Correcting the Merton and Henriksson timing model

This article provides evidence of a common bias found in traditional timing models, which is related with a negative correlation between timing and stock-picking abilities resulting in spurious coefficients. We consider as a possible cause for this bias the failure to include in the timing models the cost of the option implied in timing activities, and on this basis we opt for a corrected version of the Merton and Henriksson's model (1981). As far as we know, this correction has not previously been applied. Our results confirm both the existence of this bias and the correction of the problem when the cost of the option is included in timing models.