Diamonds and precious metals for reduction of portfolio tail risk

ABSTRACT

We study the performance of diamonds compared to gold and other precious metals in mitigating the tail risk of a diversified equity market portfolio over the period June 2007 to October 2018. Our results display a diversification benefit of some diamond indices, which also improve the portfolio reward-to-risk ratio. To corroborate this evidence, we study the dependence structure and tail dependence of diamonds and a broad equity market portfolio and compare it to the dependence obtained with gold and other precious metals. Results from fitting a bivariate copula show that the average left tail dependence reaches its minimum when diamonds are used. We also show that using shares of diamond-mining companies does not provide the same benefits.     

Regional and copula estimation effects on EU and US energy equity portfolios

ABSTRACT

The aim of this paper is to investigate the regional interdependence structure of energy equities in the US and in the EU. Based on weekly stock prices of 28 big energy firms in the two regions from 2008 to 2019, we compare the efficiency of using bivariate or multivariate copulas to describe the dependence structure of energy equities. Furthermore, we investigate the impact of the choice between these two methods on the performance of energy equity portfolios. Our empirical results show that multivariate copulas, such as C-Vine, allow to better describe the dependence structure of energy equities. We also find that there is a stronger and more complex dependence structure among EU energy equities than among US energy equities. Our scenario analysis also shows that the dependence structure is stronger during the GFC while being weaker during the ESDC. More importantly, the correlation matrix obtained from the multivariate copula method allows to obtain optimal mean-CVaR portfolios with a higher performance than that from the bivariate copula method. More importantly, optimal portfolios constituted with multivariate copulas allow to reduce the portfolio’s sensitivity to oil prices.     

Portfolio Composition and Valuation Effects in Emerging Market Economies*

ABSTRACT

The increase in cross-border assets and liabilities of nations with globalization, implies small asset price and currency movements create large wealth changes. The national net external position is increasingly driven by valuation effects, which the current account does not capture. We analyze valuation effects for a group of seven emerging economies, namely Brazil, Colombia, India, Republic of Korea, Mexico, Peru and Turkey for the time period 2005:Q1-2015:Q4 by scrutinizing their external asset portfolio while controlling for country fundamentals. Both asset and liability categories of Direct Investment equity are found to positively impact valuation. Equity liabilities and debt assets of Portfolio Investment positively influence valuation. Debt liabilities of all kinds of investment negatively impact valuation. Countries with stronger currency tend to gain through valuation effects. An appreciated real effective exchange rate is associated with higher valuation gains. We also found non-linear effects of the composition of external debt portfolio by interacting external portfolio and country characteristics. The external portfolio selection of emerging economies (with more in Direct Investment equity liabilities and Portfolio Investment debt assets) in the period has shielded them from global volatility, and enabled valuation gains.     

Financial integration and the ASEAN-5 equity markets

The existence of long-run relationships among the ASEAN-5 equity markets is empirically investigated. This study utilized weekly data spanning January 1988 to August 1999. The results of Granger noncausality test due to Toda and Yamamoto (Journal of Econometrics,66, 225–50, 1995) reveal that the Singapore equity market was not affected by other markets except by the Philippines in the long run. This result shows that there exist opportunities for beneficial international portfolio diversification within the context of the Asean-5 equity markets.     

Optimal Utilitarian Taxation and Horizontal Equity

We impose a horizontal equity restriction on the problem of finding the optimal utilitarian tax mix. The horizontal equity constraint requires that individuals with the same ability have to pay the same amount of taxes regardless of their preferences for leisure. Contrary to normal findings, we find that a good that is complementary to leisure can be encouraged by the tax system and that a good that normally should be discouraged by the tax system can be subsidized even if the economy is composed of only two private commodities plus leisure. Also, the marginal effective tax rate can be different from zero at the top of the ability distribution when the tax mix obeys the horizontal equity constraint.     

Diversification into Emerging Markets – An Australian and the US Perspective Using a Time‐varying Approach

Over the past two decades, a number of studies have examined the benefits of diversifying equity investments internationally, particularly into emerging markets. In the portfolio construction process, many researchers have criticised Markowitz's Portfolio Theory because of its inherent assumptions such as symmetric and constant correlations. In this study, we use a conditional copula model to estimate the time‐varying asymmetric correlations of stock markets and construct optimal portfolios by using estimated correlations. We find that optimised portfolios provide significant benefits for both Australian and the US investors. Out‐of‐sample results show Copula model provides results closer to the in‐sample‐estimated benefits of diversification. The results have important implications for portfolio managers who seek to diversify into emerging markets.     

Hedging and diversification across commodity assets

ABSTRACT

We investigate the conditional cross effects and volatility spillover between equity markets and commodity markets (oil and gold), Fama and French HML and SMB factors, volatility index (VIX) and bonds using different multivariate GARCH specifications considering the potential asymmetry and persistence behaviours. We analyse the dynamic conditional correlation between the US equity market and a set of commodity prices and risk factors to forecast the transmission of shock to the equity market firstly, and to determine and compare the optimal hedge ratios from the different models based on the hedging effectiveness of each model. Our findings suggest that all models confirm the significant returns and volatility spillovers. More importantly, we find that GO-GARCH is the best-fit model for modelling the joint dynamics of different financial variables. The results of the current study have implications for investors: (i) the equity market displays inverted dynamics with the volatility index suggesting strong evidence of diversification benefit; (ii) of the hedging assets gold appears the best hedge for the US equity market as it has a higher hedge effectiveness than oil and bonds over time; and (iii) despite these important results, a better hedge may be obtained by using well-selected firm sized and profitability-based portfolios.     

Rational inattention,long-run consumption risk,and portfolio choice

This paper explores how the introduction of rational inattention (RI) – that agents process information subject to finite channel capacity – affects optimal consumption and investment decisions in an otherwise standard intertemporal model of portfolio choice. We first explicitly derive optimal consumption and portfolio rules under RI and then show that introducing RI reduces the optimal share of savings invested in the risky asset because inattentive investors face greater long-run consumption risk. We also show that the investment horizon matters for portfolio allocation in the presence of RI, even if investment opportunities are constant and the utility function of investors is constant relative risk aversion. Second, after aggregating across investors, we show that introducing RI can better explain the observed joint dynamics of aggregate consumption and the equity return. Finally, we show that RI increases the implied equity premium because investors under RI face greater long-run consumption risk and thus require higher compensation in equilibrium.     

Individual account investment options and portfolio choice: Behavioral lessons from 401(k) plans

This paper examines how the menu of investment options made available to workers in defined contribution plans influences portfolio choice. Using unique panel data of 401(k) plans in the U.S., we present three principle findings. First, we show that the share of investment options in a particular asset class (i.e., company stock, equities, fixed income, and balanced funds) has a significant effect on aggregate participant portfolio allocations across these asset classes. Second, we document that the vast majority of the new funds added to 401(k) plans are high-cost actively-managed equity funds, as opposed to lower-cost equity index funds. Third, because the average share of assets invested in low-cost equity index funds declines with an increase in the number of options, average portfolio expenses increase and average portfolio performance is thus depressed. All of these findings are obtained from a panel data set, enabling us to control for heterogeneity in the investment preferences of workers across firms and across time.     

OPTIMAL INTERNATIONAL ASSET ALLOCATION WITH TIME-VARYING RISK

This paper examines the optimal allocation each period of an internationally diversified portfolio from the different points of view of a UK and a US investor. We find that investor location affects optimal asset allocation. The presence of exchange rate risk causes the markets to appear not fully integrated and creates a preference for home assets. Domestic equity is the dominant asset in the optimal portfolio for both investors, but the US investor bears less risk than the UK investor, and holds less foreign equity – 20% compared with 25%. Survey evidence indicates actual shares are 6% and 18%, respectively, making the home‐bias puzzle more acute for US than UK investors. There would seem to be more potential gains from increased international diversification for the US than the UK investor.     

Taxi,Takeoff and Landing: Behavioural Patterns of Capital Flows to Emerging Markets

This paper analyses volatility, persistence, predictability, correlation, comovement (or contagion risk) and sudden stop (reversibility) of capital flows (foreign direct investment (FDI), foreign portfolio equity investment, long-term and short-term debt flows) using time series econometric techniques for 24 emerging economies over 1970–2014. This is informative on the pattern and relationship between capital inflows, with implications for accommodating macroeconomic policies in countries receiving inflows. The paper also addresses the predictions of conventional theory, that differences are associated with the maturity of the capital (long-term vs. short-term), with the information-based trade-off model of Goldstein and Razin [(2006). An information-based trade off between foreign direct investment and foreign portfolio investment. Journal of International Economics, 70(1), 271–295], that differences are associated with the structure of the capital (equity vs. debt). In line with the latter, equity flows (FDI and portfolio) are less volatile and persistent, more predictable and less susceptible to sudden stops than debt flows. Contrary to conventional theory, short-term flows are not more volatile, but there is evidence that correlations and risks of contagion are strong within all capital flow components.     

Risk Appetite,Home Bias and the Unstable Demand for Emerging Market Assets

Home bias arises when the actual portfolio of an investor consists of a smaller proportion of foreign assets than that predicted by standard portfolio theory for the observed set of risks and returns on available assets. The existence and persistence of home bias undermines the theoretical case for the efficiency of international capital markets. In this paper we use data on UK pension fund portfolios to measure home bias, and find that this is doubly acute in the case of emerging market equity—a bias against overseas assets as a whole being further magnified by a bias against emerging markets within the foreign equity class as a whole. Moreover, contrary to the conventional assumption that risk aversion is both relatively low and stable over time (canonised in neoclassical theory by the derivation of constant relative risk aversion from the utility function itself) our finding that home bias fluctuates over time suggests that risk aversion is in fact time‐variant and path‐dependent. We sketch an alternative Keynesian approach in conclusion.     

Fund Portfolio Holdings and Affiliated Analyst's Objectivity: Do Equity and Employment Relationship Matter?

The author investigates how the equity relationship between fund company and brokerage firm as well as employment relationship between analyst and brokerage firm affect affiliated fund stock portfolio holding and the affiliated analyst's objectivity. By using the specific data of such equity and employment relationship, the author finds that equity and employment relationship do matter in fund portfolio holdings and analyst objectivity. Specifically, analysts tend to release more optimal ratings on stocks that have been hold by the funds, and the funds tend to significantly reduce the stocks in their portfolio once the analysts have announced high ratings on the stocks. Moreover, the analysts in employment relationships with majority shareholders of funds and with a low reputation reveal worse objectivity. In addition, from the point of abnormal return, analysts in employment relationships with majority shareholders of funds and with a low reputation damage the interests of common investors.     

Designing social security - a portfolio choice approach

Public social security systems may provide diversification of risks to individuals’ life-time income. Capturing that a pay-as-you-go system (paygo) may be considered as a “quasi-asset”, we study the optimal size of the paygo system as well as the optimal split between funded and unfunded pension saving by means of a theoretical portfolio choice framework. A low-yielding paygo system can benefit individuals if it contributes to hedge other risks to their lifetime resources. Numerical calculations indicate that optimal social security systems should be at least partly paygo financed in many economies. The optimal magnitude of the paygo system depends on the specified risk concept as well as the stochastic properties of stock market returns and implicit paygo-returns.     

Regional stock market integration in Singapore: A multivariate analysis

This paper evaluates the time-varying integration of the Singapore stock market in the ASEAN-5 region based on a conditional version of the International Capital Asset Pricing Model (ICAPM) with c-DCC-FIAPARCH parameters. This model allows for dynamic changes in the degree of market integration, regional market risk premium, regional exchange-rate risk premium, and domestic market risk premium. Our findings show several interesting facts. First, the time-varying degree of integration in the Singapore market is satisfactorily explained by the level of trade openness and the term premium of US interest rates, which have recently tended to increase, however these markets remain substantially segmented from the world market. Second, the local market risk premium is found to explain a significant proportion of the total risk premium for emerging market returns. Our findings illustrate several important implications for portfolio hedgers for making optimal portfolio allocations, engaging in risk management and forecasting future volatility in equity markets. Our results are also of interest for both policymakers and investors, with respect to regional development policies and dedicated portfolio investment strategies in the ASEAN-5 region.     

Correlations and volatility spillovers across commodity and stock markets: Linking energies,food, and gold

This paper employs a VAR-GARCH model to investigate the return links and volatility transmission between the S&P 500 and commodity price indices for energy, food, gold and beverages over the turbulent period from 2000 to 2011. Understanding the price behavior of commodity prices and the volatility transmission mechanism between these markets and the stock exchanges are crucial for each participant, including governments, traders, portfolio managers, consumers, and producers. For return and volatility spillover, the results show significant transmission among the S&P 500 and commodity markets. The past shocks and volatility of the S&P 500 strongly influenced the oil and gold markets. This study finds that the highest conditional correlations are between the S&P 500 and gold index and the S&P 500 and WTI index. We also analyze the optimal weights and hedge ratios for commodities/S&P 500 portfolio holdings using the estimates for each index. Overall, our findings illustrate several important implications for portfolio hedgers for making optimal portfolio allocations, engaging in risk management and forecasting future volatility in equity and commodity markets.     

A Race for Long Horizon Bankruptcy Prediction

ABSTRACT

This study compares the accuracy and efficiency of five different estimation methods for predicting financial distress of small and medium-sized enterprises. We apply different methods for a large set of financial and non-financial variables, using filter and wrapper selection, to predict bankruptcy up to 10 years before the event in an open, European economy. Our findings show that logistic regression and neural networks are superior to other approaches. We document how the cost-return ratio considerably affects the location of optimal cut-off points and attainable profit in credit decisions. Once a loan provider selects a particular prediction model, an effort should be made to find the optimal cut-off score to maximize the efficiency of the technique. Indeed, this often involves determining several cut-off levels where the portfolio of products and services exhibits different cost-return characteristics.     

Equity home bias,incomplete financial markets,and nominal rigidities

Abstract This paper analyzes optimal portfolio decisions in a monetary open‐economy framework. It is found that market completeness and the specific form of nominal rigidities, namely, nominal price vs. nominal wage rigidities, matter for justifying the observed structure of equity holdings. When markets are complete, sticky prices generate a negative correlation between the non‐diversifiable labour income and the profit of domestic firms with respect to the productivity shocks, which explains why households invest little abroad. In contrast, when markets are incomplete, rigidities in goods prices result in a counterfactual ‘super home bias’, because domestic equities provide a good hedge against not only the labour income risk but also the relative price risk. Wage rigidities, however, have the opposite effect. Therefore, nominal rigidities in both goods prices and wage rates are needed to address the empirical composition of gross equity positions under incomplete markets.     

Policy mix to foster innovation in the Dominican Republic: attempts from an empirical perspective

ABSTRACT

This paper aims to understand firms’ preferences for incentives to foster innovation in Dominican firms. A key research question arises: What are the most preferred science, technology, and innovation (STI) policy options to support innovation in Dominican firms? This research relies on the concept of policy mix and the conjoint analysis to support the empirical approach. Over 300 firms were surveyed across the country, and we discovered that Dominican firms prefer more complex STI policy options, including at the same time research grants, guarantee funds, and tax incentives to support several kinds of innovative activities. But also, firms need to understand the potential of available options such as tax credit and other monetary instruments, including guarantee funds. It is concluded that in the medium and long term, the STI policy mix approach could support as part of the Dominican policy agenda, an economic transition toward a more resilient and competitive economy.     

Estimating the optimal hedge ratio in the presence of potential unknown structural breaks

We propose a new approach in the estimation of the optimal hedge ratio that allows the hedge ratio to vary over time but without the necessity of frequently rebalancing the portfolio. We apply this in the context of the US and UK equity markets using weekly spot share prices and future share prices during the period 5 January 1999 to 29 September 2009. Our method is to test for cointegration in the presence of two potentially unknown structural breaks by determining the timing of each via the underlying data. The empirical findings reveal that the spot and future prices are strongly cointegrated in each market. The estimated parameters disclose that the optimal hedge ratio is not constant in case of the US and the UK. We find one negative and one positive shift in the optimal hedge ratio in the US. However, we find only one significant and positive shift in the optimal hedge ratio in the UK. The implication of these findings from the perspective of both investors as well as policy-makers is elaborated on in the main text.