A research paper on predicting market returns for currency and other investments won the 2013 AQR Insight Award, the second year AQR Capital Management has awarded $100,000 for unpublished research.
The paper, “Conditional Risk Premia in Currency Markets and Other Asset Classes,” uses the downside risk capital asset pricing model to price the cross section of currency returns. It was authored by Martin Lettau, Kruttschnitt Family Chair in Financial Institutions at Haas School of Business, University of California at Berkeley, and two of his students — Michael Weber, Ph.D. candidate, finance, and Matteo Maggiori, now assistant professor of finance at Stern School of Business, New York University.
“CAPM doesn't distinguish between down states and up states,” Mr. Lettau said in a telephone interview. “We noticed a strong pattern of correlation patterns changing in down states.”
The paper determined that currency returns are associated with aggregate market risk, but that the normal CAPM does not explain the cross sections of returns because the currency beta spread is not large enough to match the cross-sectional variation in expected returns. Historically, currencies with higher interest rates result in higher returns, but by using the downside risk CAPM, Mr. Lettau found that the return spreads switch in down markets.
“Hedge funds are very concerned about this,” Mr. Lettau said.
The research was then expanded to other asset classes, and the authors determined that the downside risk CAPM can do the same for equity, commodity and sovereign bond returns.
“The same patterns hold for carry trade-like investments in other markets,” Mr. Lettau said. “I was surprised by how well it worked” with other asset classes.
Messrs. Lettau, Weber and Maggiori will share a portion of the $100,000 prize with Tomasz Piskorski, Edward S. Gordon associate Professor of Real Estate and Finance at the Graduate School of Business, Columbia University; James Witkin, research manager at the same school; and Amit Seru, associate professor of finance at the University of Chicago Booth School of Business. The authors were awarded the designation of Distinguished Paper for their work on how to identify and quantify misreported loans in the $2 trillion market for private mortgage-backed securities.
More information on the awards is available on AQR's website.