Variance trading and market price of variance risk

This paper develops a new approach for variance trading. We show that the discretely-sampled realized variance can be robustly replicated under very general conditions, including when the price can jump. The replication strategy specifies the exact timing for rebalancing in the underlying. The deviations from the optimal schedule can lead to surprisingly large hedging errors. In the empirical application, we synthesize the prices of the variance contract on S&P 500 index over the period from 01/1990 to 12/2009. We find that the market variance risk is priced, its risk premium is negative and economically very large. The variance risk premium cannot be explained by the known risk factors and option returns.     

The VIX,the variance premium and stock market volatility

We decompose the squared VIX index, derived from US S&P500 options prices, into the conditional variance of stock returns and the equity variance premium. We evaluate a plethora of state-of-the-art volatility forecasting models to produce an accurate measure of the conditional variance. We then examine the predictive power of the VIX and its two components for stock market returns, economic activity and financial instability. The variance premium predicts stock returns while the conditional stock market variance predicts economic activity and has a relatively higher predictive power for financial instability than does the variance premium.     

Banks’ risk taking,financial innovation and macroeconomic risk

This paper shows how financial innovation in combination with the fall of macroeconomic risk can explain the strong growth of the primary and secondary credit markets in the U.S. economy. We document empirically the fall in macroeconomic risk, the expansion of the prime and secondary credit market and we provide evidence that changes in macroeconomic risk are closely related to the evolution of the prime market. In the theoretical part of the paper we study in a simple portfolio optimization framework the effect of financial innovation and macroeconomic risk on banks’ risk taking. The results of the model show that financial innovation increases bank appetite for risky investment both in the prime and secondary markets and that this effect is stronger in environments with low aggregate macroeconomic risk. In addition the banking system becomes less stable because of the portfolio risk of each individual bank increases.     

Robustness of stable volatility strategies

The paper analyzes the robustness of stable volatility strategies, i.e. strategies in which the portfolio weight of the stock is inversely proportional to its local volatility. These strategies are optimal for a CRRA investor if the stock follows a diffusion process, the expected excess return is proportional to its volatility, and the hedging demand is zero. We assess the performance of stable volatility strategies when these restrictive assumptions do not hold, in particular, when the risk premium is not proportional to volatility and when the stock price is subject to jumps. We find that stable volatility strategies are indeed robust or close to robust under a maxmin decision rule. In addition to our theoretical results, we perform a simulation analysis to evaluate strategies that scale the portfolio weight by the volatility, variance or a constant portfolio weight, and also analyze the strategies using empirical excess returns. Both analyses confirm the robustness of stable volatility strategies.     

Do cryptocurrencies provide better hedging? Evidence from major equity markets during COVID-19 pandemic

Using the five-minute interval price data of two cryptocurrencies and eight stock market indices, we examine the risk spillover and hedging effectiveness between these two assets. Our approach provides a comparative assessment encompassing the pre-COVID-19 and COVID-19 sample periods. We employ copula models to assess the dependence and risk spillover from Bitcoin and Ethereum to stock market returns during both the pre-COVID-19 and COVID-19 periods. Notably, the COVID-19 pandemic has increased the risk spillover from Bitcoin and Ethereum to stock market returns. The findings vis-à-vis portfolio weights and hedge effectiveness highlight hedging gains; however, optimal investments in Bitcoin and Ethereum have reduced during the COVID-19 pandemic, while the cost of hedging has increased during this period. The findings also confirm that cryptocurrencies cannot provide incremental gains by hedging stock market risk during the COVID-19 pandemic.     

How can investors build a better portfolio in small open economies? Evidence from Asia’s Four Little Dragons

This study investigates the role of hedging and portfolio design among stocks, exchange rates, and gold in small open economies (SOEs) from 4 January 2000 to 31 March 2020. We adopt the trivariate dynamic conditional correlation-fractionally integrated asymmetric power ARCH model and unconditional quantile regression model, and our findings show that the hedging role of the U.S. dollar (USD) and gold against stocks differs under regular and extreme market conditions. The USD can act as a powerful hedge asset for stocks in regular market periods. Moreover, during the global financial crisis and COVID-19 outbreak, the safe-haven effect of gold becomes stronger for almost all stocks, whereas the USD can serve as a strong safe haven against stock markets of Korea, Taiwan, and Singapore when stock returns are extremely low. In terms of portfolio designing, we find that adding the USD and gold to portfolios improves their hedging effectiveness, and the optimally weighted stock-USD-gold portfolio is the best portfolio strategy, irrespective of referring to return or risk.     

Corporate tax,financial leverage,and portfolio risk

We examine the theoretical implications of corporate income tax for a risky portfolio in a aggregate-endowment economy. In this model, corporate income tax affects the portfolio risk associated with the rebalancing motive during market clearance. An asset is defined as a portfolio of stocks and bonds whose portfolio weights are similar to financial leverage. Corporate tax can decrease after-tax consumption from dividends (increase leverage) and increase the tax shield that increases dividends (decrease leverage). Changes in dividends are responsible for the correlation between expected dividend growth and consumption growth and, thus, affect stock pricing and returns. Overall, the model is characterized by tax-induced portfolio risk associated with financial leverage.     

Pricing the hedging factor in the cross-section of stock returns

We investigate the role of investors’ net hedging strategy (factor) in predicting stock returns and pricing the cross-section of individual stocks and equity portfolios. We estimate stock exposure to changes in the hedging factor and show that the hedging premium is driven by outperformance of stocks with large positive net hedging betas, which explains their higher average returns. We find the positive hedging premium indicates risk-averse investors demand extra compensation to hold stocks with higher equity risk premiums, and they are themselves willing to pay higher prices for stocks with positive hedging betas.     

Firm size,economic risks,and the cross-section of international stock returns

Recent empirical evidence from developed markets indicates a negative relation between value premium and firm size. We find that the value premium in small stocks is consistently priced in the cross-section of international returns, whereas the value premium in big stocks is not. Based on US data, we show that the small-stock value premium is associated with business cycle news and reflects changes in macroeconomic, especially credit market related risks. Our results hold true for regional and global equity markets and remain valid after controlling for firm characteristics and prominent profitability and investment factors.     

Idiosyncratic risk,market risk and correlation dynamics in the US real estate investment trusts

This study examines total, market and idiosyncratic risk and correlation dynamics using weekly return data on two US REIT firm samples from 1988 to 2008. We find that both market and idiosyncratic variance are time-varying and that idiosyncratic variance represents a dominant component of a REIT firm’s total variance. We find a decline in idiosyncratic risk as well as a rise in average REIT correlation during the new REIT era, from 1993 to 2008. This recent downward trend of idiosyncratic risk among REITs is different to the stylized upward trend of idiosyncratic risk among stocks. There is bi-lateral Granger causality between the market and idiosyncratic risks. Finally, we detect a positive relationship between the idiosyncratic risk and expected returns, implying that the risk premium of REITs is positively related to the idiosyncratic risk during the period new REIT era, 1993–2008. Our results have important asset-pricing implications for under-diversified investors.     

INFORMATION IN THE YIELD CURVE: A MACRO‐FINANCE APPROACH

We use a macro‐finance model, incorporating macroeconomic and financial factors, to study the term premium in the US bond market. Estimating the model using Bayesian techniques, we find that a single factor explains most of the variation in bond risk premiums. Furthermore, the model‐implied risk premiums account for up to 40% of the variability of one‐ and two‐year excess returns. Using the model to decompose yield spreads into an expectations and a term premium component, we find that, although this decomposition does not seem important to forecast economic activity, it is crucial to forecast inflation for most forecasting horizons. Copyright © 2012 John Wiley & Sons, Ltd.     

Market efficiency,asset returns,and the size of the risk premium in global equity markets

An important economic insight is that observed equity prices must equal the present value of the cash flows associated with the equity claim. An implication of this insight is that present values of cash flows must also quantitatively justify the observed volatility and cross-correlations of asset returns. In this paper, we show that parametric economic models for present values can indeed account for the observed high ex post return volatility and cross-correlation observed across five major equity markets—the U.S., the U.K., France, Germany, and Japan. We present evidence that cash flow growth rates contain a small predictable long-run component; this feature, in conjunction with time-varying systematic risk, can justify key empirical characteristics of observed equity prices. Our model also has direct implications for the level of equity prices and specific versions of the model can, in many cases, capture observed price levels. Our evidence suggests that the ex ante risk premium on the global market portfolio has dropped considerably—we show that this fall in the risk premium is related to a decline in the conditional variance of global real cash flow growth rates.     

An analysis of the capital asset pricing model in the Egyptian stock market

This paper offers evidence confirming the validity of applying modern portfolio theory and capital asset pricing models to the emerging stock market of Egypt. The results indicate that market risk, as measured by beta and preference for skewness, seems to play a significant role in the returns dynamics in the Egyptian stock market. There is a significant and positive premium for companies with positive skewness. With regard to the return-risk trade off, the results indicate that a portfolio that was based on consumer staples and financial companies (mainly banks) with low betas had outperformed a portfolio containing construction, materials, hotels, and weaving companies with larger betas. Historically, the government's nationalizations that took place, between the mid fifties to the mid sixties, had adversely affected companies in the industrial and construction sectors more than consumer staples companies and banks. This could explain why lower beta companies were observed more in consumer staples, banks, and pharmaceuticals.     

商业银行压力测试的国内外研究现状及其评述

在经济金融全球化不断发展的背景下,银行业稳健性对整个宏观经济的健康发展及抵御危机的能力至关重要。在实务应用上,仅仅使用日常风险度量工具(VAR)来衡量市场风险是不恰当的,压力测试作为VAR的重要补充,旨在用来测量某些小概率事件对银行经营或其所拥有的投资组合造成的影响,压力测试现已成为风险管理强有力的工具,在各国政策当局的金融稳定性评估中获得了广泛应用。     

Financial Risk Propensity,Business Cycles and Perceived Risk Exposure

We analyse whether individual financial risk propensity changes over time with background financial conditions, as well as personal and subjective portfolio risk exposure. We elicit risk propensity from six different self‐assessed facets collected in a long panel data set from the DNB Household Survey, annually covering the period 1995–2015. Risk propensity is generally higher during periods of economic growth and lower during periods of recession, but is untrended when elicited, using questions referring to safe investments. Our risk propensity measure is also higher following positive stock market returns or subjectively large risk exposure in own past investments.     

Measuring financial risk and portfolio reversion with time changed tempered stable Lévy processes

Given that underlying assets in financial markets exhibit stylized facts such as leptokurtosis, asymmetry, clustering properties and heteroskedasticity effect, this paper applies the stochastic volatility models driven by tempered stable Lévy processes to construct time changed tempered stable Lévy processes (TSSV) for financial risk measurement and portfolio reversion. The TSSV model framework permits infinite activity jump behaviors of returns dynamics and time varying volatility consistently observed in financial markets by introducing time changing volatility into tempered stable processes which specially refer to normal tempered stable (NTS) distribution as well as classical tempered stable (CTS) distribution, capturing leptokurtosis, fat tailedness and asymmetry features of returns in addition to volatility clustering effect in stochastic volatility. Through employing the analytical characteristic function and fast Fourier transform (FFT) technique, the closed form formulas for probability density function (PDF) of returns, value at risk (VaR) and conditional value at risk (CVaR) can be derived. Finally, in order to forecast extreme events and volatile market, we perform empirical researches on Hangseng index to measure risks and construct portfolio based on risk adjusted reward risk stock selection criteria employing TSSV models, with the stochastic volatility normal tempered stable (NTSSV) model producing superior performances relative to others.     

Cross-hedging minimum return guarantees: Basis and liquidity risks

We reveal pitfalls in the hedging of insurance contracts with a minimum return guarantee on the underlying investment, e.g. an external mutual fund. We analyze basis risk entailed by hedging the guarantee with a dynamic portfolio of proxy assets for the funds. We also take account of liquidity risk which arises since the insurer may need to advance funds for performing the hedge. Based on a least-squares Monte Carlo simulation, we study the economic implications of basis and liquidity risks. We demonstrate that both risks may be surprisingly high and show how the design of the contract and the hedging strategy may help to alleviate them.     

Region-wide connectedness of Asian equity and currency markets

This study systemically analyzes the dynamics of interdependence between the Asian equity and currency markets. The novelty of our study is that unlike other studies that explore either co-movements among equity markets or co-movements among currency markets, we pay particular attention to the interdependence between the two in terms of both return and volatility connectedness. We find that the contribution of crossspillovers between the Asian equities and currencies is substantial for the region-wide connectedness of both the returns and volatilities. We also find that the short-term spillovers are far more important for the return spillovers, while the long-term spillovers are far more important for the volatility spillovers, presumably reflecting the long-lasting effects of volatility shocks. All the results consistently underline the pivotal role of cross-interdependence between equity and currency markets, both as channels for integrating Asian financial markets and as sources of financial contagion across these markets. Our findings will provide useful guidance for portfolio risk management to adopt better hedging strategies for foreign exchange risks involved in the international investment of Asian equities.     

Dynamic portfolio choice under ambiguity and regime switching mean returns

I examine a continuous-time intertemporal consumption and portfolio choice problem under ambiguity, where expected returns of a risky asset follow a hidden Markov chain. Investors with Chen and Epstein's (2002) recursive multiple priors utility possess a set of priors for unobservable investment opportunities. The optimal consumption and portfolio policies are explicitly characterized in terms of the Malliavin derivatives and stochastic integrals. When the model is calibrated to U.S. stock market data, I find that continuous Bayesian revisions under incomplete information generate ambiguity-driven hedging demands that mitigate intertemporal hedging demands. In addition, ambiguity aversion magnifies the importance of hedging demands in the optimal portfolio policies. Out-of-sample experiments demonstrate the economic importance of accounting for ambiguity.