Showing papers by "J.P. Morgan & Co. published in 2008"

Mortality Density Forecasts: An Analysis of Six Stochastic Mortality Models

Abstract: We investigate the uncertainty of forecasts of future mortality generated by a number of previously proposed stochastic mortality models. We specify fully the stochastic structure of the models to enable them to generate forecasts. Mortality fan charts are then used to compare and contrast the models, with the conclusion that model risk can be significant. The models are also assessed individually with reference to three criteria that focus on the plausibility of their forecasts: biological reasonableness of forecast mortality term structures; biological reasonableness of individual stochastic components of the forecasting model (for example, the cohort erect); and reasonableness of forecast levels of uncertainty relative to historical levels of uncertainty. In addition, we consider a fourth assessment criterion dealing with the robustness of forecasts relative to the sample period used to fit the model. To illustrate the assessment methodology, we analyse a data set consisting of national population data for England & Wales, for Males aged between 60 and 90 years old. We note that this particular data set may favour those models designed for application to older ages, such as variants of Cairns-Blake-Dowd, and emphasise that a similar analysis should be conducted for the specific data set of interest to the reader. We draw some conclusions based on the analysis and compare to the application of the models for the same age group and gender for the United States population. Finally, we note the broader application of the approach to model selection for alternate data sets and populations

Backtesting Stochastic Mortality Models: An Ex-Post Evaluation of Multi-Period Ahead-Density Forecasts

Abstract: This study sets out a backtesting framework applicable to the multi-period-ahead forecasts from stochastic mortality models and uses it to evaluate the forecasting performance of six different stochastic mortality models applied to English & Welsh male mortality data. The models considered are: Lee-Carter’s 1992 one-factor model; a version of Renshaw-Haberman’s 2006 extension of the Lee-Carter model to allow for a cohort effect; the age-period-cohort model of Currie (2006), which is a simplified version of Renshaw-Haberman; Cairns, Blake and Dowd’s 2006 two-factor model; and two generalised versions of the latter with an added cohort effect. For the data set used herein the results from applying this methodology suggest that the models perform adequately by most backtests, and that there is little difference between the performances of five of the models. The remaining model, however, shows forecast instability. The study also finds that density forecasts that allow for uncertainty in the parameters of the mortality model are more plausible than forecasts that do not allow for such uncertainty.

A new framework for dynamic credit portfolio loss modelling

Abstract: We present the SPA framework, a novel approach to the modeling of the dynamics of portfolio default losses. In this framework, models are specified by a two-layer process. The first layer models the dynamics of portfolio loss distributions in the absence of information about default times. This background process can be explicitly calibrated to the full grid of marginal loss distributions as implied by initial CDO tranche values indexed on maturity, as well as to the prices of suitable options. We give sufficient conditions for consistent dynamics. The second layer models the loss process itself as a Markov process conditioned on the path taken by the background process. The choice of loss process is non-unique. We present a number of choices, and discuss their advantages and disadvantages. Several concrete model examples are given, and valuation in the new framework is described in detail. Among the specific securities for which algorithms are presented are CDO tranche options and leveraged super-senior tranches.

Optimal modification factor and convergence of the Wang-Landau algorithm.

Abstract: We propose a strategy to achieve the fastest convergence in the Wang-Landau algorithm with varying modification factors. With this strategy, the convergence of a simulation is at least as good as the conventional Monte Carlo algorithm, i.e., the statistical error vanishes as $1∕\sqrt{t}$, where $t$ is a normalized time of the simulation. However, we also prove that the error cannot vanish faster than $1∕t$. Our findings are consistent with the $1∕t$ Wang-Landau algorithm discovered recently, and we argue that one needs external information in the simulation to beat the conventional Monte Carlo algorithm.

Sovereign rescheduling probabilities in emerging markets: a comparison with credit rating agencies’ ratings

Abstract: This study estimates default probabilities of 124 emerging countries from 1981 to 2002 as a function of a set of macroeconomic and political variables. The estimated probabilities are then compared with the default rates implied by sovereign credit ratings of three major international credit rating agencies (CRAs) – Moody's Investor's Service, Standard & Poor's and Fitch Ratings. Sovereign debt default probabilities are used by investors in pricing sovereign bonds and loans as well as in determining country risk exposure. The study finds that CRAs usually underestimate the risk of sovereign debt as the sovereign credit ratings from rating agencies are usually too optimistic.

The Era of Cross‐Border M&A: How Current Market Dynamics are Changing the M&A Landscape

Abstract: Rising equity volatility, surging energy prices, a weakening dollar, and widening credit spreads are influencing both tactical financing decisions and long-term financial strategy. Amid this turbulence is a quickly changing global M&A landscape that portends long-term opportunities to deliver value to shareholders. In this environment, the authors offer the following suggestions for U.S. multinationals: (1) continue looking overseas for well-positioned targets, especially in emerging markets, even in the context of a weak U.S. dollar; (2) consider using their financial flexibility for opportunistic deals today now that asset values are contracting; and (3) critically evaluate non-core assets at home or abroad that might be valuable to cross-border acquirers. For multinationals in Europe and developing economies, the time may be right to consider transformational cross-border “megadeals.” Emerging-market companies have the opportunity to buy low and sell high by using high-valued equity as an acquisition currency, particularly to gain access to developed markets. Companies in need of new capital should consider the financial and strategic benefits of selling minority stakes to a sovereign wealth fund or other foreign partner.

Computationally Efficient Gaussian Maximum Likelihood Methods for Vector ARFIMA Models

Abstract: In this paper, we discuss two distinct multivariate time series models that extend the univariate ARFIMA model. We describe algorithms for computing the covariances of each model, for computing the quadratic form and approximating the determinant for maximum likelihood estimation, and for simulating from each model. We compare the speed and accuracy of each algorithm to existing methods and measure the performance of the maximum likelihood estimator compared to existing methods. We also fit models to data on unemployment and inflation in the United States, to data on goods and services inflation in the United States, and to data about precipitation in the Great Lakes.

Two Exotic Lookback Options

Abstract: This paper formally analyses two exotic options with lookback features, referred to as extreme spread lookback options and look‐barrier options, first introduced by Bermin. The holder of such options receives partial protection from large price movements in the underlying, but at roughly the cost of a plain vanilla contract. This is achieved by increasing the leverage through either floating the strike price (for the case of extreme spread options) or introducing a partial barrier window (for the case of look‐barrier options). We show how to statically replicate the prices of these hybrid exotic derivatives with more elementary European binary options and their images, using new methods first introduced by Buchen and Konstandatos. These methods allow considerable simplification in the analysis, leading to closed‐form representations in the Black–Scholes framework.

Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?

Abstract: Few areas of monetary economics have been studied as extensively as the transmission mechanism. The literature on this topic has evolved substantially over the years, following the waxing and waning of conceptual frameworks and the changing characteristics of the financial system. In this paper, taking as a starting point a brief overview of the extant work on the interaction between capital regulation, the business cycle and the transmission mechanism, we offer some broader reflections on the characteristics of the transmission mechanism in light of the evolution of the financial system. We argue that insufficient attention has so far been paid to the link between monetary policy and the perception and pricing of risk by economic agents - what might be termed the "risk-taking channel" of monetary policy. We develop the concept, compare it with current views of the transmission mechanism, explore its mutually reinforcing link with "liquidity" and analyse its interaction with monetary policy reaction functions. We argue that changes in the financial system and prudential regulation may have increased the importance of the risk-taking channel and that prevailing macroeconomic paradigms and associated models are not well suited to capturing it, thereby also reducing their effectiveness as guides to monetary policy.

Not All Trading Volumes are Created Equal: Capital Gains Overhang and the Earnings Announcement Volume Premium

Abstract: We examine a possible cause for the higher returns realized by stocks that experience high abnormal trading volume around earnings announcements. We find that this earnings announcement volume premium is concentrated in stocks with either large aggregate unrealized capital gains or large aggregate unrealized capital losses. A high volume minus low volume portfolio conditioned on the magnitude of capital gains overhang generates returns as high as 11% per year. These returns are significant and robust to conventional risk adjustments. Our finding suggests that the high returns accruing to high volume stocks are associated with selling pressure, which is independent of fundamentals, coming from a subset of investors who base their selling decisions on the magnitude of unrealized capital gains or losses. The patterns we document also suggest that the well known disposition effect may not hold for stocks with extreme unrealized capital losses and are consistent with recent theoretical and empirical research that shows extreme losses prompt selling.

A Study About the Existence of the Leverage Effect in Stochastic Volatility Models

Abstract: The empirical relationship between the return of an asset and the volatility of the asset has been well documented in the financial literature. Named the leverage e ffect or sometimes risk-premium effect, it is observed in real data that, when the return of the asset decreases, the volatility increases and vice-versa. Consequently, it is important to demonstrate that any formulated model for the asset price is capable to generate this eff ect observed in practice. Furthermore, we need to understand the conditions on the parameters present in the model that guarantee the apparition of the leverage effect. In this paper we analyze two general speci cations of stochastic volatility models and their capability of generating the perceived leverage effect. We derive conditions for the apparition of leverage e ffect in both of these stochastic volatility models. We exemplify using stochastic volatility models used in practice and we explicitly state the conditions for the existence of the leverage effect in these examples.

Connecting singular control with optimal switching

Abstract: We summarize our recent work, on a new theoretical connection between singular control of finite variation and optimal switching problems. This correspondence not only provides a novel method for analyzing multidimensional singular control problems, but also builds links among singular controls, Dynkin games, and sequential optimal stopping problems.

Solving Singular Control from Optimal Switching

Abstract: This report summarizes some of our recent work (Guo and Tomecek, SIAM J Control Optim 47(1):421–443, 2008; A class of singular control problems and smooth fit principle, 2008) on a new theoretical connection between singular control of finite variation and optimal switching problems. This correspondence not only provides a novel method for analyzing multi-dimensional singular control problems, but also builds links among singular controls, Dynkin games, and sequential optimal stopping problems.

Network Structure and Design in the Deregulated U.S. Airline Industry: An Argument for Re-Regulation?

Abstract: This paper develops a model to explain and analyze the evolution of network structure (connectivity) and design (flight frequency, aircraft size, prices) in the post-deregulation U.S. airline industry. We show that legacy carriers choice of Hub-and-Spoke networks and the emergence of low cost carriers (LCCs) operating Point-to-Point networks were optimal choices. We demonstrate that LCCs need not necessarily charge lower prices, and their entry impacted legacy carriers' prices in all markets, even those where there is no direct competition. We show that in response to entry, legacy carriers optimally lower flight frequency, leading to longer wait times between flights for which passengers are compensated by lower prices; conversely, if the entrant later exits, legacy carriers raise flight frequency and therefore prices, which may erroneously appear to be predatory pricing when in fact it is the consequence of optimal network redesign. Finally, we demonstrate that even though low cost carriers lower prices, total social welfare with competing network structures can also be lowered. In other words, the poor financial performance of legacy carriers is not due to their inefficiency per se but due to an efficient Hub-and-Spoke network undermined by competition from inefficient Point-to-Point networks. We argue that social welfare may have been, and still can be, higher if entry and exit in air passenger travel industry is regulated.

Alpha insurance: A computational framework to measure hedging demands for active investors

Abstract: The purpose of the paper is to develop the concept of portfolio insurance against active managers' stock selection risks. The insurance premium is estimated through the use of exotic options and the impact on investors' utility is analysed within a multi-moment efficient frontier framework. For illustration, the suggested methodology is applied to the Swiss Market Index and employed to estimate the hedging demands faced by investors when the portfolio choice problem is considered in a multi-period framework.