Generalized DEA model of fundamental analysis and its application to portfolio optimization

Fundamental analysis is used in asset selection for equity portfolio management. In this paper, a generalized data envelopment analysis (DEA) model is developed to analyze a firm’s financial statements over time in order to determine a relative financial strength indicator (RFSI) that is predictive of firm’s stock price returns. RFSI is based on maximizing the correlation between the DEA-based score of financial strength and the stock market performance. This maximization involves a difficult binary nonlinear program that requires iterative re-configuration of parameters of financial statements as inputs and outputs. We utilize a two-step heuristic algorithm that combines random sampling and local search optimization. The proposed approach is tested with 230 firms from various US technology-industries to determine optimized RFSI indicators for stock selection. Then, those selected stocks are used within portfolio optimization models to demonstrate the usefulness of the scheme for portfolio risk management.     

A comparative study of the probability of default for global financial firms

This article presents a modification of Merton’s (1976) ruin option pricing model to estimate the implied probability of default from stock and option market prices. To test the model, we analyze all global financial firms with traded options in the US and focus on the subprime mortgage crisis period. We compare the performance of the implied probability of default from our model to the expected default frequencies based on the Moody’s KMV model and agency credit ratings by constructing cumulative accuracy profiles (CAP) and the receiver operating characteristic (ROC). We find that the probability of default estimates from our model are equal or superior to other credit risk measures studied based on CAP and ROC. In particular, during the subprime crisis our model surpassed credit ratings and matched or exceeded KMV in anticipating the magnitude of the crisis. We have also found some initial evidence that adding off-balance-sheet derivatives exposure improves the performance of the KMV model.     

An analysis of portfolio selection with background risk

This paper investigates the impact of background risk on an investor’s portfolio choice in a mean–variance framework, and analyzes the properties of efficient portfolios as well as the investor’s hedging behaviour in the presence of background risk. Our model implies that the efficient portfolio with background risk can be separated into two independent components: the traditional mean–variance efficient portfolio, and a self-financing component constructed to hedge against background risk. Our analysis also shows that the presence of background risk shifts the efficient frontier of financial assets to the right with no changes in its shape. Moreover, both the composition of the hedge portfolio and the location of the efficient frontier are greatly affected by a number of background risk factors, including the proportion of background assets in total wealth and the correlation between background risk and financial risk.     

The price-setting behavior of banks: An analysis of open-end leverage certificates on the German market

This paper presents the first analysis of open-end leverage certificates on the German market. The major innovations of these certificates are twofold. First, issuers announce a price-setting formula according to which they are willing to buy and sell the certificates over time. Second, the product’s lifetime is potentially endless. Our main findings are that the price-setting formula is (i) designed to strongly favor the issuer and (ii) is consistent with the main outcome of the ‘life cycle hypothesis’ for structured financial products [Stoimenov, P.A., Wilkens, S., 2005. Are structured products ‘fairly’ priced? An analysis of the German market for equity-linked instruments. Journal of Banking and Finance 29, 2971–2993]. (iii) This holds for different product features and also in the presence of issuers’ credit risk and jump risk in the underlying.     

Capital expenditures,financial constraints,and the use of options

This paper analyzes why gold mining firms use options instead of linear strategies to hedge their gold price risk. Consistent with financial constraints based theories, the largest and least financially constrained firms are the most likely to hedge with insurance strategies (put options), while more constrained firms finance the purchase of puts by selling calls (collars). The most financially constrained firms use strategies that involve selling calls. Firms with large investment programs are also more likely to use insurance rather than linear strategies. Firms’ hedging instrument choices are also correlated with current market conditions, suggesting that managers’ market views partially drive hedging instrument choices.     

Foreign exchange market efficiency under recent crises: Asia-Pacific focus

The Asia-Pacific region’s currency markets are generally efficient within-country when tested using the 30 and 31 cointegration technique whereas market efficiency fails to hold when tested using Fama’s (1984) conventional regression. Using the Pilbeam and Olmo (2011) model, we reconcile these conflicting findings. The Pilbeam and Olmo (2011) model confirms within-country market efficiency. It further confirms that free-float currency markets are more resilient than managed-float currency markets among 12 Asia-Pacific economies. From the across-country perspective, the foreign exchange markets are mostly efficient and the results show that the 1997–1998 Asian financial crisis was a more disturbing event than the 2008–2009 global financial crisis in the region.     

Optimizing international portfolios with options and forwards

We develop a stochastic programming model to address in a unified manner a number of interrelated decisions in international portfolio management: optimal portfolio diversification and mitigation of market and currency risks. The goal is to control the portfolio’s total risk exposure and attain an effective balance between risk and expected return. By incorporating options and forward contracts in the portfolio optimization model we are able to numerically assess the performance of alternative tactics for mitigating exposure to the primary risks. We find that control of market risk with options has more significant impact on portfolio performance than currency hedging. We demonstrate through extensive empirical tests that incremental benefits, in terms of reducing risk and generating profits, are gained when both the market and currency risks are jointly controlled through appropriate means.     

基于政府参与情形的混合巨灾债券设计与实证分析

我国是属于自然灾害多发的国家,但由于保险市场与资本市场相对落后,目前对于巨灾的管理仍然主要依靠政府事后的财政拨款与民间捐赠。本文借鉴并改进了国内外相关研究结论,构建了由保险市场、资本市场以及政府所组成的巨灾风险分担模型。在该模型的基础上,以熵测度为准则,设计了一种有政府参与的混合巨灾债券,这种债券是传统的简单巨灾债券与...     

Reading between the lines: An empirical examination of qualitative attributes of financial analysts’ reports

This paper examines whether two qualitative attributes of financial analysts’ reports, detail and tone, are significant in explaining how the market responds to analysts’ reports, after controlling for the information contained in the reports’ quantitative summary measures. Report detail is hypothesized to reflect the level of effort expended by the analyst in preparing the report, and therefore the usefulness of their intrinsic firm value estimates. Report tone is predicted to signal the analyst’s underlying sentiment regarding the firm and may be used to assess the extent to which analysts’ conflicts of interest interfere with the mapping of firm value estimates into stock recommendations. Consistent with these hypotheses, we find that the tone of financial analyst reports contain significant information content incremental to the reports’ earnings forecasts and recommendations, and report complexity (one component of report detail) helps explain cross-sectional variation in the market’s response to the reports’ recommendations.     

The world price of liquidity risk

This paper empirically tests the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.     

Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.     

Discrete hedging of American-type options using local risk minimization

Local risk minimization and total risk minimization discrete hedging have been extensively studied for European options [e.g., Schweizer, M., 1995. Variance-optimal hedging in discrete time. Mathematics of Operation Research 20, 1–32; Schweizer, M., 2001. A guided tour through quadratic hedging approaches. In: Jouini, E., Cvitanic, J., Musiela, M., Option pricing, interest rates and risk management, Cambridge University Press, pp. 538–574]. In practice, hedging of options with American features is more relevant. For example, equity linked variable annuities provide surrender benefits which are essentially embedded American options. In this paper we generalize both quadratic and piecewise linear local risk minimization hedging frameworks to American options. We illustrate that local risk minimization methods outperform delta hedging when the market is highly incomplete. In addition, compared to European options, distributions of the hedging costs are typically more skewed and heavy-tailed. Moreover, in contrast to quadratic local risk minimization, piecewise linear risk minimization hedging strategies can be significantly different, resulting in larger probabilities of small costs but also larger extreme cost.     

The intertemporal capital asset pricing model with dynamic conditional correlations

The intertemporal capital asset pricing model of Merton (1973) is examined using the dynamic conditional correlation (DCC) model of Engle (2002). The mean-reverting DCC model is used to estimate a stock’s (portfolio’s) conditional covariance with the market and test whether the conditional covariance predicts time-variation in the stock’s (portfolio’s) expected return. The risk-aversion coefficient, restricted to be the same across assets in panel regression, is estimated to be between two and four and highly significant. The risk premium induced by the conditional covariation of assets with the market portfolio remains positive and significant after controlling for risk premia induced by conditional covariation with macroeconomic, financial, and volatility factors.     

Optimal strike prices of stock options for effort-averse executives

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.     

Scenario Simulation: Theory and methodology

This paper presents a new simulation methodology for quantitative risk analysis of large multi-currency portfolios. The model discretizes the multivariate distribution of market variables into a limited number of scenarios. This results in a high degree of computational efficiency when there are many sources of risk and numerical accuracy dictates a large Monte Carlo sample. Both market and credit risk are incorporated. The model has broad applications in financial risk management, including value at risk. Numerical examples are provided to illustrate some of its practical applications.     

Transmission of the financial and sovereign debt crises to the EMU: Stock prices,CDS spreads and exchange rates

This paper tests for the transmission of the 2007–2010 financial and sovereign debt crises to fifteen EMU countries. We use daily data from 2003 to 2010 on country financial and non-financial stock market indexes to analyze the stock market returns for three country groups within EMU: North, South and Small. The following results hold for both the North and South European countries, while the smallest countries seem to be relatively isolated from international events. First, we find strong evidence of crisis transmission to European non-financials from US non-financials, but not for financials. Second, in order to test how the sovereign debt crisis affects stock market developments we split the crisis in pre- and post-Lehman sub periods. Results show that financials become significantly more dependent on changes in the difference between the Greek and German CDS spreads after Lehman’s collapse, compared to the pre-Lehman sub period. However, this increase is much smaller for non-financials. Third, before the crisis euro appreciations coincide with European stock market decreases, whereas this relationship reverses during the crisis. Finally, this reversal seems to be triggered by Lehman’s collapse.     

Relationship lending,hierarchical distance and credit tightening: Evidence from the financial crisis

This paper examines the firms’ credit availability during the 2007–2009 financial crisis using a dataset of 5331 bank–firm relationships provided by borrowers’ credit folders of three Italian banks. It aims to test whether a strong lender–borrower relationship can produce less credit rationing for borrowing firms even during a credit crunch period. The results show that exclusivity of the relationship can mitigate the firm credit rationing. We also verify the influence of lending organizational structure during crisis. A new measure of distance in lending technologies has been introduced: the hierarchical distance calculated as the distance between the branch that originates the loan and the location of the hierarchical level responsible for financing decision. Our findings document a negative impact of distance on credit availability, consistent with the idea that proximity facilitates the transmission of soft information.     

The efficacy of regulatory intervention: Evidence from the distribution of informed option trading

A substantive body of equity-market academic research documents an extensive range of costs arising from the SEC’s October 2000 adoption of strictures on selective disclosure and insider trading; suggesting an unusual outcome, specifically, an increase in informed trading. We investigate the efficacy of the SEC’s regulations by examining informed trading in an attractive setting for exploiting private information; the options market. Using data on the S&P 1500 industrial firms, our analysis indicates that about 38% of firms exhibited symptoms of informed option trading prior to regulatory intervention. After regulatory intervention, we observe that only 19% of firms show symptoms of informed trading. In additional testing of ADR firms – explicitly exempt from complying with Reg FD, we find no evidence of a change in informed option trading from pre- to post-regulation; suggesting that the SEC’s strictures on US firms led a to a significant reduction in informed option trading. Notably, our proxies for large shareholder and financial analyst access are associated with the largest decreases in informed option trading. In developing a unique measure of informed trading based on option market data, we provide evidence on the efficacy of security regulation in limiting informed trading.     

Does multinationality matter? Implications of operational hedging for the exchange risk exposure

An important issue in global corporate risk management is whether the multinationality of a firm matters in terms of its effect on exchange risk exposure. In this paper, we examine the exchange risk exposure of US firms during 1983–2006, comparing multinational and non-multinational firms and focusing on the role of operational hedging. Since MNCs and non-multinationals differ in size and other characteristics, we construct matched samples of MNCs and non-multinationals based on the propensity score method. We find that the multinationality in fact matters for a firm’s exchange exposure but not in the way usually presumed – the exchange risk exposures are actually smaller and less significant for MNCs than non-multinationals. The results are robust with respect to different samples and model specifications. There is evidence that operational hedging decreases a firm’s exchange risk exposure and increases its stock returns. The effective deployment of operational risk management strategies provides one reason why MNCs may have insignificant exchange risk exposure estimates.     

An analysis of option pricing under systematic consumption risk using GARCH

An issue in the pricing of contingent claims is whether to account for consumption risk. This is relevant for contingent claims on stock indices, such as the FTSE 100 share price index, as investor’s desire for smooth consumption is often used to explain risk premiums on stock market portfolios, but is not used to explain risk premiums on contingent claims themselves. This paper addresses this fundamental question by allowing for consumption in an economy to be correlated with returns. Daily data on the FTSE 100 share price index are used to compare three option pricing models: the Black–Scholes option pricing model, a GARCH (1, 1) model priced under a risk-neutral framework, and a GARCH (1, 1) model priced under systematic consumption risk. The findings are that accounting for systematic consumption risk only provides improved accuracy for in-the-money call options. When the correlation between consumption and returns increases, the model that accounts for consumption risk will produce lower call option prices than observed prices for in-the-money call options. These results combined imply that the potential consumption-related premium in the market for contingent claims is constant in the case of FTSE 100 index options.