The price of advice

We develop a model of consulting (advising) where the role of the consultant is to reveal signals to her client that refine the client's original private estimate of the profitability of a project. Although the client can perfectly observe and evaluate these signals, the consultant may only be able to do the same imperfectly, or not at all. This captures the idea that the expert may not fully understand the impact of her advice on the client. We characterize the optimal contract between the consultant and her client. It is a menu consisting of pairs of transfers specifying payments between the two parties in case the project is undertaken by the client and in case it is not. The main result of the article is that in the optimal mechanism, the consultant obtains the same profit as though she could perfectly observe and evaluate the impact of the signals whose release she controls on the client's profit estimate.     

“Relative Importance of Risk Sources in Insurance Systems”, Edward W. Frees,April 1998

Abstract

This paper considers a Sparre Andersen collective risk model in which the distribution of the interclaim time is that of a sum of n independent exponential random variables; thus, the Erlang(n) model is a special case. The analysis is focused on the function φ(u), the expected discounted penalty at ruin, with u being the initial surplus. The penalty may depend on the deficit at ruin and possibly also on the surplus immediately before ruin. It is shown that the function φ(u) satisfies a certain integro-differential equation and that this equation can be solved in terms of Laplace transforms, extending a result found in Lin (2003). As a consequence, a closed-form expression is obtained for the discounted joint probability density of the deficit at ruin and the surplus just before ruin, if the initial surplus is zero. For this formula and other results, the roots of Lundberg’s fundamental equation in the right half of the complex plane play a central role. Also, it is shown that φ(u) satisfies Li’s (2003) renewal equation. Under the assumption that the penalty depends only on the deficit at ruin and that the individual claim amount density is a combination of exponential densities, a closed-form expression for φ(u) is derived. In this context, known results of the Cauchy matrix are useful. Surprisingly, certain results are best expressed in terms of divided differences, a topic deleted from the actuarial examinations at the end of last century.     

典型事实、极值理论与金融市场动态风险测度研究

本文在金融市场典型事实约束下,运用ARFIMA模型对金融市场条件收益率建模,运用GARCH、GJR、FIGARCH、APARCH、FIAPARCH等5种模型对金融波动率进行建模,进而运用极值理论(EVT)对标准收益的极端尾部风险建模来测度各股市的动态风险,并用返回测试(Back-testing)方法检验模型的适应性。实证结果表明,总的来说,FIAPARCH-EVT模型对各个市场具有较强的适应性,风险测度能力较为优越。进一步,本文在ARFIMA-FIAPARCH模型下,假定标准收益分别服从正态分布(N)、学生t分布(st)、有偏学生t分布(skst)、广义误差分布(GED)共4种分布,对各股市的动态风险测度的准确性进行检验,并和EVT方法的测度结果进行对比分析。结果表明,EVT方法风险测度能力优于其他方法,有偏学生t分布假设下的风险测度模型虽然略逊于EVT方法,但也不失为一种较好的方法;ARFIMA-FI-APARCH-EVT不仅在中国大陆沪深股市表现最为可靠,而且在其他市场也表现出同样的可靠性。     

Forecasting market risk of portfolios: copula-Markov switching multifractal approach

This paper proposes a new methodology for modeling and forecasting market risks of portfolios. It is based on a combination of copula functions and Markov switching multifractal (MSM) processes. We assess the performance of the copula-MSM model by computing the value at risk of a portfolio composed of the NASDAQ composite index and the S&P 500. Using the likelihood ratio (LR) test by Christoffersen [1998. “Evaluating Interval Forecasts.” International Economic Review 39: 841–862], the GMM duration-based test by Candelon et al. [2011. “Backtesting Value at Risk: A GMM Duration-based Test.” Journal of Financial Econometrics 9: 314–343] and the superior predictive ability (SPA) test by Hansen [2005. “A Test for Superior Predictive Ability.” Journal of Business and Economic Statistics 23, 365–380] we evaluate the predictive ability of the copula-MSM model and compare it to other common approaches such as historical simulation, variance–covariance, RiskMetrics, copula-GARCH and constant conditional correlation GARCH (CCC-GARCH) models. We find that the copula-MSM model is more robust, provides the best fit and outperforms the other models in terms of forecasting accuracy and VaR prediction.     

Does the Market Value Financial Expertise on Audit Committees of Boards of Directors?

We examine three‐day cumulative abnormal returns around the announcement of 702 newly appointed outside directors assigned to audit committees during a period before implementation of the Sarbanes‐Oxley Act (SOX). Motivated by the SOX requirement that public companies disclose whether they have a financial expert on their audit committee, we test whether the market reacts favorably to the appointment of directors with financial expertise to the audit committee. In addition, because it is controversial whether SOX should define financial experts narrowly to include primarily accounting financial experts (as initially proposed) or more broadly to include nonaccounting financial experts (as ultimately passed), we separately examine appointments of each type of expert. We find a positive market reaction to the appointment of accounting financial experts assigned to audit committees but no reaction to nonaccounting financial experts assigned to audit committees, consistent with accounting‐based financial skills, but not broader financial skills, improving the audit committee's ability to ensure high‐quality financial reporting. In addition, we find that this positive reaction is concentrated among firms with relatively strong corporate governance, consistent with accounting financial expertise complementing strong governance, possibly because strong governance helps channel the expertise toward enhancing shareholder value. Together, these findings are consistent with financial expertise on audit committees improving corporate governance but only when both the expert and the appointing firm possess characteristics that facilitate the effective use of the expertise.     

Overconfidence and trading volume

Theoretical models predict that overconfident investors will trade more than rational investors. We directly test this hypothesis by correlating individual overconfidence scores with several measures of trading volume of individual investors. Approximately 3,000 online broker investors were asked to answer an internet questionnaire which was designed to measure various facets of overconfidence (miscalibration, volatility estimates, better than average effect). The measures of trading volume were calculated by the trades of 215 individual investors who answered the questionnaire. We find that investors who think that they are above average in terms of investment skills or past performance (but who did not have above average performance in the past) trade more. Measures of miscalibration are, contrary to theory, unrelated to measures of trading volume. This result is striking as theoretical models that incorporate overconfident investors mainly motivate this assumption by the calibration literature and model overconfidence as underestimation of the variance of signals. In connection with other recent findings, we conclude that the usual way of motivating and modeling overconfidence which is mainly based on the calibration literature has to be treated with caution. Moreover, our way of empirically evaluating behavioral finance models—the correlation of economic and psychological variables and the combination of psychometric measures of judgment biases (such as overconfidence scores) and field data—seems to be a promising way to better understand which psychological phenomena actually drive economic behavior.

Task assignments and incentives: generalists versus specialists

I develop an agency model of job assignments where jobs differ based on the breadth of tasks. A tradeoff between task complementarities and relative abilities of workers results in those with balanced skills being assigned to multitask jobs. The same tradeoff between complementarities and relative abilities also influences incentives to sort privately informed workers to jobs. I then draw on a variety of sources (survey data, case studies, and anecdotal evidence) to suggest that relative abilities and multitasking play an important role in managerial assignments of nonacademic research scientists.     

Is liquidity the missing link?

Durand et al. (2006a ) argue that the Australian market is both internationally integrated and domestically segmented. They find that the US‐based three‐factor model captures returns of the largest stocks in Australia (evidence of international integration), but that it is unable to account for the returns of the smallest stocks (evidence of domestic segmentation). This study resolves the puzzle left by Durand et al. (2006a) . Incorporating a liquidity factor provides the missing link in their analysis: it results in a model that permits both the international integration of the largest stocks and the model can account for the returns of the smallest stocks. Our analysis highlights the important role of liquidity in Australian asset pricing.     

On a multivariate Markov chain model for credit risk measurement

In this paper, we use credibility theory to estimate credit transition matrices in a multivariate Markov chain model for credit rating. A transition matrix is estimated by a linear combination of the prior estimate of the transition matrix and the empirical transition matrix. These estimates can be easily computed by solving a set of linear programming (LP) problems. The estimation procedure can be implemented easily on Excel spreadsheets without requiring much computational effort and time. The number of parameters is O(s² m² ), where s is the dimension of the categorical time series for credit ratings and m is the number of possible credit ratings for a security. Numerical evaluations of credit risk measures based on our model are presented.     

Organizational Structures and Exchange Processes

Formal organizations have a division of labor and some form of co-ordination. This paper explores how these social structures could be generated by an exchange process that governs work flow through an organization. Specifically, the exchange process controls how work tasks are assigned and carried out, and how members receive rewards for participating in a work group of the organization. A discrete-event simulation model is used to explore how the exchange process generates division of labor and co-ordination networks. The model contains members, called bureaucrats, with two kinds of skills: skill at referring work to others; and skill in completing work tasks. Both kinds of skills are distributed differentially across bureaucrats. Two types of rational exchange are explored: independent exchange and pooled exchange. For independent exchange, rewards go the bureaucrat who completes the task; in pooled exchange rewards are shared with the bureaucrat who referred the task. Both exchange processes generate a division of labor in a work group, with pooled exchange exhibiting the most pronounced division of labor. Also, pooled exchange leads to more efficient processing of work than independent exchange.     

Non-exponential bounds for stop-loss premiums and ruin probabilities

We present an inventory of non-exponential bounds for ruin probabilities and stop-loss premiums in the general Sparre-Andersen model (renewal model) of risk theory. Various additional bounds are given if one assumes that the ladder height distribution F associated with the risk process belongs to a certain class of distributions, in particular if it is concave or it exhibits a (positive or negative) aging property. In most cases, these bounds are shown to improve existing ones in the literature and/or possess the correct asymptotic behaviour when the distribution F is subexponential. Since in the classical (compound Poisson) risk model the ladder height distribution is always concave, all the bounds given in the paper are also valid for this model. Finally, in many cases the results of the paper are also valid for any compound geometric distribution.     

The monetary model in the presence of I(2) components: long-run relationships, short-run dynamics and forecasting of the Greek drachma

This paper re-examines the long-run properties of the monetary exchange rate model using data for the drachma–dollar and drachma–mark exchange rates under the hypothesis that the system contains variables that are I(2). Using the recent I(2) test by Paruolo (On the determination of integration indices in I(2) systems. J. Economet. 72 (1996) 313–356) to examine the presence of I(2) and I(1) components in a multivariate context we find that the system contains two I(2) variables in both cases and this finding is reconfirmed by the estimated roots of the companion matrix (Do purchasing power parity and uncovered interest rate parity hold in the long-run? An example of likelihood inference in a multivariate time-series model. Juselius, J. Economet. 69 (1995) 211–240). The I(2) component led to the transformation of the estimated model by imposing long-run but not short-run proportionality between domestic and foreign money. Two statistically significant cointegrating vectors were found and, by imposing linear restrictions on each vector as suggested by Johansen and Juselius (Identification of the long-run and the short-run structure: an applicaion to the ISLM model. J. Economet. 63 (1994) 7–36) and Johansen (Identifying restrictions of linear equations with applications to simultaneous equations and cointegration. J. Economet. 69 (1995b) 111–132), the order and rank conditions for identification are satisfied, but the test for overidentifying restrictions was not significant only for the case of the drachma/mark rate. The main findings suggest that we reject the forward-looking version of the monetary model for the drachma/dollar case but not when the drachma/mark rate is used, a result that is attributed to the monetary and exchange rate policy followed by the Greek authorities since Greece's joining of the European Union. Furthermore, we test for parameter stability using the tests developed by Hansen and Johansen (Recursive estimation in cointegrated VAR-models. Working paper (1993) University of Copenhagen) and it is shown that the dimension of the cointegration rank is sample independent while the estimated coefficients do not exhibit instabilities in recursive estimations. Finally, it is shown that the monetary model outperforms the random walk model in an out-of-sample forecasting contest.     

基于Copula函数的国际原油价格与股票市场收益的相关性研究

针对国际原油价格与金砖五国股票市场收益之间的相关性问题,使用 AR(p)-GARCH(1,1)-Copula 模型进行检验。运用广义误差分布(GED)获取收益残差序列,对 WTI 原油价格和金砖五国股市收益之间的相关性进行实证分析。研究结果表明,国际原油价格与中国股市收益呈现微弱的相关关系,而与其他四国股市收益的相关关系较为明显。用时变 SJC Copula 模型刻画国际原油价格与金砖五国股票市场收益的相关性最为合适。     

An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence

We extend Campbell's (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.     

The Stochastic Properties of Major Canadian Exchange Rates

This paper extends the results of Akgiray and Booth [2] on the stochastic properties of five major Canadian exchange rates using the EGARCH-M model along with the generalized error distribution (GED). In addition to the issue of first- and second-order dependencies, explored by the authors, the paper (1) addresses the issue of asymmetric volatility, (2) examines the extent to which volatility affects future movements in these exchange rates, (3) measures the amount of kurtosis in the data, and (4) investigates the transmission mechanism of innovations and volatility shocks across the five Canadian exchange rate markets. The five Canadian dollar exchange rates are for the U.S. dollar, the Japanese yen, the British pound, the German mark, and the French franc. Changes in Canadian exchange rates are conditionally heteroskedastic, a finding which is in line with that of Akgiray and Booth [2]. There is no evidence supporting the assertion that volatility triggers such changes. The hypothesis of asymmetric volatility is rejected for all Canadian exchange rates; thus unexpected appreciations and depreciations of the Canadian currency have similar impact on future volatility of these exchange rates. Innovations in the Canadian exchange rate markets for the U.S. dollar, the British pound, and French franc influence the Japanese yen market, while innovations in the markets of the British pound and German mark influence the French franc market. Significant but negative volatility spillovers radiate from the German mark market to the U.S. dollar market and from the French franc market to the German mark market, resulting in lower levels of volatility in both the U.S. and German markets. The distributions of all five series of Canadian exchange rates are highly leptokurtic relative to the normal distribution. The GED distribution provides a good characterization of these distributions.     

Testing Conditional Asset Pricing Models Using a Markov Chain Monte Carlo Approach

We use Markov Chain Monte Carlo (MCMC) methods for the parameter estimation and the testing of conditional asset pricing models. In contrast to traditional approaches, it is truly conditional because the assumption that time variation in betas is driven by a set of conditioning variables is not necessary. Moreover, the approach has exact finite sample properties and accounts for errors‐in‐variables. Using S&P 500 panel data, we analyse the empirical performance of the CAPM and the Fama and French (1993) three‐factor model. We find that time‐variation of betas in the CAPM and the time variation of the coefficients for the size factor (SMB) and the distress factor (HML) in the three‐factor model improve the empirical performance. Therefore, our findings are consistent with time variation of firm‐specific exposure to market risk, systematic credit risk and systematic size effects. However, a Bayesian model comparison trading off goodness of fit and model complexity indicates that the conditional CAPM performs best, followed by the conditional three‐factor model, the unconditional CAPM, and the unconditional three‐factor model.     

The Goal Project: A Group Assignment to Encourage Creative Thinking,Leadership Abilities and Communication Skills

Abstract

The classroom assignment described in this paper, The Goal Project, gives students an opportunity to develop four of the skills and abilities required to be a successful accountant. In 1990, the Accounting Education Change Commission issued Position Statement Number One, Objectives of Education for Accountants. Appendix B of that statement contains eight categories of knowledge, skills, personal capacities and attitudes that are needed by accounting graduates. The Institute of Management Accountants has outlined the work of a management accountant to include working in small business teams and participating in strategic decision making. The project described in this paper replicates the work an accountant would perform when working in problem-solving teams. Data was collected and results are included from a questionnaire completed by 166 students who participated in The Goal Project. The results of perceived improvement in creative problem solving, leadership skills, and oral and written communication skills are presented.     

On accurate and provably efficient GARCH option pricing algorithms

The GARCH model has been very successful in capturing the serial correlation of asset return volatilities. As a result, applying the model to options pricing attracts a lot of attention. However, previous tree-based GARCH option pricing algorithms suffer from exponential running time, a cut-off maturity, inaccuracy, or some combination thereof. Specifically, this paper proves that the popular trinomial-tree option pricing algorithms of Ritchken and Trevor (Ritchken, P. and Trevor, R., Pricing options under generalized GARCH and stochastic volatility processes. J. Finance, , 54(1), 377–402.) and Cakici and Topyan (Cakici, N. and Topyan, K., The GARCH option pricing model: a lattice approach. J. Comput. Finance, , 3(4), 71–85.) explode exponentially when the number of partitions per day, n, exceeds a threshold determined by the GARCH parameters. Furthermore, when explosion happens, the tree cannot grow beyond a certain maturity date, making it unable to price derivatives with a longer maturity. As a result, the algorithms must be limited to using small n, which may have accuracy problems. The paper presents an alternative trinomial-tree GARCH option pricing algorithm. This algorithm provably does not have the short-maturity problem. Furthermore, the tree-size growth is guaranteed to be quadratic if n is less than a threshold easily determined by the model parameters. This level of efficiency makes the proposed algorithm practical. The surprising finding for the first time places a tree-based GARCH option pricing algorithm in the same complexity class as binomial trees under the Black–Scholes model. Extensive numerical evaluation is conducted to confirm the analytical results and the numerical accuracy of the proposed algorithm. Of independent interest is a simple and efficient technique to calculate the transition probabilities of a multinomial tree using generating functions.     

Conditional Asset Pricing and Stock Market Anomalies in Europe

This study provides European evidence on the ability of static and dynamic specifications of the Fama‐French (1993) three‐factor model to price 25 size‐B/M portfolios. In contrast to US evidence, we detect a small‐growth premium and find that the size effect is still present in Europe. Furthermore, we document strong time variation in factor risk loadings. Incorporating these risk fluctuations in conditional specifications of the three‐factor model clearly improves its ability to explain time variation in expected returns. However, the model still fails to completely capture cross‐sectional variation in returns as it is unable to explain the momentum effect.