Two-sided coherent risk measures and their application in realistic portfolio optimization

By using a different derivation scheme, a new class of two-sided coherent risk measures is constructed in this paper. Different from existing coherent risk measures, both positive and negative deviations from the expected return are considered in the new measure simultaneously but differently. This innovation makes it easy to reasonably describe and control the asymmetry and fat-tail characteristics of the loss distribution and to properly reflect the investor’s risk attitude. With its easy computation of the new risk measure, a realistic portfolio selection model is established by taking into account typical market frictions such as taxes, transaction costs, and value constraints. Empirical results demonstrate that our new portfolio selection model can not only suitably reflect the impact of different trading constraints, but find more robust optimal portfolios, which are better than the optimal portfolio obtained under the conditional value-at-risk measure in terms of diversification and typical performance ratios.     

No-arbitrage criteria for financial markets with transaction costs and incomplete information

This note deals with criteria of absence of arbitrage opportunities for an investor acting in a market with frictions and having a limited access to the information flow. We develop a mathematical scheme covering major models of financial markets with transaction costs and prove several results including a criterion for the robust no-arbitrage property and a hedging theorem.      

Corporate debt issues and interest rate risk management: Hedging or market timing?

Apart from the obvious reasons for raising capital, a firm can hedge its interest rate exposure by issuing debt, the value of which moves in an opposite direction from the value of its assets as interest rate varies. We examine whether firms in the UK market make full use of debt issuances for hedging purposes or if they have other considerations. Our evidence shows that firms’ choices of debt issues are primarily driven by debt market conditions in an effort to lower their costs of capital rather than managing their firm-specific interest rate exposures. This suggests that market timing, as opposed to hedging, is the primary motivation behind corporate debt issuances.     

Tick size change on the Stock Exchange of Thailand

This paper explores the impact of an exogenous tick size reduction on bid-ask spreads, depths, and trading volume on the Stock Exchange of Thailand (SET). On November 5, 2001, the SET implemented a tick size reduction on stocks priced below THB 25. Even though trading on SET is largely dominated by retail investors, the tick reduction produces similar empirical results found in markets where institutional investors are more dominant. Tick reduction on the SET is associated with declines in spreads, and quoted and accumulated market depths. The study finds no significant change in trading volume due to the reduction.

A change in market microstructure: the switch to electronic screen trading on the New Zealand stock exchange

The New Zealand Stock Exchange (NZSE) switched from open outcry trading to an electronic screen trading system on June 24, 1991. The change was made by the members of the exchange to improve the trading system and to reduce costs. This paper investigates empirically whether improvement was achieved through a reduction in transaction costs. The tests and results focus on order-flow migration to the exchange from alternative execution locations and changes in bid-ask spreads. On balance, we conclude that transaction costs have declined.     

Do Japanese candlesticks help solve the trader’s dilemma?

In this paper, we investigate whether Japanese candlesticks can help traders to find the best trade-off between market timing and market impact costs. Based on fixed-effect panel regressions on a sample of 81 European stocks, we show that implicit transaction costs are better characterized by using specific Japanese candlesticks patterns. Although market timing costs are not lower when Hammer-like and Doji configurations occur, market impact costs are significantly lower when and after a Doji structure occurs. We further check the potential gains through order submission simulations and find that submission strategies based on the occurrence of Doji result in significantly lower market impact cost than random submission strategies. These findings are of great interest for investors who look for occasional liquidity pools to execute their orders inexpensively such as institutional traders or hedgers.     

Hedging efficiently under correlation

We show that when a derivative portfolio has different correlated underlyings, hedging using classical greeks (first-order derivatives) is not the best possible choice. We first show how to adjust greeks to take correlation into account and reduce P&L volatility. Then we embed correlation-adjusted greeks in a global hedging strategy that reduces cost of hedging without increasing P&L volatility, by optimization of hedge re-adjustments. The strategy is justified in terms of a balance between transaction costs and risk-aversion, but, unlike more complex proposals from previous literature, it is completely defined by observable parameters, geometrically intuitive, and easy to implement for an arbitrary number of risk factors. We test our findings on a CVA hedging example. We first consider daily re-hedging: in this test, correlation-adjusted greeks allow the reduction of P&L volatility by more than 30% compared to standard deltas. Then we apply our general strategy to a context where a CVA portfolio is exposed to both credit and interest rate risk. The strategy keeps P&L volatility in line with daily standard delta-hedging, but with massive cost-saving: only six rebalances of the illiquid credit hedge are performed, over a period of six months.     

Liquidating large security positions strategically: a pragmatic and empirical approach

This article investigates static liquidation strategies for large security positions in illiquid markets. Under the assumption that the liquidation horizon is given exogenously, a discretionary liquidity trader solves for the optimal sales trajectory so as to maximize an objective function that considers the expected liquidation revenues and their standard deviation. Although existing literature tends to focus on theoretical aspects with the intention of deriving closed-form solutions for special types of market impact functions, this article considers a framework that is able to capture important empirical phenomena in the stock market, such as the intraday U-shaped pattern of price impact and the resiliency of the order book. The new model is very flexible since it allows for liquidation intervals of varying length and foregoes the assumption of constant speed of trading. Examples with real-world order book data demonstrate how the setup can be implemented numerically and provide deeper insight into relevant properties of the model.