How is VIX related to the short-term price reversal?

A theoretical and empirical investigation.

Iman Honarvar
Maastricht University, the Netherlands
December 23rd, 2015
Abstract: I provide a theoretical justification for the positive relationship,
previously empirically found between VIX and the equity short-term price reversal. I
show an idiosyncratic liquidity shock to an asset creates a short-term reversal

effect in this asset and any asset correlated with it, and thus, it spreads to the
whole market. The strength of the short-term reversal effect in the market
depends on assets covariances. Given that VIX is a proxy for stocks average
covariance, the positive relationship between VIX and the equity short-term
reversal must exist. My empirical tests confirm my theoretical conjecture and
show that the returns of the equity short-term reversal strategies are robustly
related to the different measures of stocks average covariance, such as VIX
and realized volatility of the S&P500 Index, and also average conditional
correlation and average conditional variance.

Keywords: Short-term Reversal, VIX, Liquidity Provision Compensation,

Liquidity Spillover

Finance Department, School of Business and Economics, Maastricht University.

Email: i.honarvargheysary@maastrichtuniversity.nl.

Electronic copy available at: http://ssrn.com/abstract=2707528

1. Introduction

Market makers set their bid and ask prices such that they are always ready to trade. At the time
of investors urgency to sell a specific asset, which usually coincide will the price fall, the market
makers are ready to buy, hoping that they can sell back to the market in a few hours (days) when
the price recovers. Thus the compensation for market makers liquidity provision is closely
related to the short-term price reversal effect. Nagel (2012) empirically shows that VIX can
positively predict the price reversal effect. He argues when VIX is high, market makers are
financially constrained (Brunnermeier and Pedersen (2008)), and therefore they require higher
return for the liquidity provision.

In this paper, I extend the unified framework of Vayanos and Wang (2011) to provide another
theoretical justification for the positive connection between VIX and the short-term price
reversal effect. I will show that even in a perfect market, where there is no information
asymmetry and the market makers are not financially constrained, an increase in the average
level of assets covariances, i.e. an increase in VIX, creates a larger price reversal effect in the
whole market.

Previous theoretical and empirical studies show that a trade with information asymmetry
coincides with a price movement that does not revert; however, a price change in a non-informed
trade1 usually reverts.2 Therefore to study the price reversal, I reply on a perfect market model
1

A non-informed trader can be a perfect rational risk-averse hedger, who allocates his portfolio

based on the publicly available information rather than personal insider information. Therefore
non-informed trading differs from noise trading, whose trade volume is a pure random walk.

Electronic copy available at: http://ssrn.com/abstract=2707528

without information asymmetry. My model is constituted of equally risk-averse investors, who

can trade one riskless asset and N risky assets in three different periods (t = 0, 1, 2). The risky
assets pay some random liquidation values at Period 2. In Period 0, the investors are identical
and therefore they all hold the market portfolio. However at Period 1, some investors, labelled as
liquidity demanders, are informed that they will receive some extra endowment at Period 2.
The extra endowment will divert the liquidity demanders portfolio from optimality, and thus this
news persuades them to trade with the remainder of the investors, labelled as liquidity
suppliers. As the liquidity suppliers portfolio is already optimal (because they did not receive
any endowment), they require some liquidity premium to engage in this trade. Therefore in
Period 1, even though the liquidation values of the risky assets are unaffected, the trading prices
deviate from the fundamental values. However later in Period 2, the asset prices coverage back
to their fundamental values. This effect, caused by the liquidity suppliers aversion to holding
risky assets, is called the short-term price reversal effect.

The extra endowment that triggers the trade, the liquidity shock, can be idiosyncratic or
systematic. I will show (e.g.) an idiosyncratic liquidity shock to asset i affects the price of this
asset and any asset correlated with it, and therefore, it can create a short-term price reversal
effect in the whole market. Ceteris paribus, the intensity of the price reversal effect is much
stronger when the investors are more risk-averse, the liquidity shock is bigger, or when the assets
covariances are higher. Given that VIX is a proxy for stocks pairwise conditional covariances,
when VIX is higher, the short-term price reversal effect is stronger.
2

See Kyle (1985), Glosten and Milgrom (1985), Campbell, Grossman and Wang (1993),

Llorente, Michaely, Saar and Wang (2002), Avramov, Chordia and Goyal (2006).

Indeed my further empirical analysis confirm this claim. To capture market makers profit from
the short-term price reversal effects for each day from 1996:1 to 2014:8, I construct portfolios
which buy (sell) the assets that underperformed (outperformed) the market over the last day(s). I
will show that the return of these portfolios are substantially positively related to VIX (a proxy
for the average covariance under the Q-measure), the realized volatility of the S&P500 (a proxy
for the average covariance under the P-measure), the average conditional correlation (Driessen,
Maenhout, Vilkov (2009)) and the average conditional variance (Bakshi, Kapadia and Madan
(2003)) of the stocks in S&P100 index. The robustness tests show that the proxies of market
financial constraints, such as the LIBOR-OIS spread, the Ted-Spread, the 1-month USD LIBOR
and the Federal Fund Rate, cannot obsolete the power of the average covariance in capturing the
short-term price reversal effect.

My research is also related to several other previous studies; Bansal, Connolly and Stivers (2014)
and Chung and Chuwonganant (2014) empirically find that the level of VIX is closely related
with stocks return, turnover and illiquidity. Cespa and Foucault (2014) study illiquidity spillover
from price informativeness perspective. Also So and Wang (2014) find that uncertainty
escalation increases the market makers excepted compensation for providing liquidity. Cheng,
Hameed, Subrahmanyam and Titman (2014) find that the magnitude of return reversals depends
on the number of informed investors and risk-averse market makers, and Andrade, Chang and
Seasholes (2008) study illiquidity spillover among correlated stocks.

The rest of the paper is structured as follows. Section 2 presents my theoretical model and its
implication about the short-term price reversal effect in the market. In Section 3, I empirically
test the predictions of my theory, and finally in Section 4, I draw the conclusion.

2. The Model
The economy contains one riskless bond and N risky assets that can be traded in three periods
(t = 0,1,2). The risk-free interest rate is equal to zero, and the riskless bond is in perfectly elastic
supply. The liquidation values of the risky assets at the final period (t = 2) is jointly normally
distributed such that
S2 ~N(S, )

(1)

Here S2 is the N 1 vector of the liquidation values at t = 2 and = [ij ] is the N N

covariance matrix. To isolate the short-term reversal effect, I assume that the expectation of the
liquidation values (S) does not change over the three short periods of the model, i.e.
E0 (S2 ) = E1 (S2 ) = S,

(2)

where Et (. ) is the expectation function given all the information available at and before time t.
This is equivalent to assuming that the economic factors, associated with the asset fair-prices, are
constant over the horizon of the study from t = 0 to t = 2. Since we study the short-term price
reversal effect that materializes within a few days, this is not a strong assumption.
Investors willingness to trade and preferences, endogenously, dictate the risky assets prices at
Period 0 (i.e. S0 , the N 1 vector of the risky assets price at t = 0), and at Period 1 (i.e. S1, the
N 1 vector of the risky assets price at t = 1). In order to quantify the price reversal effect, we
must find the asset prices at these two periods.

Investors will consume all their wealth at Period 2, and they have identical exponential utility
functions,
5

U(C) = exp(C),

(3)

where and C are, respectively, the coefficient of risk-aversion and the consumption level.

At Period 0, the investors are identical. They have the same initial wealth, risk-aversion
coefficients and utility functions. Therefore at Period 0, all investors hold the market portfolio
besides the riskless bond i.e.
0 = .

(4)

Here 0 is the N 1 vector of the investors holdings at Period 0, and is the N 1 vector of
the market portfolio.
At Period 1, a population 0 < < 1 of the investors are informed that they will get the extra
endowment of zM(S2 S) at the final period (t = 2). Here z is a normally distributed random
variable such that z~N(0 2z ) and E(zS2 ) = 0. I refer to z as the liquidity shock. Moreover M
is the N 1 vector of assets sensitivity to (loading on) the liquidity shock. Although these
investors are informed about the size of the liquidity shock (z) at Period 1, they will receive the
endowment at Period 2.
Lets assume that the liquidity shock only hits the ith asset.3 In other words all the elements in M
are zero except the ith , which is equal to 1. At Period 1, when the population of the investors
3

Without loss of generality, in my model I assume that the liquidity shock is asset-specific. In

other words, the population of the investors get the extra endowment for only one of the assets.
Therefore I assume that only one element in the vector M is equal to 1, and the rest of the
elements are zero. Obviously, to study the effect of a systematic liquidity shock, which affect
6

get the news about the extra endowment, they know that if they do nothing their portfolio will
deviate from its optimality for the next time interval, from t = 1 to t = 2. This news persuades
them to rebalance their portfolio such that it remains optimal. For example if they are informed
that z is positive, they will have more than enough (optimal) units of the ith asset at Period 2.
Therefore at Period 1, they must reduce their exposure to the ith asset by selling a portion of their
holdings on this asset. Since the investors, who get the extra endowment, initiate the trade they
are called the liquidity demanders (indexed with d). The rest of the investors (1 ), who
accommodate these demands, are called the liquidity suppliers (indexed with s).

The liquidity suppliers and the liquidity demanders are equally risk-averse. Since the liquidity
suppliers portfolio is already optimal, they do not have any incentive to buy the ith asset unless
the price of asset i is lower that its risk-adjusted expected payoff. Hence the liquidity suppliers
provide liquidity to the market by charging a liquidity premium, a price discount on asset i.
Remarkably, it is the liquidity suppliers risk-aversion that creates temporary jumps in prices.
These jumps are the liquidity suppliers compensation for providing liquidity and immediacy to
the market. The risk-averse liquidity suppliers of my model resemble the risk-averse market
makers in the models of Grossman and Miller (1988), Brunnermeier and Pedersen (2008), and
Andrade, Chang and Seasholes (2008).

The implications of the outlined model are presented in the following four propositions.
Appendix A provides the proofs of all propositions.

several assets with different magnitudes, one could assume that M is the vector of the factor
loadings on the liquidity risk.

Proposition 1: As mentioned before, at Period 0 the investors are identical and they hold the
same portfolios 0 = . However at Period 1, they will be randomly segregated to the liquidity
demanders and the liquidity suppliers. The liquidity demanders are informed that they will
receive the extra endowment of zM(S2 S) at the final period (t = 2). After knowing the size
of the liquidity shock (z), the liquidity demanders will reallocate their portfolios to hold 1d units
of the risky assets. One can show that the N 1 vectors of the liquidity demanders optimal
holding (1d ) and the liquidity suppliers optimal holding (1s ) are respectively:

1d =

1 1
(S S1 ) zM,

(5)

1 1
(S S1 ).

(6)

1s =

Proposition 2: At Period 1 the liquidity demanders initiate the trade. To persuade the liquidity
suppliers to engage in this trade, the prices (S1) must adjust. One can show that the Period 1
equilibrium asset prices are:
S1 = S zM.

(7)

Therefore an asset-specific liquidity shock to the ith asset will be transmitted to all other assets
that have a non-zero covariance with asset i.
Proposition 3: At Period 1, when the size of the liquidity shock z is known, the asset prices
deviate from their fundamental values, but later in Period 2, they converge back. This
phenomenon is called the short-term price reversal, and it is measured as the negative of the
autocovariations in the price processes, i.e.

 = diag(Cov(S2 S1 , S1 S0 )).

(8)

Here diag(. ) returns the diagonal elements vector and Cov(S2 S1 , S1 S0 ) is the N N matrix
of the auto-covariation in the price processes. One can show that
= 2 2 2z diag(MM ).

(9)

When an asset-specific liquidity shock affects the ith risky asset, it will created short-term price
reversal effect in asset i and the assets correlated with it. The magnitudes of the price reversal
effects for any asset (j) and the market portfolio index (m) will be:
j = 2 2 2z 2ij .
N
m

(10)

2 2 2z wk wj ik ij

(11)

k=1 j=1

Here wi stands for the weight of asset i in the market portfolio index, and ij is the covariance
between assets i and j.
Proposition 4:4 The price of the assets before observing the liquidity shock z will be,

S0 = S

( 1 )
0

1 +

(12)

Such that
4

Proposition 4 is not directly used in this paper, but it is very useful in understanding the

connection between the liquidity risk premium and assets pairwise covariances.

0 = (1 + 2 2z (2 2)M M)

(13)

1 = 2 2z M

(14)

= |

1 + 2 2z 2 M M
2 M1
| exp (
)
0
20

(15)

For example if asset i is prone to the liquidity shocks z~N(0 2z ), then ex-ante price of any
asset j in this market will be

S0j = Sj k kj
k=0

( 1 )
0

1 +

(16)

ji

Thus even though the liquidity shock hits asset i, the investors will require

1
)
0

1+

ji as the

liquidity risk premium for investing on asset j, because a liquidity shock spreads to any
correlated asset.

3. Empirical Results
The theory predicts when assets pairwise covariances are higher, the price reversal effects are
stronger. Therefore since VIX is a proxy for stocks pairwise conditional covariances, it must be
closely related to the short-term reversal effect in the stock market. In this section, I test the
validity of this theoretical finding. I construct different short-term price reversal strategy
portfolios and show that they are more profitable when the average level of the covariances
increases. For each day these portfolios buy the stocks with negative market-adjusted returns
over the last day, and short-sell the stocks with positive market-adjusted returns, hoping that
these returns will be reverted in following day. By using the market-adjusted returns, I make sure
10

that in everyday, the price reversal strategy portfolio has both long and short positions. Having
both long and short positions reduces the portfolio exposure to other risk factors such as the
Fama-French risk factors.

In a relevant study, Nagel (2012) proposes and compares the three weighting strategies shown in
Equation 17 to 19. Model 1 and 2 have been also used by Lehman (1990) and Lo and MacKinlay
(1988), respectively.

Method 1:

Method 2:

Method 3:

wi,t =

R m,t1 R i,t1
1
( 2 N
i=0 |R m,t1 R i,t1 |)

wi,t =
wi,t =

R m,t1 R i,t1
N

(17)

(18)

R m,t1 R i,t1
2
1
( 2 N
i=0(R m,t1 R i,t1 ) )

(19)

I also follow Nagel (2012) and use these strategies for the empirical part of the paper. Clearly the
weight of each stock on each day depends negatively on its market-adjusted return on the
previous day. If on day t 1 a stock outperforms (underperforms) the market, the weight of this
stock on day t will be negative (positive). Therefore if its good (bad) performance on day t 1 is
reverted with a bad (good) return on day t, this stock will contribute positively to the day t
portfolio return. To construct the price reversal strategy portfolios, I obtain the daily closing
transaction prices of the stocks, traded in NYSE, AMEX and NASDAQ from the CRSP
database.

Hansch, Naik, and Viswanathan (1998) show that especially for illiquid stocks, the price
reversion might take more than one day. Also Hendershott, Menkveld (2014) find that the
11

average price pressure caused by asynchronously arriving investors is about 0.49% with a halflife of 0.54 to 2.11 days. Therefore following Nagel (2012), I also construct five independent
portfolios such that the weight of each asset depends on j = 1, , 5 days (past week) delayed
stock returns, and then I take the simple average of the constructed portfolio returns.

I also compute the daily realized volatility of the S&P 500 Index, as a proxy for the average
covariance of the stocks under the P-measure. To this end, I calculate each days realized
volatility as the standard deviation of the intraday (5-minute) observations on the S&P 500 Index
return, taken from the Tick Data. Moreover using the mythologies of Bakshi, Kapadia and
Madan (2003) and also Driessen, Maenhout, Vilkov (2009), I compute the average conditional
correlation and the average conditional variance of the S&P 100 stocks. For this purpose, I
obtain the daily prices of the options traded on the S&P 100 Index and its constituents from
OptionMetrics database.

Summary Statistics

Table 1 provides summary statistics on the market and the price reversal strategy portfolios. The
frequency of the time series is daily, and they range from 1996:1 to 2014:8.

[Please Insert Table 1 Here.]

Also Table 2 provides the corresponding correlation matrix.

[Please Insert Table 2 Here.]

The weighting strategies shown Equation 17 to 19, by construction, tend to buy (sell) low (high)
beta stocks in the days that the market return is positive and vice versa. To ensure that the
12

variations of the constructed portfolios are not driven by the market fluctuations, following
Nagel (2012), I neutralize the returns with respect to the market using Equation 20.

Price Reversalt = 0 + 1 R m,t + 2 (R m,t sign(R m,t1 )) + t .

(20)

Therefore for the regression analysis, I report the results based on both the return time series of
the portfolios constructed using Equation 17 to 19 (i.e. Price Reversalt ), and also the return of
these portfolios orthogonalized to the market return using Equation 20 (i.e. t ).
Regression Results

To test the theoretical prediction of the model, I regress the daily return of the constructed shortterm reversal portfolios (in basis points) on VIX, the average correlation and the average
variance of the S&P100 stocks. I also include a dummy vector that is equal to one before the
decimalization (i.e. April 9th 2001), and zero after that.

The results, reported in Table 3 and 4, confirm my theoretical conjecture. In both tables, Panel
(A) and (B) respectively refer to the short-term reversal strategies constructed based on last day
and last week of stock returns. The higher values for VIX, the average correlation or the average
variance of the stocks in the market are generally associated with more positive returns in all of
the short-term price reversal portfolios. Also the estimated coefficients of the dummy variable
are always significantly positive, meaning that before the decimalization the short-term reversal
strategies were more profitable.

[Please Insert Table 3 Here.]

[Please Insert Table 4 Here.]

13

If the financially constrained balance-sheets of market makers are the main derivers of the shortterm price reversal effect in the market, the credit-risk and financing proxies of the market must
be better variables to explain this effect. Therefore I repeat the previous regressions, after adding
the LIBOR-OIS spread, the Ted-Spread, the 1-month USD LIBOR and the Federal Fund Rate to
the regressors. The results, shown in Table 5 and 6, suggest that none of these proxies can
obsolete the substantial relationship between VIX and the short-term reversal. 5

[Please Insert Table 5 Here.]

[Please Insert Table 6 Here.]

Remarkably, based on the results shown in Table 5 and 6, the estimated coefficients for the 1month USD LIBOR is not always significantly positive and the sign of the estimated coefficients
for the Ted-Spread are mostly negative. These findings suggest that the role of the covariance in
explaining the short-term price reversal effect cannot be replaced by the financial constraints
proxies.

To test the robustness of the results found in Table 5 and 6, I run these regressions again after
adding the market excess return, SMB, HML, momentum and the S&P 500 dividend yield to the

The LIBOR-OIS spread, the 1-month USD LIBOR and the Federal Fund Rate are extremely

correlated. To avoid multicollinearity, I only use one of these time series beside the Ted-Spread
as the regressors. In Table 5 and 6, I only report the results based on one of these combinations,
i.e. the 1-month USD LIBOR and the Ted-Spread. The other combinations provide qualitatively
similar results, excluded for the sake of brevity. These results are available upon request.

14

regressions. In every case, VIX is substantially positively related to the return of all short-term
price reversal portfolios.

[Please Insert Table 7 Here.]

VIX Index is the measure of the market volatility expectation under the risk-neutral measure, and
therefore, it is the summation of the realized volatility and the volatility risk premium. To ensure
that the variations in the short-term price reversal are not driven by the volatility risk premium, I
repeat the regressions with the daily realized volatility. For this purpose, I compute the
conditional volatility of each day using 5-minutes observations on the S&P 500 Index returns.
The results, provided in Table 8 to 10, are qualitatively the same as my findings for VIX; the
realized volatility for the S&P 500 Index, which is a weighted sum of stocks-pairwise
covariances, is significantly positively correlated with the short-term price reversal in the stock
prices.

[Please Insert Table 8 Here.]

[Please Insert Table 9 Here.]

[Please Insert Table 10 Here.]

4. Conclusion
The short-term price reversal effect is known to be a proxy for the market makers liquidity
provision compensation. Previous studies empirically show a positive relationship between VIX
Index and the short-term price reversal effect. These studies argue that when VIX Index is high,
the short-term price reversal effect is stronger, because in such periods the market is in turmoil
15

and therefore financially constrained market makers expect more compensation for providing
liquidity.

In this paper, I provide another theoretical justification for the positive relationship between the
short-term price reversal effect and VIX Index. More specifically I show that a liquidity shock
can create short-term price reversal effect in the whole market, and the intensity of this reversal
effect is higher when the covariance values among asset-pairs are higher. Since VIX Index is a
proxy for stocks pairwise conditional covariances, the positive relation between VIX and the
short-term price reversal effect must exist.

My further empirical analyses robustly confirm my theoretical findings. More specifically, I find
that return of short-term reversal strategies are substantially positively related to VIX (a proxy
for the average covariance under the Q-measure), the realized volatility of the S&P500 (a proxy
for the average covariance under the P-measure), the average conditional correlation and the
average conditional variance of the stocks in S&P100 index.

16

Tables

Table 1: Summary Statistics

Value
Weighted
Market
Return

S&P 100
Volatility

5%

-1.92%

10%

S&P 100
Average
Correlation

S&P 100
Average
Variance

0.105

0.238

-1.37%

0.114

25%

-0.52%

Median

Summary Statistics

Percentiles

Portfolios Conditioned on the Past

Week Returns

Portfolios Conditioned on the

Yesterday Returns

Method 1

Method 2

Method 3

Method 1

Method 2

Method 3

0.036

-0.39%

0.00%

-3.18%

-0.74%

-0.01%

-5.81%

0.272

0.039

-0.20%

0.00%

-1.49%

-0.25%

0.00%

-2.15%

0.141

0.366

0.049

0.06%

0.00%

0.53%

0.37%

0.00%

3.21%

0.09%

0.188

0.446

0.075

0.33%

0.00%

2.46%

1.13%

0.01%

8.75%

75%

0.65%

0.231

0.544

0.127

0.69%

0.01%

4.40%

2.50%

0.03%

14.87%

90%

1.33%

0.29

0.642

0.201

1.04%

0.01%

6.25%

3.73%

0.05%

21.21%

95%

1.82%

0.347

0.715

0.259

1.36%

0.02%

7.85%

4.57%

0.07%

24.79%

Number of
Observations

4696

Beta

..

..

..

0.12

0.84

0.18

1.18

Annualized Sharpe
Ratio

0.52

..

..

..

9.14

7.01

10.09

12.89

10.43

14.61

Average

0.04%

0.2

0.46

0.1

0.40%

0.01%

2.50%

1.50%

0.02%

9.09%

St. Dev.

1.25%

0.08

0.14

0.08

0.70%

0.01%

3.94%

1.85%

0.03%

9.88%

Skew

-0.11

1.71

0.43

2.31

1.54

5.98

1.09

0.7

2.45

0.08

Kurt

7.04

5.35

0.15

8.45

28.34

89.66

14.81

7.16

22.49

2.99

Moments

17

Correlations

Portfolios Conditioned on the Portfolios Conditioned on the

Past Week Returns
Yesterday Returns
SMB

HML

Mom

Ted
Spread

Dividend 1M-USDYield
LIBOR

Method 1 Method 2 Method 3 Method 1 Method 2 Method 3

Value Weighted
Market Return

1.00

-0.12

-0.11

-0.10

0.07

-0.13

-0.26

-0.03

0.02

-0.01

0.21

0.19

0.26

0.13

0.15

0.15

S&P 100 Volatility

-0.12

1.00

0.58

0.88

-0.03

-0.03

0.00

0.50

-0.28

0.01

0.24

0.32

0.14

0.32

0.42

0.21

-0.11

0.58

1.00

0.16

-0.04

-0.01

-0.02

0.08

0.25

-0.44

0.08

0.07

0.07

0.12

0.12

0.12

-0.10

0.88

0.16

1.00

-0.02

-0.03

0.01

0.55

-0.46

0.21

0.23

0.33

0.11

0.28

0.42

0.16

SMB

0.07

-0.03

-0.04

-0.02

1.00

-0.15

0.08

-0.02

0.00

-0.02

0.01

-0.01

0.06

-0.04

-0.06

-0.01

HML

-0.13

-0.03

-0.01

-0.03

-0.15

1.00

-0.28

-0.03

-0.01

0.01

-0.06

-0.06

-0.06

-0.02

-0.03

-0.02

Mom

-0.26

0.00

-0.02

0.01

0.08

-0.28

1.00

0.01

-0.04

0.04

0.02

0.01

0.03

0.04

0.02

0.06

S&P 100 Average

Correlation
S&P 100 Average
Variance

Ted Spread

-0.03

0.50

0.08

0.55

-0.02

-0.03

0.01

1.00

-0.12

0.40

0.16

0.23

0.09

0.18

0.27

0.12

Dividend Yield

0.02

-0.28

0.25

-0.46

0.00

-0.01

-0.04

-0.12

1.00

-0.38

-0.13

-0.18

-0.05

-0.13

-0.21

-0.05

1M-USD-LIBOR

-0.01

0.01

-0.44

0.21

-0.02

0.01

0.04

0.40

-0.38

1.00

0.18

0.18

0.13

0.27

0.28

0.25

Method 1

0.21

0.24

0.08

0.23

0.01

-0.06

0.02

0.16

-0.13

0.18

1.00

0.92

0.88

0.66

0.68

0.55

Method 2

0.19

0.32

0.07

0.33

-0.01

-0.06

0.01

0.23

-0.18

0.18

0.92

1.00

0.75

0.61

0.73

0.46

Method 3

0.26

0.14

0.07

0.11

0.06

-0.06

0.03

0.09

-0.05

0.13

0.88

0.75

1.00

0.55

0.53

0.60

Method 1

0.13

0.32

0.12

0.28

-0.04

-0.02

0.04

0.18

-0.13

0.27

0.66

0.61

0.55

1.00

0.92

0.88

Method 2

0.15

0.42

0.12

0.42

-0.06

-0.03

0.02

0.27

-0.21

0.28

0.68

0.73

0.53

0.92

1.00

0.74

Method 3

0.15

0.21

0.12

0.16

-0.01

-0.02

0.06

0.12

-0.05

0.25

0.55

0.46

0.60

0.88

0.74

1.00

Portfolios
Conditioned
on the Past
Week
Returns
Portfolios
Conditioned
on the
Yesterday
Returns

18

Value
S&P 100 S&P 100
Weighted S&P 100
Average Average
Market Volatility
Correlation Variance
Return

Table 3: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Weights Model

Model 1

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.2416

R2 = 0.2506

Coefficient

T-stat

Coefficient

T-stat

Intercept

-0.1698

-2.66

Intercept

-1.7156

-27.29

Dummy

1.5556

29.53

Dummy

1.5453

29.77

VIX

6.2380

20.70

VIX

6.4807

21.83

R2 = 0.2950
Model 2

R2 = 0.3072

Coefficient

T-stat

Coefficient

T-stat

Intercept

-0.0158

-15.01

Intercept

-0.0370

-35.99

Dummy

0.0243

27.91

Dummy

0.0241

28.38

VIX

0.1506

30.28

VIX

0.1531

31.51

R2 = 0.1677
Coefficient
Model 3

R2 = 0.1768
T-stat

Coefficient

T-stat

Intercept

2.7975

7.83

Intercept

-6.6969

-19.07

Dummy

7.7319

26.21

Dummy

7.6568

26.40

VIX

20.8345

12.35

VIX

22.9735

13.85

Panel (B): Portfolios Conditioned on the Past Week Returns

Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0. 1100
Model 1

R2 = 0.1234

Coefficient

T-stat

Coefficient

T-stat

Intercept

-0.0685

-2.64

Intercept

-0.5022

-19.93

Dummy

0.3509

16.36

Dummy

0.3441

16.53

VIX

1.8718

15.26

VIX

2.0521

17.24

R2 = 0.1400
Model 2

R2 = 0.1457

Coefficient

T-stat

Intercept

-0.0052

-11.14

Dummy

0.0057

14.75

VIX

0.0466

21.15

Coefficient

T-stat

Intercept

-0.0113

-24.88

Dummy

0.0056

14.89

VIX

0.0492

22.96

R2 = 0.0495
Model 3

19

R2 = 0.0601

Coefficient

T-stat

Coefficient

T-stat

Intercept

0.9647

6.34

Intercept

-1.8137

-12.42

Dummy

1.5576

12.39

Dummy

1.5059

12.48

VIX

5.5681

7.74

VIX

7.0338

10.19

Table 4: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.2413

Model 1

R2 = 0.2511

Coefficients

T-stat

Intercept

-0.5442

-6.24

Dummy

1.7523

Ave Correlation

2.6398
3.3838

Ave Variance

Coefficients

T-stat

Intercept

-2.1165

-24.66

30.97

Dummy

1.7514

31.43

14.94

Ave Correlation

2.7671

15.90

10.23

Ave Variance

3.5172

10.79

R2 = 0.2879

Model 2

R2 = 0.2999

Coefficients

T-stat

Intercept

-0.0148

-10.25

Coefficients

T-stat

Intercept

-0.0366

-25.92

Dummy

0.0248

26.44

Dummy

0.0249

27.10

Ave Correlation

0.0343

11.71

Ave Correlation

0.0365

12.74

Ave Variance

0.1278

23.28

Ave Variance

0.1280

23.87

R2 = 0.1879

Model 3

R2 = 0.1988

Coefficients

T-stat

Coefficients

T-stat

Intercept

-0.7701

-1.60

Intercept

-10.4214

-22.02

Dummy

9.2931

29.70

Dummy

9.2719

30.18

Ave Correlation

15.3916

15.75

Ave Correlation

16.2988

16.99

Ave Variance

1.8642

1.02

Ave Variance

3.3359

1.86

Panel (B): Portfolios Conditioned on the Past Week Returns

Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.1061

Model 1

R2 = 0.1199

Coefficients

T-stat

Intercept

-0.0894

-2.51

Coefficients

T-stat

Intercept

-0.5388

-15.62
16.60

Dummy

0.3731

16.16

Dummy

0.3717

Ave Correlation

0.5287

7.34

Ave Correlation

0.6119

8.75

Ave Variance

1.4090

10.44

Ave Variance

1.5237

11.63

R2 = 0.1418
Coefficients
Model 2

R2 = 0.1560
T-stat

20

T-stat

Intercept

-0.0034

-5.40

Intercept

-0.0098

-15.83

Dummy

0.0053

12.71

Dummy

0.0052

13.06

Ave Correlation

0.0064

4.97

Ave Correlation

0.0077

6.17

Ave Variance

0.0460

19.00

Ave Variance

0.0474

20.15

R2 = 0.0523

Model 3

Coefficients

R2 = 0.0645

Coefficients

T-stat

Intercept

0.3648

1.76

Coefficients

T-stat

Intercept

-2.5225

-12.67

Dummy

1.8296

13.57

Dummy

1.8153

14.05

Ave Correlation

3.0867

7.33

Ave Correlation

3.7124

9.20

Ave Variance

2.0662

2.62

Ave Variance

3.0691

4.06

Table 5: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.2461

Model 1

R2 = 0.2565

Coefficients

T-stat

Coefficients

T-stat

Intercept

-0.2322

-3.05

Intercept

-1.8039

-24.08

Dummy

1.5617

19.42

Dummy

1.5258

19.27

VIX

7.2331

19.72

VIX

7.6516

21.19

LIBOR1m

1.6881

1.00

LIBOR1m

2.6390

1.58

Ted Spread

-0.3684

-5.08

Ted Spread

-0.4268

-5.98

R2 = 0.2967

Model 2

R2 = 0.3102

Coefficients

T-stat

Coefficients

T-stat

Intercept

-0.0181

-14.36

Intercept

-0.0398

-32.42

Dummy

0.0213

16.05

Dummy

0.0207

15.97

VIX

0.1601

26.39

VIX

0.1669

28.18

LIBOR1m

0.0894

3.19

LIBOR1m

0.1081

3.96

Ted Spread

-0.0028

-2.31

Ted Spread

-0.0042

-3.62

R2 = 0.1723
Coefficients
Model 3

R2 = 0.1825
T-stat

Coefficients

T-stat

Intercept

2.6284

6.17

Intercept

-7.0272

-16.78

Dummy

8.0169

17.80

Dummy

7.7623

17.54

VIX

25.7926

12.55

VIX

28.8547

14.30

LIBOR1m

2.1678

0.23

LIBOR1m

8.2723

0.89

Ted Spread

-1.8990

-4.68

Ted Spread

-2.1944

-5.50

Panel (B): Portfolios Conditioned on the Past Week Returns

Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.1102

Model 1

R2 = 0.1245

Coefficients

T-stat

Coefficients

T-stat

Intercept

-0.0857

-2.76

Intercept

-0.5351

-17.76

Dummy

0.3313

10.09

Dummy

0.3079

9.67

VIX

1.9664

13.13

VIX

2.2442

15.45

LIBOR1m

0.6557

0.95

LIBOR1m

1.2419

1.85

Ted Spread

-0.0300

-1.01

Ted Spread

-0.0618

-2.15

R2 = 0.1426

Model 2

R2 = 0.1568

Coefficients

T-stat

Coefficients

T-stat

Intercept

-0.0056

-10.11

Intercept

-0.0120

-22.14

Dummy

0.0046

7.88

Dummy

0.0043

7.45

VIX

0.0446

16.57

VIX

0.0489

18.73

LIBOR1m

0.0217

1.75

LIBOR1m

0.0316

2.62

Ted Spread

0.0010

1.93

Ted Spread

0.0004

0.82

R2 = 0.0497

Model 3

21

R2 = 0.0611

Coefficients

T-stat

Coefficients

T-stat

Intercept

0.9533

5.23

Dummy

1.5892

8.26

Intercept

-1.9368

-11.09

Dummy

1.4136

VIX

6.0073

7.66

6.84

VIX

8.1173

LIBOR1m

9.64

0.0365

0.01

LIBOR1m

4.2622

Ted Spread

1.10

-0.1698

-0.98

Ted Spread

-0.3764

-2.26

Weights Model

Model 1

Model 2

Model 3

Weights Model

Model 1

Model 2

Model 3

22

Table 6: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.2443
R2 = 0.2556
Coefficients
T-stat
Coefficients
T-stat
Intercept
-0.7606
-6.84
Intercept
-2.3795
-21.76
Dummy
1.5770
19.55
Dummy
1.5384
19.39
Ave Correlation
2.9785
14.93
Ave Correlation
3.1790
16.20
Ave Variance
3.9834
10.41
Ave Variance
4.2490
11.28
LIBOR1m
6.3683
3.49
LIBOR1m
7.7406
4.31
Ted Spread
-0.2694
-3.70
Ted Spread
-0.3285
-4.59
R2 = 0.2899
R2 = 0.3032
Coefficients
T-stat
Coefficients
T-stat
Intercept
-0.0189
-10.22
Intercept
-0.0415
-23.06
Dummy
0.0215
16.05
Dummy
0.0208
15.94
Ave Correlation
0.0399
12.06
Ave Correlation
0.0435
13.47
Ave Variance
0.1312
20.65
Ave Variance
0.1348
21.74
LIBOR1m
0.1089
3.59
LIBOR1m
0.1356
4.58
Ted Spread
-0.00220
-1.83
Ted Spread
-0.00370
-3.10
R2 = 0.1914
R2 = 0.2042
Coefficients
T-stat
Coefficients
T-stat
Intercept
-2.2949
-3.73
Intercept
-12.2583
-20.34
Dummy
8.0435
18.04
Dummy
7.7675
17.76
Ave Correlation
17.6209
15.98
Ave Correlation
18.9960
17.56
Ave Variance
4.3909
2.08
Ave Variance
6.5050
3.13
LIBOR1m
42.7688
4.23
LIBOR1m
51.6776
5.22
Ted Spread
-1.2845
-3.19
Ted Spread
-1.5927
-4.04
Panel (B): Portfolios Conditioned on the Past Week Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.1066
R2 = 0.1214
Coefficients
T-stat
Coefficients
T-stat
Intercept
-0.1348
-2.97
Intercept
-0.6136
-13.93
Dummy
0.3353
10.17
Dummy
0.3100
9.70
Ave Correlation
0.5888
7.22
Ave Correlation
0.7171
9.07
Ave Variance
1.4162
9.06
Ave Variance
1.6015
10.56
LIBOR1m
1.1907
1.59
LIBOR1m
2.0419
2.82
Ted Spread
-0.0137
-0.46
Ted Spread
-0.0463
-1.61
R2 = 0.1431
R2 = 0.1574
Coefficients
T-stat
Coefficients
T-stat
Intercept
-0.0041
-5.05
Intercept
-0.0110
-13.86
Dummy
0.0047
7.92
Dummy
0.0043
7.45
Ave Correlation
0.0070
4.79
Ave Correlation
0.0091
6.41
Ave Variance
0.0428
15.28
Ave Variance
0.0456
16.75
LIBOR1m
0.0135
1.01
LIBOR1m
0.0278
2.14
Ted Spread
0.00100
1.84
Ted Spread
0.00040
0.71
R2 = 0.0530
R2 = 0.0666
Coefficients
T-stat
Coefficients
T-stat
Intercept
0.0806
0.30
Intercept
-3.0224
-11.90
Dummy
1.5925
8.28
Dummy
1.4022
7.61
Ave Correlation
3.4570
7.26
Ave Correlation
4.4066
9.66
Ave Variance
2.0483
2.24
Ave Variance
3.5011
4.00
LIBOR1m
7.3695
1.69
LIBOR1m
13.5338
3.24
Ted Spread
-0.0627
-0.36
Ted Spread
-0.2779
-1.67

Weights Model

Model 1

Model 2

Model 3

Weights Model

Model 1

Model 2

Model 3

23

Table 7: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.2870
R2 = 0.2726
Coefficients
T-stat
Coefficients
Intercept
-1.31
-8.85
Intercept
-2.76
Dummy
1.45
18.42
Dummy
1.46
VIX
9.10
23.16
VIX
8.99
Rm-Rf
28.96
14.75
Rm-Rf
10.14
SMB
-10.09
-2.76
SMB
-9.55
HML
7.53
2.02
HML
6.59
Mom
16.69
6.44
Mom
16.76
Dividend Yield
36.60
7.29
Dividend Yield
36.01
Ted Spread
-0.56
-7.71
Ted Spread
-0.58
LIBOR1m
7.69
4.31
LIBOR1m
7.59
R2 = 0.3433
R2 = 0.3204
Coefficients
T-stat
Coefficients
Intercept
-0.03
-10.94
Intercept
-0.05
Dummy
0.02
15.31
Dummy
0.02
VIX
0.18
28.13
VIX
0.18
Rm-Rf
0.57
17.78
Rm-Rf
0.19
SMB
-0.27
-4.42
SMB
-0.25
HML
0.12
1.96
HML
0.09
Mom
0.25
5.80
Mom
0.25
Dividend Yield
0.22
2.67
Dividend Yield
0.20
Ted Spread
0.00
-3.93
Ted Spread
-0.01
LIBOR1m
0.14
4.81
LIBOR1m
0.14
R2 = 0.2318
R2 = 0.2133
Coefficients
T-stat
Coefficients
Intercept
-5.83
-7.10
Intercept
-14.79
Dummy
7.24
16.58
Dummy
7.25
VIX
39.48
18.11
VIX
39.25
Rm-Rf
172.68
15.86
Rm-Rf
53.88
SMB
-11.27
-0.56
SMB
-10.20
HML
65.28
3.15
HML
63.39
Mom
123.69
8.61
Mom
123.83
Dividend Yield
297.36
10.68
Dividend Yield
296.17
Ted Spread
-3.37
-8.29
Ted Spread
-3.40
LIBOR1m
48.53
4.90
LIBOR1m
48.35
Panel (B): Portfolios Conditioned on the Past Week Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.1706
R2 = 0.1314
Coefficients
T-stat
Coefficients
Intercept
-0.23
-3.87
Intercept
-0.61
Dummy
0.30
9.26
Dummy
0.30
VIX
2.44
15.31
VIX
2.39
Rm-Rf
14.32
18.00
Rm-Rf
2.82
SMB
-0.01
0.00
SMB
0.20
HML
0.17
0.11
HML
-0.20
Mom
5.46
5.19
Mom
5.48
Dividend Yield
2.69
1.32
Dividend Yield
2.46
Ted Spread
-0.07
-2.40
Ted Spread
-0.08
LIBOR1m
1.67
2.31
LIBOR1m
1.63
R2 = 0.2000
R2 = 0.1645
Coefficients
T-stat
Coefficients
Intercept
-0.01
-4.83
Intercept
-0.01
Dummy
0.00
7.28
Dummy
0.00
VIX
0.05
17.19
VIX
0.05
Rm-Rf
0.25
17.61
Rm-Rf
0.06
SMB
-0.04
-1.33
SMB
-0.03
HML
-0.02
-0.61
HML
-0.03
Mom
0.09
4.73
Mom
0.09
Dividend Yield
-0.07
-1.94
Dividend Yield
-0.08
Ted Spread
0.00
1.41
Ted Spread
0.00
LIBOR1m
0.02
1.81
LIBOR1m
0.02
R2 = 0.1419
R2 = 0.0784
Coefficients
T-stat
Coefficients
Intercept
-0.79
-2.30
Intercept
-3.20
Dummy
1.30
7.07
Dummy
1.31
VIX
10.20
11.10
VIX
10.03
Rm-Rf
98.12
21.38
Rm-Rf
15.83
SMB
27.34
3.20
SMB
28.14
HML
13.38
1.53
HML
11.97
Mom
45.54
7.52
Mom
45.65
Dividend Yield
46.85
3.99
Dividend Yield
45.96
Ted Spread
-0.56
-3.27
Ted Spread
-0.58
LIBOR1m
10.86
2.60
LIBOR1m
10.72

T-stat
-18.64
18.49
22.84
5.16
-2.61
1.76
6.46
7.16
-7.91
4.25
T-stat
-18.75
15.48
27.40
6.01
-4.08
1.39
5.85
2.40
-4.39
4.69
T-stat
-18.02
16.61
18.00
4.95
-0.50
3.06
8.61
10.63
-8.37
4.88

T-stat
-10.20
9.34
15.03
3.54
0.13
-0.13
5.22
1.21
-2.60
2.26
T-stat
-9.56
7.40
16.75
3.88
-1.12
-0.96
4.76
-2.10
1.11
1.74
T-stat
-9.26
7.13
10.91
3.45
3.30
1.37
7.53
3.92
-3.41
2.57

Table 8: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.2258
Model 1

R2 = 0.2327

Coefficient

T-stat

Intercept

0.4161

8.70

Coefficient

T-stat

Intercept

-1.1504

-24.39

Dummy

1.6058

Realized Volatility

6.2913

30.47

Dummy

1.5978

30.75

16.35

Realized Volatility

6.5330

17.21

R2 = 0.2627
Model 2

R2 = 0.2705

Coefficient

T-stat

Intercept

-0.0036

-4.35

Coefficient

T-stat

Intercept

-0.0253

-31.35

Dummy

0.0251

Realized Volatility

0.1724

27.67

Dummy

0.0250

28.10

26.00

Realized Volatility

0.1731

26.65

R2 = 0.1586
Model 3

R2 = 0.1660

Coefficient

T-stat

5.0419

18.95

Dummy

7.7756

26.53

Realized Volatility

19.5463

9.13

Intercept

Coefficient

T-stat

-4.5811

-17.51

Dummy

7.7162

26.77

Realized Volatility

22.0967

10.50

Intercept

Panel (B): Portfolios Conditioned on the Past Week Returns

Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.0932
Model 1

R2 = 0.1037

Coefficient

T-stat

Intercept

0.1231

6.35

Coefficient

T-stat

Intercept

-0.3098

-16.47

Dummy

0.3649

Realized Volatility

1.7565

17.08

Dummy

0.3595

17.35

11.26

Realized Volatility

1.9641

12.98

R2 = 0.1093
Model 2

R2 = 0.1195

Coefficient

T-stat

Intercept

-0.0009

-2.57

Coefficient

T-stat

Intercept

-0.0071

-19.84

Dummy

0.0060

Realized Volatility

0.0486

14.92

Dummy

0.0059

15.11

16.56

Realized Volatility

0.0513

17.93

R2 = 0.0431
Model 3

24

R2 = 0.0512

Coefficient

T-stat

Intercept

1.5604

13.54

Coefficient

T-stat

Intercept

-1.1712

-10.59

Dummy

1.5832

Realized Volatility

5.1358

12.47

Dummy

1.5422

12.65

5.54

Realized Volatility

6.8954

7.75

Table 9: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.2293

Model 1

R2 = 0.2365

Coefficients

T-stat

Intercept

0.5447

9.38

Coefficients

T-stat

Intercept

-1.0293

-17.97

Dummy

1.8297

23.31

Dummy

1.8079

23.36

Realized Volatility

6.6097

14.58

Realized Volatility

7.0048

15.67

LIBOR1m

-5.4191

-3.24

LIBOR1m

-4.8099

-2.91

Ted Spread

-0.1189

-1.69

Ted Spread

-0.1630

-2.35

R2 = 0.2632

Model 2

R2 = 0.2708

Coefficients

T-stat

Intercept

-0.0027

-2.68

Coefficients

T-stat

Intercept

-0.0245

-24.96

Dummy

0.0267

19.71

Dummy

0.0264

19.86

Realized Volatility

0.1687

21.56

Realized Volatility

0.1731

22.58

LIBOR1m

-0.0479

-1.66

LIBOR1m

-0.0365

-1.29

Ted Spread

0.0009

0.75

Ted Spread

-0.0001

-0.12

R2 = 0.1639

Model 3

R2 = 0.1717

Coefficients

T-stat

Coefficients

T-stat

Intercept

5.8325

18.07

Dummy

9.1483

20.97

Intercept

-3.8483

-12.13

Dummy

8.9838

Realized Volatility

22.3510

20.94

8.87

Realized Volatility

25.7353

LIBOR1m

10.39

-31.8719

-3.43

LIBOR1m

-27.7695

Ted Spread

-3.04

-0.9825

-2.51

Ted Spread

-1.2191

-3.17

Panel (B): Portfolios Conditioned on the Past Week Returns

Weights Model

Reversal Returns Portfolio

Adjusted Reversal Returns Portfolio

R2 = 0.0947

Model 1

R2 = 0.1044

Coefficients

T-stat

Intercept

0.1494

6.34

Coefficients

T-stat

Intercept

-0.2886

-12.61

Dummy

0.4121

12.93

Dummy

0.3971

12.84

Realized Volatility

1.5451

8.40

Realized Volatility

1.8397

10.30

LIBOR1m

-1.5830

-2.33

LIBOR1m

-1.1923

-1.81

Ted Spread

0.0578

2.02

Ted Spread

0.0329

1.19

R2 = 0.1143

Model 2

R2 = 0.1230

Coefficients

T-stat

Intercept

-0.0008

-1.77

Coefficients

T-stat

Intercept

-0.0070

-16.16

Dummy

0.0063

10.54

Dummy

0.0061

10.42

Realized Volatility

0.0396

11.44

Realized Volatility

0.0438

13.00

LIBOR1m

-0.0227

-1.77

LIBOR1m

-0.0162

-1.30

Ted Spread

0.0027

4.96

Ted Spread

0.0022

4.20

R2 = 0.0439

Model 3

25

R2 = 0.0518

Coefficients

T-stat

Coefficients

T-stat

Intercept

1.7142

12.23

Dummy

1.8545

9.79

Intercept

-1.0573

-7.85

Dummy

1.7408

Realized Volatility

4.7487

9.57

4.34

Realized Volatility

7.0858

LIBOR1m

6.75

-7.7907

-1.93

LIBOR1m

-4.9535

-1.28

Ted Spread

0.0858

0.51

Ted Spread

-0.0781

-0.48

Weights Model

Model 1

Model 2

Model 3

Weights Model

Model 1

Model 2

Model 3

26

Table 10: Regression Results

Panel (A): Portfolios Conditioned on the Yesterday Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.2645
R2 = 0.2479
Coefficients
T-stat
Coefficients
Intercept
0.09
0.72
Intercept
-1.40
Dummy
1.78
23.15
Dummy
1.79
Realized Volatility
8.09
17.07
Realized Volatility
7.85
Rm-Rf
27.59
13.88
Rm-Rf
8.70
SMB
-10.49
-2.83
SMB
-10.02
HML
7.88
2.10
HML
6.86
Mom
18.66
7.10
Mom
18.62
Dividend Yield
15.89
3.27
Dividend Yield
15.10
Ted Spread
-0.22
-3.13
Ted Spread
-0.23
LIBOR1m
-2.95
-1.71
LIBOR1m
-3.10
R2 = 0.3094
R2 = 0.2824
Coefficients
T-stat
Coefficients
Intercept
0.00
-0.93
Intercept
-0.02
Dummy
0.03
19.67
Dummy
0.03
Realized Volatility
0.19
22.83
Realized Volatility
0.18
Rm-Rf
0.57
16.69
Rm-Rf
0.18
SMB
-0.25
-4.02
SMB
-0.24
HML
0.14
2.11
HML
0.10
Mom
0.31
6.81
Mom
0.30
Dividend Yield
-0.12
-1.40
Dividend Yield
-0.15
Ted Spread
0.00
0.13
Ted Spread
0.00
LIBOR1m
-0.05
-1.61
LIBOR1m
-0.05
R2 = 0.2166
R2 = 0.1962
Coefficients
T-stat
Coefficients
Intercept
0.54
0.79
Intercept
-8.70
Dummy
8.79
20.77
Dummy
8.80
Realized Volatility
35.09
13.44
Realized Volatility
34.58
Rm-Rf
166.54
15.21
Rm-Rf
48.21
SMB
-13.25
-0.65
SMB
-12.25
HML
67.37
3.25
HML
65.22
Mom
131.99
9.11
Mom
131.90
Dividend Yield
206.29
7.71
Dividend Yield
204.62
Ted Spread
-1.94
-5.00
Ted Spread
-1.95
LIBOR1m
-4.00
-0.42
LIBOR1m
-4.31
Panel (B): Portfolios Conditioned on the Past Week Returns
Reversal Returns Portfolio
Adjusted Reversal Returns Portfolio
R2 = 0.1575
R2 = 0.1134
Coefficients
T-stat
Coefficients
Intercept
0.18
3.57
Intercept
-0.21
Dummy
0.39
12.68
Dummy
0.39
Realized Volatility
1.96
10.30
Realized Volatility
1.87
Rm-Rf
13.96
17.51
Rm-Rf
2.35
SMB
0.00
0.00
SMB
0.18
HML
0.17
0.11
HML
-0.21
Mom
6.07
5.76
Mom
6.06
Dividend Yield
-3.52
-1.81
Dividend Yield
-3.82
Ted Spread
0.04
1.33
Ted Spread
0.03
LIBOR1m
-1.53
-2.21
LIBOR1m
-1.59
R2 = 0.1745
R2 = 0.1364
Coefficients
T-stat
Coefficients
Intercept
0.00
2.66
Intercept
0.00
Dummy
0.01
10.33
Dummy
0.01
Realized Volatility
0.04
12.03
Realized Volatility
0.04
Rm-Rf
0.25
16.50
Rm-Rf
0.05
SMB
-0.03
-1.16
SMB
-0.03
HML
-0.02
-0.57
HML
-0.03
Mom
0.10
5.22
Mom
0.10
Dividend Yield
-0.18
-5.02
Dividend Yield
-0.19
Ted Spread
0.00
5.01
Ted Spread
0.00
LIBOR1m
-0.04
-2.76
LIBOR1m
-0.04
R2 = 0.1340
R2 = 0.0679
Coefficients
T-stat
Coefficients
Intercept
0.78
2.68
Intercept
-1.68
Dummy
1.68
9.31
Dummy
1.69
Realized Volatility
9.28
8.33
Realized Volatility
8.92
Rm-Rf
96.70
20.69
Rm-Rf
14.82
SMB
26.78
3.07
SMB
27.48
HML
15.12
1.71
HML
13.62
Mom
47.72
7.72
Mom
47.66
Dividend Yield
24.16
2.11
Dividend Yield
22.98
Ted Spread
-0.20
-1.21
Ted Spread
-0.21
LIBOR1m
-1.69
-0.42
LIBOR1m
-1.91

T-stat
-11.28
23.20
16.53
4.37
-2.70
1.82
7.07
3.10
-3.24
-1.79
T-stat
-10.24
19.78
21.63
5.27
-3.72
1.51
6.75
-1.74
-0.12
-1.78
T-stat
-12.73
20.79
13.24
4.40
-0.60
3.15
9.10
7.64
-5.04
-0.45

T-stat
-4.30
12.75
9.81
2.94
0.12
-0.14
5.74
-1.96
1.22
-2.29
T-stat
-3.03
10.44
11.33
3.17
-0.99
-0.94
5.19
-5.24
4.85
-2.87
T-stat
-5.76
9.36
8.00
3.17
3.15
1.54
7.71
2.01
-1.29
-0.47

Appendix A
Proof of Proposition 1: The liquidity demanders try to maximize their expected utility of t = 2,
by choosing the optimum value of 1d at t = 1. The liquidity demanders wealth at t = 2 will be
constitute of their wealth from t = 1 (i.e. W1 ) their capital gain from investing on the risky assets

(i.e. 1d (S2 S1 )) and the extra endowment zM(S2 S) that they receive at t = 2.

W2d = W1 + 1d (S2 S1 ) + zM(S2 S).

At t = 1, the liquidity demanders expectation about their final utility (i.e. U1d ) will be

U1d = [exp (W1 1d (S2 S1 ) zM (S2 S))].

U1d = [exp(W1 1d S2 + 1d S1 zM S2 + zM S)].

At t = 1, the size of the liquidity shock (z) is already known. Therefore, S2 is the only random
variable in this equation. Given that S2 ~N(S ), we have

U1d

= exp (W1 +

U1d

1d S1

+ zM S

= exp (W1 +

1d (S1

(1d

+ zM) S +

S) +

2 d

(1 + zM) (1d + zM)).

2

2 d

(1 + zM) (1d + zM)).

2

To maximize the expected utility in terms of the risky assets weights (i.e. 1d ), we must set the
corresponding derivative to zero.

27

U1d
1d
yields

= 0.

S1 S + 2 (1d + zM) = 0.

S1 S + (1d + zM) = 0.

1d + zM =

1 1
(S S1 ),

which gives the optimal holding of the liquidity demanders on the risky assets at t = 1.

1d =

1 1
(S S1 ) zM

Similarly one can show that the optimal holding of the liquidity suppliers on the risky assets is

1s =

1 1
(S S1 )

Proof of Proposition 2: At t = 1, a population of the investors (the liquidity demanders) hold

1d and the rest of them hold 1s . The aggregate holdings must be equal to the number of all
shares outstanding in the whole market.
1d + (1 )1s = ,
1
1
From Proposition 1, we know that 1d = 1 (S S1 ) zM and 1s = 1 (S S1 ), thus

(1 ) 1
1
(S S1 ) zM +
(S S1 ) = ,

28

 1 (S S1 ) = + zM.
Therefore the equilibrium prices at t = 1, will be
S1 = S ( + zM)

Proof of Proposition 3: From Proposition 2 we have

S1 = S ( + zM)
which gives
S2 S1 = S2 S + ( + zM)
S1 S0 = S ( + zM) S0
= diag(Cov(S2 S1 , S1 S0 )) = diag(E((S2 S1 )(S1 S0 ) ) E(S2 S1 )E(S1 S0 ))
= diag(E((zM)(zM) ) E(zM)E(zM))
= diag(E(2 2 z 2 MM))
= diag(2 2 MM 2z )
= 2 2 2z diag(MM )
0
For example if M = [1] then
0

29

21 21
2 2 2
z diag ([21 22
21 23

21 22
22 22
23 22

21 23
21 21
2
2
2
23 22 ]) = z [22 22 ]
23 23
23 23

For a market portfolio

S2m S1m = W(S2 S + ( + zM))
S1m S0m = W(S ( + zM) S0 )
M = Cov(S2M S1M , S1M S0M ) = (E ((S2M S1M )(S1M S0M ) ) E(S2M S1M )E(S1M S0M ))
M = E((zW M)(zW M) ) E(zW M)E(zW M)
M = E(2 2 z 2 W MM W)
M = 2 2 2z W MM W
M = 2 2 2z W MM W
0
For example if M = [1] then
0
3
M

2 2 2z wi wj 2i 2j
i=1 j=1

Proof of Proposition 4: Given the results of Proposition 1 and 2, one can show,
1d = + ( 1)zM

30

1s = + zM

Moreover we know that

W1 = W0 + 0 (S1 S0 )
W1 = W0 + 0 (S S0 ( + zM))
So

U1d

= exp (W1 +

1d (S1

S) +

2 d

(1 + zM) (1d + zM))

2

W1

d
1 (S1 S)

U1d = exp
W0 0 (S S0 ( + zM))
2 ( + ( 1)zM) ( + zM)
(

2
( + ( 1)zM + zM) ( + ( 1)zM + zM)

2
+

2 d
( +zM) (d
1 +zM)
2 1

U1d = exp (W0 0 S + 0 S0 + 2 0 ( + zM) 2 2 z M

2 ( 1)zM 2 ( 1)z 2 M M
2
+ ( + 2z M + z 2 2 M M))
2

We define

Ad = W0 + 0 S 0 S0 0 +
2

31

Bd = 0 M (1 ) M
Cd = (2 2)M M
1
U1d = exp ( (Ad + Bd z + Cd z 2 ))
2
Fd

exp (Ad
U0d = [U1d ] =

Bd 2z
)
2 (1 + Cd 2z )

)
|1 +

Cd 2z |

3 2z (0 M + (1 ) M)2
Fd = W0 + 0 S 0 S0 0 +
2
2 (1 + 2 2z (2 2)M M)
At t = 0 the investors are identical, and thereby, they all hold the market portfolio, (i.e. 0 = )
thus

3 2z ( M)2
Fd = W0 + S S0
2
2 (1 + 2 2z (2 2)M M)

Fd
3 2z ( M)(M)
= S S0

1 + 2 2z (2 2)M M

Similarly for the liquidity suppliers, we know that

U1s = exp (W1 + 1s (S1 S) +

gives

32

2 s s
),
2 1 1

s1 (S1 S)

W1

U1s = exp
W0 0 (S S0 ( + zM))
2 ( + zM) ( + zM)
(
2
+ ( + zM) ( + zM) ,

2
2 s s
1
2 1

U1s = exp (W0 0 S + 0 S0 + 2 0 ( + zM) 2 22 zM

2
z M M + ( + 2z M + z 2 2 M M))
2
2 2 2

We define

As = W0 + 0 S 0 S0 0 +
2
Bs = ( 0 ) M
Cs = 2 M M
1
U1s = exp ( (As + Bs z + Cs z 2 ))
2
Fs

exp (As
U0s = [U1s ] =

Bs 2 2z
)
2 (1 + Cs 2z )
)
s
2
|1 + C z |

3 2 2z (( 0 ) M)2
Fs = W0 + 0 S 0 S0 0 +
2
2 (1 + 2 2z 2 M M)
33

Again at t = 0 the investors are identical, and therefore they all hold the market portfolio, (i.e.
0 = )

Fs = W0 + S S0
2
Fs
= S S0

Before a liquidity shock occurs, we know that a population of the investors will be liquidity
demanders and the rest will be liquidity suppliers. Therefore the aggregate utility will be
U0 = U0d + (1 )U0s ,
To optimize the holding on the risky assets at t = 0, we must set the corresponding derivative to
zero, thus
U0
U0d
U0s
(1
=
+ )
= 0,

Fd
1
Fs
exp(Fd ) (
)+
exp(Fs ) ( ) = 0

|1 + 2 2z (2 2)M M|
|1 + 2 2z 2 M M|

1 + 2 2z 2 M M
Fd
Fs
))
|
|
exp((F

F
(
)
+
(
)=0
d
s
1 1 + 2 2z (2 2)M M

We define 0 = (1 + 2 2z (2 2)M M) and 1 = 2 2z M, thus one can show that

Fd Fs =

34

3 2z ( M)2
1 M
=
2(1 + 2 2z (2 2)M M)
20

Therefore,

1 + 2 2z 2 M M
2 1 M Fd
Fs
|
| exp (
)(
)+( )= 0
1
0
20

Also we know that

Fs
= S S0

Fd
1 (M)
= S S0

0
Therefore,

1 + 2 2z 2 M M
2 1 M
1 (M)
|
| exp (
) (S S0
) + (S S0 )
1
0
20
0
=0

1+2 2z 2 M M

We define = |

2 1 M

| exp (

20

). In this case > 0 and

1 (M)
(S S0
) + (S S0 ) = 0
1
0
+ 1
1 (M)
(S S0 )
(
)=0
1
1
0
Which gives the risky assets equilibrium price at t = 0 with

35

S0 = S

( 1 )
0

1 +

0
For example if M = [1] then
0
1
)
0

S0i = Si 0,i ij

1 + i2
3

j=0

36

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38