased predictive validity when participants could choose predictor weights, but not when making holistic predictions or adjusting optimal model predictions. Giving decision makers a role in designing mechanical rules through choosing weights based on explicit predictive validity information could help promote the implementation and validity of mechanical prediction in practice.

Download Full-text

The Cross Section of Expected Returns and Amortized Spreads

Review of Pacific Basin Financial Markets and Policies ◽

10.1142/s0219091506000872 ◽

2006 ◽

Vol 09 (04) ◽

pp. 597-638 ◽

Cited By ~ 2

Author(s):

Zhongzhi Lawrence He ◽

Lawrence Kryzanowski

Keyword(s):

Asset Pricing ◽

Risk Premium ◽

Overlapping Generations ◽

Expected Returns ◽

Relative Importance ◽

Expected Return ◽

Cross Sectional ◽

Market Risk Premium ◽

The Cross ◽

Level Effect

The cross-sectional relationship between expected returns and amortized spreads is studied in an overlapping-generations economy with an average investor. The commonality in liquidity is directly incorporated into the asset-pricing relation. In a static equilibrium, the amortized spread of an asset is related to its expected return through four channels; namely: the equilibrium zero-beta rate, the market risk premium, a level effect, and an incremental sensitivity effect. Although both are present over the entire period, their relative importance shifts from a significant level to a significant sensitivity effect from the earlier to most recent sub-period in the Canadian stock market.

Download Full-text

Haunted by a Doppelgänger

Experimental Psychology (formerly Zeitschrift für Experimentelle Psychologie) ◽

10.1027/1618-3169/a000221 ◽

2014 ◽

Vol 61 (1) ◽

pp. 12-22 ◽

Cited By ~ 11

Author(s):

Bettina von Helversen ◽

Stefan M. Herzog ◽

Jörg Rieskamp

Keyword(s):

Relevant Information ◽

Psychological Research ◽

Decision Makers ◽

Human Judgment ◽

Rule Based ◽

New Employees ◽

High Performing ◽

Facial Similarity ◽

Similarity Effect ◽

Judgment Strategy

Judging other people is a common and important task. Every day professionals make decisions that affect the lives of other people when they diagnose medical conditions, grant parole, or hire new employees. To prevent discrimination, professional standards require that decision makers render accurate and unbiased judgments solely based on relevant information. Facial similarity to previously encountered persons can be a potential source of bias. Psychological research suggests that people only rely on similarity-based judgment strategies if the provided information does not allow them to make accurate rule-based judgments. Our study shows, however, that facial similarity to previously encountered persons influences judgment even in situations in which relevant information is available for making accurate rule-based judgments and where similarity is irrelevant for the task and relying on similarity is detrimental. In two experiments in an employment context we show that applicants who looked similar to high-performing former employees were judged as more suitable than applicants who looked similar to low-performing former employees. This similarity effect was found despite the fact that the participants used the relevant résumé information about the applicants by following a rule-based judgment strategy. These findings suggest that similarity-based and rule-based processes simultaneously underlie human judgment.

Download Full-text