Idiosyncratic production risk, growth and the business cycle

We introduce a neoclassical growth economy with idiosyncratic production risk and incomplete markets. Each agent is an entrepreneur operating her own technology with her own capital stock. The general equilibrium is characterized by a closed-form recursion in the CARA-normal case. Incomplete markets introduce a risk premium on private equity, which reduces the demand for investment. As compared to complete markets, the steady state can thus have both a lower capital stock due to investment risk, and a lower interest rate due to precautionary savings. Furthermore, the anticipation of high real interest rates in the future feeds back into high risk premia and low investment in the present, thus slowing down convergence to the steady state. Our results highlight the importance of private risk premia for capital accumulation and business cycles.     

Co-monotonicity of optimal investments and the design of structured financial products

We prove that, under very weak conditions, optimal financial products on complete markets are co-monotone with the reversed state price density. Optimality is meant in the sense of the maximization of an arbitrary preference model, e.g., expected utility theory or prospect theory. The proof is based on a result from transport theory. We apply the general result to specific situations, in particular the case of a market described by the Capital Asset Pricing Model or the Black–Scholes model, where we derive a generalization of the two-fund-separation theorem and give an extension to APT factor models and structured products with several underlyings. We use our results to derive a new approach to optimization in wealth management, based on a direct optimization of the return distribution of the portfolio. In particular, we show that optimal products can (essentially) be written as monotonic functions of the market return. We provide existence and nonexistence results for optimal products in this framework. Finally we apply our results to the study of bonus certificates, show that they are not optimal, and construct a cheaper product yielding the same return distribution.     

Optimal investment under multi-factor stochastic volatility

We consider a model for multivariate intertemporal portfolio choice in complete and incomplete markets with a multi-factor stochastic covariance matrix of asset returns. The optimal investment strategies are derived in closed form. We estimate the model parameters and illustrate the optimal investment based on two stock indices: S&P500 and DAX. It is also shown that the model satisfies several stylized facts well known in the literature. We analyse the welfare losses due to suboptimal investment strategies and we find that investors who invest myopically, ignore derivative assets, model volatility by one factor and ignore stochastic covariance between asset returns can incur significant welfare losses.     

Factors driving aggregate mortality rates in postwar Germany

Using German data over the period 1956–2006, this study provides a comprehensive empirical analysis of factors driving aggregate mortality rates over time. It differs from previous contributions in this field by simultaneously considering an extensive set of macroeconomic, socioeconomic, and ecological factors as explanatory variables. Our regression analysis shows that sex- and age-specific mortality rates vary substantially in their response to external factors. Strongest associations are found with changes in real GDP, flu epidemics, and the two lifestyle variables—alcohol and cigarette consumption—in both univariate and multivariate setups. Further analysis indicates that these effects are primarily contemporary, whereas other indicators, such as weather conditions, exert lagged effects. We derive optimal multivariate models for every age group that provide a good fit to the observed variation in annual mortality rates, and thereby confirm the relevance of the identified factors.     

Optimal risk transfer and investment policies based upon stochastic differential utilities

This paper addresses the stochastic differential utility (SDU) version of the issue raised by Barrieu and El Karoui (Quantitative Finance, 2:181–188, 2002a) in which optimal risk transfer from a bank to an investor, realized by transacting well-designed derivatives written on relevant illiquid assets, was␣mainly studied in two cases with and without an available financial market. From a stochastic maximum principle as described in Yong and Zhou (Stochastic controls: Hamiltonian systems and HJB equations. Springer-Verlag, New York, 1999) we shall derive necessary and sufficient conditions for optimality in several SDU-based maximization problems. It is also shown that the optimal risk transfer, consumptions, investment policies of both agents are characterized by a forward–backward stochastic differential equation (FBSDE) system.     

Better the devil you know: The influence of political incumbency on Australian financial market uncertainty

The Australian federal election cycle, which occurs approximately every 3 years, causes much media attention and invokes indecision regarding investment decisions in both the real economy and financial markets. This paper constructs measures of political uncertainty and formally explores their relationship with market uncertainty, as measured by implied volatility. The empirical evidence suggests that increasing (decreasing) levels of uncertainty around the election result induce higher (lower) levels of market uncertainty. In a case of the market preferring the devil it knows, an increasing (decreasing) likelihood of the incumbent party, whose economic policies are well-known, winning the election, reduces market uncertainty. The results remain significant even after controlling for a number of macroeconomic variables, and when an alternative GARCH framework is considered.     

FISCAL DEFICITS AND MACROECONOMIC PERFORMANCE IN DEVELOPING COUNTRIES

Although fiscal adjustment was urged on developing countriesduring the 1980s to lead them out of economic malaise, considerableuncertainty remains about the relations between fiscal policyand macroeconomic performance. To illustrate how financial markets,private spending, and the external sector react to fiscal policies,the behavior of holdings of money and public debt, private consumptionand investment, the trade balance, and the real exchange rateis modeled for a sample of ten developing countries. The studiesfind strong evidence that over the medium term, money financingof the deficit leads to higher inflation, while debt financingleads to higher real interest rates or increased repressionof financial markets, with the fiscal gains coming at increasinglyunfavorable terms. Consumers respond differently to conventionaltaxes, unconventional taxes (through inflation or interest andcredit controls), and debt financing, in ways that make fiscaladjustment the most effective means of increasing national saving.Private investment—but not private consumption—issensitive to the real interest rate, which rises under domesticborrowing to finance the deficit. Contrary to the popular presumption,in some countries private investment increases when public investmentdecreases. There is strong evidence that fiscal deficits spillover into external deficits, leading to appreciation of thereal exchange rate. Fiscal deficits and growth are self-reinforcing:good fiscal management preserves access to foreign lending andavoids the crowding out of private investment, while growthstabilizes the budget and improves the fiscal position. Thevirtuous circle of growth and good fiscal management is oneof the strongest arguments for a policy of low and stable fiscaldeficits.      

Arbitrage and deflators in illiquid markets

This paper presents a stochastic model for discrete-time trading in financial markets where trading costs are given by convex cost functions and portfolios are constrained by convex sets. The model does not assume the existence of a cash account/numeraire. In addition to classical frictionless markets and markets with transaction costs or bid–ask spreads, our framework covers markets with nonlinear illiquidity effects for large instantaneous trades. In the presence of nonlinearities, the classical notion of arbitrage turns out to have two equally meaningful generalizations, a marginal and a scalable one. We study their relations to state price deflators by analyzing two auxiliary market models describing the local and global behavior of the cost functions and constraints.     

Complete Versus Incomplete Insurance Contracts under Adverse Selection with Multiple Risks

This article extends the standard adverse-selection model for competitive insurance markets, which assumes a single source of risk, to the case where individuals are subject to multiple risks. We compare the following market situations—the case where insurers can offer comprehensive policies against all sources or risks (complete contracts) and the case where different risks are covered by separate policies (incomplete contracts). In the latter case, we consider whether the insurer of a particular risk has perfect information regarding an individual's coverage against other sources of risks. The analysis emphasizes the informational role of bundling in multidimensional screening. When the market situation allows bundling, it is shown that in equilibrium the low-risk type with respect to a particular source of risk does not necessarily obtain partial coverage against that particular risk.     

Conglomerate investment under various capital market conditions

This paper studies the investment of diversified and focused firms under various capital market conditions. When external capital becomes more costly at the aggregate level, investment declines in focused firms but remains unchanged in diversified firms. This investment advantage enjoyed by diversified firms could attribute to both their easy access to external capital and their ability to substitute internal capital markets for costly external markets. Consistent with the internal capital market argument, our findings show that the investment advantage exists for diversified firms even after we control for their easy access to external markets. We also find that the role of internal markets in financing investment is more important for diversified firms that are more financially constrained in external markets. Finally, we find that the segment-level investment becomes more efficient in conglomerates’ internal capital markets under depressed external capital market conditions. Overall, our findings suggest that internal capital allocation functions as a valuable and efficient substitute for diversified firms in a tightened external capital market.     

Momentum in Residential Real Estate

This paper examines whether there is return momentum in residential real estate in the U.S. Case and Shiller (American economic review 79(1):128–137, 1989) document evidence of positive return correlation in four U.S. cities. Similar to Jegadeesh and Titman’s (Journal of finance 56:699–720, 1993) stock market momentum paper, we construct long-short zero cost investment portfolios from more than 380 metropolitan areas based on their lagged returns. Our results show that momentum of returns in the U.S. residential housing is statistically significant and economically meaningful during our 1983 to 2008 sample period. On average, zero cost investment portfolios that buy past winning housing markets and short sell past losing markets earn up to 8.92% annually. Our results are robust to different sub-periods and more pronounced in the Northeast and West regions. While zero cost portfolios of residential real estate indices is not a tradable strategy, the implications of our results can be useful for builders, potential home owners, mortgage originators and traders of real estate options.     

On the Evolution of Investment Strategies and the Kelly Rule--A Darwinian Approach

This paper complements theoretical studies on the Kelly rulein evolutionary finance by studying a Darwinian model of selectionand reproduction in which the diversity of investment strategiesis maintained through genetic programming. We find that investmentstrategies which optimize long-term performance can emerge inmarkets populated by unsophisticated investors. Regardless whetherthe market is complete or incomplete and whether states arei.i.d. or Markov, the Kelly rule is obtained as the asymptoticoutcome. With price-dependent rather than just state-dependentinvestment strategies, the market portfolio plays an importantrole as a protection against severe losses in volatile markets.     

Arbitrage and Viability in Insurance Markets

Insurance markets are subject to transaction costs and constraints on portfolio holdings. Therefore, unlike the frictionless asset markets case, viability is not equivalent to absence of arbitrage possibilities. We use the concept of unbounded arbitrage to characterize viable prices on a complete and an incomplete insurance market. In the complete market, there is an insurance contract for every possible event. In the incomplete market, risk can be insured through proportional and excess of loss like insurance contracts. We show how the the structure of viable prices is affected by the portfolio constraints, the transaction costs, and the structure of marketed contracts.     

Stochastic dividend yields and derivatives pricing in complete markets

When an underlying yields a stochastic dividend yield, derivatives with linear payoff at their maturities that are written on this underlying have the following properties: (i) they have a unique price only if markets are complete; (ii) the dynamic strategies that replicate these contingent claims contain hedging components against the state variables in the economy; (iii) the prices of these derivatives will depend upon the dynamics of the market prices of risk even when markets are complete. Within an affine framework, we explicitly price forward and futures contracts with stochastic dividends. We also show that the quantitative impact of assuming that dividends are deterministic when they are actually stochastic is significant. JEL Classification G12 · G13     

What Determines the Domestic Bias and Foreign Bias? Evidence from Mutual Fund Equity Allocations Worldwide

We examine how mutual funds from 26 developed and developing countries allocate their investment between domestic and foreign equity markets and what factors determine their asset allocations worldwide. We find robust evidence that these funds, in aggregate, allocate a disproportionately larger fraction of investment to domestic stocks. Results indicate that the stock market development and familiarity variables have significant, but asymmetric, effects on the domestic bias (domestic investors overweighting the local markets) and foreign bias (foreign investors under or overweighting the overseas markets), and that economic development, capital controls, and withholding tax variables have significant effects only on the foreign bias.     

Optimal hedging for fund and insurance managers with partially observable investment flows

All financial practitioners are working in incomplete markets full of unhedgeable risk factors. Making the situation worse, they are only equipped with imperfect information on the relevant processes. In addition to the market risk, fund and insurance managers have to be prepared for sudden and possibly contagious changes in the investment flows from their clients so that they can avoid the over- as well as under-hedging. In this work, the prices of securities, the occurrences of insured events and (possibly a network of) investment flows are used to infer their drifts and intensities by a stochastic filtering technique. We utilize the inferred information to provide the optimal hedging strategy based on the mean-variance (or quadratic) risk criterion. A BSDE approach allows a systematic derivation of the optimal strategy, which is shown to be implementable by a set of simple ODEs and standard Monte Carlo simulation. The presented framework may also be useful for manufacturers and energy firms to install an efficient overlay of dynamic hedging by financial derivatives to minimize the costs.     

The supermartingale property of the optimal wealth process for general semimartingales

We consider an incomplete stochastic financial market where the price processes are described by a vector valued semimartingale that is possibly non locally bounded. We face the classical problem of utility maximization from terminal wealth, under the assumption that the utility function is finite-valued and smooth on the entire real line and satisfies reasonable asymptotic elasticity. In this general setting, it was shown in Biagini and Frittelli (Financ. Stoch. 9, 493–517, 2005) that the optimal claim admits an integral representation as soon as the minimax σ-martingale measure is equivalent to the reference probability measure. We show that the optimal wealth process is in fact a supermartingale with respect to every σ-martingale measure with finite generalized entropy, thus extending the analogous result proved by Schachermayer (Financ. Stoch. 4, 433–457, 2003) for the locally bounded case.      

Revisiting the supply side effects of government spending

We revisit the macroeconomic effects of government consumption in the neoclassical growth model when agents face uninsured idiosyncratic investment risk. Under complete markets, a permanent increase in government consumption has no long-run effect on interest rates and capital intensity, while it increases work hours due to the negative wealth effect. These results are upset once we allow for incomplete markets. The same negative wealth effect now causes a reduction in risk taking and the demand for investment. This leads to a lower risk-free rate and, under certain conditions, also to a lower capital-labor ratio and lower productivity.     

Investing in the size factor

This paper investigates the role of the size factor for constructing investment portfolios and proposes a dynamic extension that accommodates the risk-free asset and time-varying weights. These weights are determined by a set of state variables given by the term structure of sovereign interest rates, variables describing market risk aversion such as the VIX index and the CRB Industrial return, and indexes reflecting investor sentiment towards the economic outlook. The empirical section explores the suitability of these state variables and analyses the out-of-sample performance of size factors idiosyncratic to the US, the UK and European financial markets that are compared against the dynamic version that optimizes the weights in each period. The results provide support to the different size factors except for periods of economic distress in which the optimal dynamic strategies are clearly superior.