Showing papers in "The Finance in 2002"

Portfolio insurance: the extreme value approach to the CPPI method

Abstract: The theory of portfolio insurance is important theory since some well-known past ...nancial crisis. The objective of the portfolio insurance is to give the investor the ability to limit downside risk while allowing some participation in upside markets. This return pattern has seemed attractive to many investors who have poured up to billions of dollars into various portfolio insurance products. Here, we are interested in a widely used one : the Constant Proportion Portfolio Insurance (CPPI). The CPPI method uses a simpli...ed strategy to allocate assets dynamically over time. It requires that two assets are exchanged on the ...nancial market : the riskless asset, B, with a constant interest rate r (= 5%) (usually Treasury bills or other liquid money market instruments) and the risky one, S (usually a market index or a basket of market indexes). This method is rather simple and consists mainly on ...xing a deterministic ‡oor such that the portfolio value will never be below this level. The exposure which is the amount invested on the risky asset is such that it is always equal to a ...xed proportion of the total portfolio value. This is done by choosing an appropriated constant, called the multiple. Nevertheless, this multiple must not ne too high to keep the guarantee. In this paper, we apply the extreme value theory to the study of this CPPI method, in particular to determine the multiple. A quantile hedging approach is introduced, which provides an upper bound on the standard multiple m. This bound is statistically estimated from the behavior of extreme variations in rates of asset returns. Moreover, we introduce the distributions of interarrival times of these extreme movements and show their impact on the portfolio insurance. We illustrate these results on S&P 500 data. 1 * GREQAM et Universite de Montpellier 1 ** THEMA, Universite de Cergy, 33 Bd du Port, 95011, CERGY, FRANCE. Tel: 331 34 25 61 72, Fax: 331 34 25 62 33, e-mail: prigent@u-cergy.fr

The disposition effect and momentum

Abstract: Prior experimental and empirical research documents that many investors have a lower propensity to sell those stocks on which they have a capital loss. This behavioral phenomenon, known as \the disposition effect, has implications for equilibrium prices. We investigate the temporal pattern of stock prices in an equilibrium that aggregates the demand functions of both rational and disposition investors. The disposition effect creates a spread between a stock's fundamental value { the stock price that would exist in the absence of a disposition effect { and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. Spread convergence, arising from the random evolution of fundamental values, generates predictable equilibrium prices. This convergence implies that stocks with large past price run-ups and stocks on which most investors experienced capital gains have higher expected returns than those that have experienced large declines and capital losses. The probability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Cross-sectional empirical tests of the model find that stocks with large aggregate unrealized capital gains tend to have higher expected returns than stocks with large aggregate unrealized capital losses and that this capital gains \overhang appears to be the key variable that generates the probability of a momentum strategy. When this capital gains variable is used as a regressor along with past returns and volume to predict future returns, the momentum effect disappears.

Accouting for Biases in Black-Scholes

Abstract: Prices of currency options commonly differ from the Black-Scholes formula along two dimensions: implied volatilities vary by strike price (volatility smiles) and maturity (implied volatility of at­the­money options increases, on average, with maturity). We account for both using Gram­Charlier expansions to approximate the conditional distribution of the logarithm of the price of the underlying security. In this setting, volatility is approximately a quadratic function of moneyness, a result we use to infer skewness and kurtosis from volatility smiles. Evidence suggests that both kurtosis in currency prices and biases in Black­Scholes option prices decline with maturity.

Multivariate extremes at work for portfolio risk measurement

Abstract: This paper proposes a methodology to provide risk measures for portfolios during extreme events. The approach is based on splitting the multivariate extreme value distribution of the assets of the portfolio into two parts: the distributions of each asset and their dependence function. The estimation problem is also investigated. Then, stress-testing is applied for market indices portfolios and Monte-Carlo based risk measures — Value-at-Risk and Expected Shortfall — are provided.

Monte Carlo Pricing of American Options Using Nonparametric Regression

Abstract: This paper provides an introduction to Monte Carlo algorithms for pricing American options written on multiple assets, with special emphasis on methods that can be applied in a multi-dimensional setting. Simulated paths can be used to estimate by nonparametric regression the continuation value of the option or the optimal exercise policy and the value functions can then be computed by backward induction. The exibilit y of nonparametric regression allows to obtain accurate price estimates with remarkable speed. For illustrative purpose we price oneand two-dimensional American options.

Latin american financial development in perspective

Abstract: This paper assesses financial sector development in Latin America, both in the banking system and in the capital markets. After a brief review of the explanatory factors and the definitions of financial development found in the literature, Latin American countries are classified in groups of similar characteristics by using cluster analysis - first worldwide and second within the region - in terms of financial depth and per capita income. In the worldwide exercise, virtually all Latin American countries appear in the same cluster, which argues in favor of a regional dimension in financial development. A comparison of the Asian and Eastern European emerging regions shows that Latin America lags behind Asia in terms of financial development and compares slightly unfavorably with Eastern Europe. In the regional cluster exercise, four relatively homogeneous groups of Latin American countries are found. Stylized facts of the four groups’ banking sectors and capital markets show - in line with the results of the more recent economic literature - that those countries which have deeper financial systems are also those with a more efficient financial system. Although no conclusions on causality can be drawn from this review, it argues in favor of a virtuous circle, in terms of financial depth and efficiency, for countries with the most appropriate structure of the financial system.

Are Interest Rate Derivatives Spanned by the Term Structure of Interest Rates

Abstract: We investigate whether the same finite dimensional dynamic system spans both interest rates (the yield curve) and interest rate options (the implied volatility surface). We find that the options market exhibits factors independent of the underlying yield curve. While three common factors are adequate to capture the systematic movement of the yield curve, we need three additional factors to capture the movement of the implied volatility surface.

Development of Non Bank Financial Institutions to Strengthen the Financial System of Bangladesh

Abstract: Non-bank financial institutions (NBFIs) represent one of the most important parts of a financial system. In Bangladesh, NBFIs are new in the financial system as compared to banking financial institutions (BFIs). Starting from the IPDC in 1981, a total of 25 NBFIs are now working in the country. As on June 30, 2001 the total amount of paid up capital and reserve of 24 NBFIs stood Tk.6901.8 million (BB, 2002). The NBFIs sector in Bangladesh consisting primarily of the development financial institutions, leasing enterprises, investment companies, merchant bankers etc. The financing modes of the NBFIs are long term in nature. Traditionally, our banking financial institutions are involved in term lending activities, which are mostly unfamiliar products for them. Inefficiency of BFIs in long-term loan management has already leaded an enormous volume of outstanding loan in our country. At this backdrop, in order to ensure flow of term loans and to meet the credit gap, NBFIs have immense importance in the economy. In addition, non-bank financial sector is important to increase the mobilization of term savings and for the sake of providing support services to the capital market. The focus of this paper is to highlight the necessity and importance of NBFIs to strengthen the financial system for rapid economic development of the country.

Do Industries Lead the Stock Market? Gradual Diffusion of Information and Cross-Asset Return Predictability

Abstract: We test the hypothesis that the gradual diffusion of information across asset markets leads to cross-asset return predictability. Using thirty-four industry portfolios and the broad market index as our test assets, we establish several key results. First, a number of industries such as retail, services, commercial real estate, metal, and petroleum lead the stock market by up to two months. In contrast, the market, which is widely followed, only leads a few industries. Importantly, an industry’s ability to lead the market is correlated with its propensity to forecast various indicators of economic activity such as industrial production growth. Consistent with our gradual-information-diffusion hypothesis, these findings indicate that the market reacts with a delay to information in industry returns about its fundamentals.

Why Do European Venture Capital Companies Syndicate

Abstract: textFinancial theory, resource-based theory and access to deal flow are used to explain syndication practices among European venture capital (VC) firms. The desire to share risk and increase portfolio diversification is a more important motive for syndication than the desire to access additional intangible resources or deal flow. Access to resources is, however, more important for non-lead than for lead investors. When resource-based motives are more important, the propensity to syndicate increases. Syndication intensity is higher for young VC firms and for VC firms, specialised in a specific investment stage. Finally, syndication strategies are similar across European countries, but differ from North American strategies.

Utility based pricing of contingent claims

Abstract: In a discrete setting, we develop a model for pricing a contingent claim. Since the presence of hedging opportunities influences the price of a contingent claim, first we introduce the optimal hedging strategy assuming a contingent claim has been issued: a strategy implemented by investing the budget plus the selling price is optimal if it maximizes the expected utility of the agent's revenue, which is the difference between the outcome of the hedging portfolio and the payoff of the claim. Next, we introduce the `reservation price' as a subjective valuation of a contingent claim. This is defined as the minimum price to be added to the initial budget that makes the issue of the claim more preferable than optimally investing in the available securities. We define the reservation price both for a short position (reservation selling price) and for a long position (reservation buying price) in the contingent claim. When the contingent claim is redundant, both the selling and the buying price collapse in the usual Arrow-Debreu price. We develop a numerical procedure to evaluate the reservation price and two applications are provided. Different utility functions are used and some qualitative properties of the reservation price are shown.

A Descriptive analysis of the finnish treasury bond market 1991-1999

Abstract: This paper presents a descriptive analysis of the primary and secondary market for Finnish treasury bonds.The paper focuses on three issues.First, we report basic descriptive statistics such as auction volumes and secondary market yields and volumes.Second, we estimate the revenues earned by primary dealers from the treasury bond market.Third, we analyse the development of the price of the auctioned bonds, relative to other benchmark bonds, around the time of the auction.We find evidence of a price decrease in the auctioned bond series before the auction and a price increase after the auction.This pattern is strongest for 1992-1994 when Treasury funding needs were heavy and secondary market trading volume of treasury bonds was modest. Key words: treasury bond auctions, secondary market JEL classification numbers: D44, G12, G20

Asset Pricing Under The Quadratic Class

Abstract: We identify and characterize a class of term structure models where bond yields are quadratic functions of the state vector. We label this class the quadratic class and aim to lay a solid theoretical foundation for its future empirical application. We consider asset pricing in general and derivative pricing in particular under the quadratic class. We provide two general transform methods in pricing a wide variety of fixed income derivatives in closed or semi­closed form. We further illustrate how the quadratic model and the transform methods can be applied to more general settings.

The End of Class Warfare: An Examination of Income Disparity

Abstract: During the 1990s, the richest quintile of a country had an average income per capita approximately ten times that of the poorest quintile. We find that the poor of a country are better off relatively, and absolutely, when the country ranks higher in average income, union participation, taxation, government spending, education, and property rights. Under these same conditions, the wealthy of a country also have more absolute per capita income, just not a higher percentage relative to the poor. Countries with substantial black market activity, high levels of international trade (as a percentage of GDP), and former Spanish colonies have greater income disparity; these features also coincide with lower incomes for both rich and poor. Key features of democracy such as political and voting rights, civil liberties and freedom of the press, while important for economic growth, are not independently associated with income inequality. We find little empirical support for a tradeoff between a high level of prosperity and greater equality. Above a very low level of development, appropriate policies are associated with both higher average and more equal income.

A General Characterization of Quadratic Term Structure Models

Abstract: In this paper, we define a strongly regular quadratic Gaussian process to characterize quadratic term structure models (QTSMs) in a general Markov setting. The key of this definition is to keep the analytical tractability of QTSMs which has the quadratic term structure of the yield curve. In order to keep this property, under the regularity condition, we have proven that no jumps are allowed in the infinitesimal generator of the underlying state process. The coefficient functions defined in the quadratic Gaussian relationship can be decided by the multi-variate Riccati Equations with a unique admissible parameter set. Based on this result, we discuss the pricing problems of QTSMs under default-free and defaultable rates.

Portfolio Selection with Probabilistic Utility, Bayesian Statistics, and Markov Chain Monte Carlo

Abstract: We propose a novel portfolio selection approach that manages to ease some of the problems that characterise standard expected utility maximisation. The optimal portfolio is no longer defined as the extremum of a suitably chosen utility function: the latter, instead, is reinterpreted as the logarithm of a probability distribution for optimal portfolios and the selected portfolio is defined as the expected value with respect to this distribution. A further theoretical aspect is the adoption of a Bayesian inference framework. We find that this approach has several attractive features, when comparing it to the standard maximisation of expected utility. We remove the over-pronounced sensitivity on external parameters that plague optimisation procedures and obtain a natural and self consistent way to account for uncertainty in knowledge and for personal views. We test the proposed method against traditional expected utility maximisation, using artificial data to simulate finite-sample behaviour, and find superior performance of our procedure. All numerical integrals are carried out by using Markov Chain Monte Carlo, where the chains are generated by an adapted version of Hybrid Monte Carlo. We present numerical results for a portfolio of eight assets using historical time series running from January 1988 to January 2002.

Die Fortbestehensprognose - Rechtliche Anforderungen und ihre betriebswirtschaftlichen Grundlagen

Abstract: Die Prognose, ob ein Unternehmen fortbestehen wird oder nicht, hat weitreichende Konsequenzen fur Eigentumer, Glaubiger und Arbeitnehmer der Gesellschaft. In Abhangigkeit von dem Prognoseergebnis sind das Vermogen und die Schulden in der Bilanz und in einem etwaigen Uberschuldungsstatus anzusetzen und zu bewerten. Letztlich kann schon der Ausgang der Fortbestehensprognose uber Wohlergehen oder Untergang des Unternehmens entscheiden. In diesem Beitrag wird nach einer kurzen Begriffsklarung die Relevanz der Fortbestehensprognose fur die Insolvenzgrunde dargestellt.Die Insolvenzordnung enthalt mit der drohenden Zahlungsunfahigkeit und der Uberschuldung zwei Insolvenzgrunde mit prognostischen Elementen. Fur die Fortbestehensprognose, die auf Basis eines Unternehmenskonzeptes, einer daraus abgeleiteten integrierten Bilanz-,Ertrags-und Finanzplanung und dem voraussichtlichen Verhalten der Stakeholder hinsichtlich der Finanzierungsbeitrage zu erarbeiten ist, stellen sich die Fragen der Nachhaltigkeit und der Wahrscheinlichkeit der Fortfuhrungsfahigkeit. Zum Prognosehorizont hat sich eine einhellige Meinung herausgebildet.Hingegen ist in der Kommentar-Literatur zu der vom Gesetzgeber geforderten „uberwiegenden Wahrscheinlichkeit“ des Fortbestehens in jungerer Zeit vermehrt eine quantitativ-statistische Interpretation zu finden. In diesem Beitrag wird gezeigt, dass sich diese Auslegung fur die Rechtspraxis nicht halten lasst. Vielmehr ist die „uberwiegende Wahrscheinlichkeit“ als juristisches Beweismas aufzufassen, welches als nicht quantifizierbare komparative Hypothesenwahrscheinlichkeit zu interpretieren ist. Letztlich kommt es hinsichtlich der „uberwiegenden Wahrscheinlichkeit des Fortbestehens“ auf die Einschatzung der Realisierbarkeit der vom Verhalten der Gesellschafter und Glaubiger abhangigen Gesamtfinanzierung an. Der Beitrag schliest mit Ausfuhrungen zur Bedeutung der Fortbestehens-Fehlprognose in der gerichtlichen Auseinandersetzung.

A Dynamic Equilibrium Model of Real Exchange Rates with General Transaction Costs

Abstract: We study the behavior of real exchange rates in a two­country dynamic equilibrium model. In this model, consumers can only consume domestic goods but can invest costlessly in capital stocks of both countries. Nevertheless, transporting goods between the two countries is costly and, hence, the rebalancing of the capital stock can only happen finitely often. We propose a realistic cost structure for goods transportation, wherein the total cost increases with the amount of shipment but the unit cost decreases with it due to economies of scale. Given such a cost structure, the optimal decisions on when and how much to transfer need to be determined jointly. The dual decision depends upon the magnitude of economies of scale, the production technology specifications, and the consumer preferences. The model can reconcile the observed large short­term volatility of the real exchange rate with its slow convergence to parity. Further, the drift and diffusion of the real exchange rate are not uniquely determined by the real exchange rate level. The dynamics of the real exchange rate can only be determined by a joint analysis of the real exchange rate and the underlying economic fundamentals such as the capital stock imbalance between the two countries.

Option pricing with Levy Process

Abstract: In this paper, we assume that log returns can be modelled by a Levy process. We give explicit formulae for option prices by means of the Fourier transform. We explain how to infer the characteristics of the Levy process from option prices. This enables us to generate an implicit volatility surface implied by market data. This model is of particular interest since it extends the seminal Black Scholes [1973] model consistently with volatility smile.

Pricing Convertible Bonds with Interest Rate, Equity, Credit and FX Risk

Abstract: Convertible bonds are hybrid securities whose pricing relies on a set of complex inter-dependencies due to the sensitivity to interest rate risk, underlying (equity) risk, FX risk, and credit risk, and due to the convertible bond’s early exercise American feature. We present a two factor model of interest rate and equity risk that is implemented using the Crank-Nicholson technique on the discretized pricing equation with projective successive over-relaxation. This paper extends a methodology proposed in the literature (TF[98]) to deal with credit risk in a self- consistent way, and proposes a new methodology to deal with FX sensitive cross-currency convertibles. A technique for extracting the price of vanilla options struck on a synthetic asset, the foreign equity in domestic currency, is employed to obtain the implied volatility for these options. These implied volatilities are then used to obtain the local volatility for use in the numerical routine. The model is designed to deal with most of the usual contractual features such as coupons, dividends, continuous and/or Bermudan call and put clauses. We suggest that credit spread adjustments in the boundary conditions can be made, to account for the negative correlation between spreads and equity. Detailed description of the numerical methods and the discretization schemes, together with their accuracy, are provided.

Contagion in Financial Markets

Abstract: This paper presents a model on contagion in nancial markets. We use a bank run framework as a mechanism to initiate a crisis and argues that liquidity crunch and imperfect information are the key culprits for a crisis to be contagious. The model proposes that a crisis is more likely to be contagious when (1) banks have similar cost-effciency structures (clustering) and (2) a large fraction of the investment is in the illiquid sector (illiquidity). The latter is an endogenous decision made by the banks. It increases with (1) the prospect of the risky asset (risk-return trade-off) and (2) the fraction of patient consumers (liquidity demand).

Die Erstellung der Fortbestehensprognose

Abstract: Eine positive Fortbestehensprognose eines Unternehmens beinhaltet eine mit uberwiegender Wahrscheinlichkeit erwartete nachhaltige Zahlungsfahigkeit. In dem Beitrag „Die Fortbestehensprognose – Rechtliche Anforderungen und ihre betriebswirtschaftlichen Grundlagen“ der Verfasser in WPg 2002, S. 225 – 240, wurde dazu aus Rechtsprechung und Gesetz die Schlussfolgerung gezogen,dass die vom Gesetzgeber in der Insolvenzordnung (InsO)geforderte „uberwiegende Wahrscheinlichkeit“ des Fortbestehens als juristisches Beweismas und damit als komparative,nicht quantifizierbare Hypothesenwahrscheinlichkeit zu interpretieren ist, die sich nicht anhand eines statistischen Kalkuls berechnen lasst. Vielmehr muss das Unternehmenskonzept und die daraus abgeleitete Gesamtfinanzierung unter Berucksichtigung der Stakeholderinteressen mit „uberwiegender Wahrscheinlichkeit“ als realisierbar (akzeptabel) und tragfahig erachtet werden. In diesem Beitrag wird die Erstellung der Fortbestehensprognose aus der ganzheitlichen Sicht eines unabhangigen Sachverstandigen auf der Grundlage eines Unternehmenskonzeptes behandelt. Der Sachverstandige hat die Fortfuhrungsfahigkeit eines Unternehmens vor dem Hintergrund des gesamtwirtschaftlichen Umfeldes und der voraussichtlichen Branchenentwicklung zu beurteilen. Die Fortbestehensprognose ist nicht gleichzusetzen mit einem Unternehmens- oder Sanierungskonzept. Vielmehr setzt sie ein solches Konzept voraus und berucksichtigt daruber hinaus auch die geplante Durchsetzung und Umsetzung sowie die Koordination (Moderation)zwischen den involvierten Akteuren. Entscheidend ist daher auch die Akzeptanz auf Seiten der zu Beitragen aufgeforderten Stakeholder. Ist der Sachverstandige mit der Erstellung des Unternehmens- oder Sanierungskonzeptes beauftragt, so ist in der Praxis die Fortbestehensprognose integraler Konzeptbestandteil. Fur ein qualifiziertes Urteil hat sich der mit der Prognose beauftragte Sachverstandige ein differenziertes Bild uber die Fortfuhrungschancen zu bilden, indem er sich in die Position der herbeigezogenen Berater versetzt und aus deren Perspektiven Umfeld-Perspektiven (Gesamtwirtschaft, Branchenentwicklung) und in den Berater-Perspektiven (Konzepterstellung, -durchsetzung und -umsetzung sowie Koordination/Moderation) gewonnenen Erkenntnissen ist die ganzheitliche Fortbestehensprognose abzuleiten. Die Fortfuhrungschancen eines Unternehmens hangen von dem Spannungsfeld der Unternehmenspotenziale und der Fortfuhrungsbarrieren ab. Die Bedeutung der verschiedenen Berater- Perspektiven wird in diesem Spannungsfeld masgeblich auch von den Herausforderungen des Krisenstadiums bestimmt. Fur die so abgeleitete Prognoseaussage gilt das Postulat der Klarheit. Die Erstellung und das Ergebnis der Fortbestehensprognose ist in einem entsprechenden Bericht zu dokumentieren. Uber die Prognoseaussage ist zudem eine eigenstandige Bescheinigung auszustellen. Der Beitrag schliest mit Ausfuhrungen zur Haftung des Sachverstandigen fur eine Fortbestehens-Fehlprognose bei Verletzung der von ihm bei der Prognoseerstellung zu beachtenden Sorgfaltspflichten. Auf die Beurteilung einer bereits durch einen Sachverstandigen erstellten Fortbestehensprognose wird in einem spateren Beitrag in dieser Zeitschrift eingegangen.

Can technological change explain the stock market collapse of 1974

Abstract: This paper uses dynamic general equilibrium models to quantitatively test the idea that technical change caused the stock market collapse of the mid 1970's, its subsequent stagnation, and recovery. First, I consider the hypothesis that the arrival of information technologies (IT) rendered old capital obsolete, and led to a collapse of equity prices. I find that shocks necessary for the IT-revolution to cause the observed drop in Tobin's q imply a two-fold increase in aggregate investment, and a strong expansion in GDP and consumption. Such predictions are orthogonal to what one observes in the data. Next, I consider the hypothesis that the productivity slowdown of the mid 1970's caused an unexpected decrease in the growth rate of shareholders' income, and equity prices fell. This hypothesis is consistent with the behavior of aggregate quantities and it delivers a large decrease in the value of equities, but is not capable of producing the persistently low values of q that characterize the data. My analysis indicates that the main challenge for a general equilibrium explanation of stock market behavior resides in reconciling the movements of Tobin's q with those of aggregate investment.