A Cautionary Note on Natural Hedging of Longevity Risk

In this article, we examine the so-called natural hedging approach for life insurers to internally manage their longevity risk exposure by adjusting their insurance portfolio. In particular, unlike the existing literature, we also consider a nonparametric mortality forecasting model that avoids the assumption that all mortality rates are driven by the same factor(s).

Our primary finding is that higher order variations in mortality rates may considerably affect the performance of natural hedging. More precisely, although results based on a parametric single factor model—in line with the existing literature—imply that almost all longevity risk can be hedged, results are far less encouraging for the nonparametric mortality model. Our finding is supported by robustness tests based on alternative mortality models.     

Hedging Longevity Risk When Interest Rates are Uncertain

Abstract

This paper proposes an asset liability management strategy to hedge the aggregate risk of annuity providers under the assumption that both the interest rate and mortality rate are stochastic. We assume that annuity providers can invest in longevity bonds, long-term coupon bonds, and shortterm zero-coupon bonds to immunize themselves from the risks of the annuity for the equity holders subject to a required profit. We demonstrate that the optimal allocation strategy can lead to the lowest risk under different yield curves and mortality rate assumptions. The longevity bond can also be regarded as an effective hedging vehicle that significantly reduces the aggregate risk of the annuity providers.     

Financial Intermediaries and the Cross‐Section of Asset Returns

Financial intermediaries trade frequently in many markets using sophisticated models. Their marginal value of wealth should therefore provide a more informative stochastic discount factor (SDF) than that of a representative consumer. Guided by theory, we use shocks to the leverage of securities broker‐dealers to construct an intermediary SDF. Intuitively, deteriorating funding conditions are associated with deleveraging and high marginal value of wealth. Our single‐factor model prices size, book‐to‐market, momentum, and bond portfolios with an R² of 77% and an average annual pricing error of 1%—performing as well as standard multifactor benchmarks designed to price these assets.     

Financial Distress and the Cross‐section of Equity Returns

We explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.     

Monetary Policy and Financial Stability: Cross‐Country Evidence

We explain the heterogeneous response of central banks to financial stability risks based on a financial stability orientation (FSO) index, which reflects statutory, regulatory, and discretionary components of central banks' monetary policy frameworks. Our baseline results from a cross‐country panel of modified Taylor rules suggest that central banks with a high FSO increase their policy rates in response to elevated financial stability risks by 0.27 percentage points more than central banks with a low orientation. Back‐of‐the‐envelope calculations suggest that this policy rate differential translates into a reduced crisis probability but also into considerably lower inflation and output growth rates.     

Failure Risk and the Cross‐Section of Hedge Fund Returns

Modeling a hedge fund's probability of failure with a dynamic logit regression, I find that the probability of a fund's failure has a significantly negative effect on the fund's future returns. A quintile portfolio with the highest failure probability underperforms a quintile portfolio with the lowest failure probability by 5% to 6% per year from 1997 to 2012. The results are robust to the definition of hedge fund failure and controlling for a large set of risk factors and fund characteristics. Moreover, the negative effect of failure probability on future fund returns is stronger for funds with weak share restrictions.     

The Cross‐Section of Credit Risk Premia and Equity Returns

We explore the link between a firm's stock returns and credit risk using a simple insight from structural models following Merton ( 1974 ): risk premia on equity and credit instruments are related because all claims on assets must earn the same compensation per unit of risk. Consistent with theory, we find that firms' stock returns increase with credit risk premia estimated from CDS spreads. Credit risk premia contain information not captured by physical or risk‐neutral default probabilities alone. This sheds new light on the “distress puzzle”—the lack of a positive relation between equity returns and default probabilities—reported in previous studies.     

Effects of Health and Longevity on Financial Risk Tolerance

We investigate the effects of health and life expectancy on tolerance of financial risk. Using a standard life-cycle model, we find that the effects of health and life expectancy on preferences over lifetime-income risk are theoretically ambiguous. However, risk tolerance is independent of health and life expectancy when utility takes one of the standard (harmonic absolute risk aversion) functional forms or when optimal consumption is constant over time. Our empirical results, using data from a stated-preference survey (n=2,795), suggest that financial risk tolerance is positively associated with both health and life expectancy; hence utility is not consistent with standard functional forms.     

The Cross‐Section of Managerial Ability,Incentives, and Risk Preferences

I estimate a dynamic investment model for mutual managers to study the cross‐sectional distribution of ability, incentives, and risk preferences. The manager's compensation depends on the size of the fund, which fluctuates due to fund returns and due to fund flows that respond to the fund's relative performance. The model provides an economic interpretation of time‐varying coefficients in performance regressions in terms of the structural parameters. I document that the estimates of fund alphas are precise and virtually unbiased. I find substantial heterogeneity in ability, risk preferences, and pay‐for‐performance sensitivities that relates to observable fund characteristics.     

Industry‐Specific Human Capital,Idiosyncratic Risk,and the Cross‐Section of Expected Stock Returns

Human capital is one of the largest assets in the economy and in theory may play an important role for asset pricing. Human capital is heterogeneous across investors. One source of heterogeneity is industry affiliation. I show that the cross‐section of expected stock returns is primarily affected by industry‐level rather than aggregate labor income risk. Furthermore, when human capital is excluded from the asset pricing model, the resulting idiosyncratic risk may appear to be priced. I find that the premium for idiosyncratic risk documented by several empirical studies depends on the covariance between stock and human capital returns.     

Pre‐Issuance Hedging of Fixed‐Rate Debt

This article analyzes several corporate hedging strategies to manage interest rate risk on fixed‐rate debt prior to issuance. The authors start by considering these strategies using a highly stylized model: a binomial forward interest rate tree that, while simple in design, illustrates derivative pricing methodologies that are used in practice. Under a given rate volatility assumption, they demonstrate expected outcomes when entering a forward bond contract, a forward‐starting pay‐fixed interest swap, and a purchased option on that swap, as well as the “default” alternative of doing nothing. In principle, the decision of whether or not to hedge, as well as how to do so, depends on management's view of future interest rate volatility and degree of comfort with possible outcomes. The authors then assess the pros and cons of hedging strategies, with considerable emphasis on practical considerations. For example, while their theoretical model would allow an issuer to “lock” a specific debt issuance, in practice one can hedge only “benchmark” interest rate risk. The authors describe the use of both Treasury locks and forward‐starting swaps to address unexpected benchmark yield changes, and discuss how factors such as the time to issuance affect an issuer's choice of instrument. For instance, Treasury locks are typically used when the time to issuance is relatively short, while interest rate swaps are more common for longer times to issuance. The article also discusses circumstances in which a “do nothing” strategy may be preferable to other alternatives, as well as the disadvantages of issuing in advance. Finally, the authors describe the impact of financial accounting on different hedge strategies.     

Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

Under what conditions will a multinational corporation alterits operations to manage its risk exposure? We show that multinationalfirms will engage in operational hedging only when both exchangerate uncertainty and demand uncertainty are present. Operationalhedging is less important for managing short-term exposures,since demand uncertainty is lower in the short term. Operationalhedging is also less important for commodity-based firms, whichface price but not quantity uncertainty. When the fixed costsof establishing a plant are low or the variability of the exchangerate is high, a firm may benefit from establishing plants inboth the domestic and foreign location. Capacity allocated tothe foreign location relative to the domestic location willincrease when the variability of foreign demand increases relativeto the variability of domestic demand or when the expected profitmargin is larger. For firms with plants in both a domestic andforeign location, the foreign currency cash flow generally willnot be independent of the exchange rate and consequently theoptimal financial hedging policy cannot be implemented withforward contracts alone. We show that the optimal financialhedging policy can be implemented using foreign currency calland put options and forward contracts.     

Cross‐region and cross‐sector asset allocation with regimes

Cross‐region and cross‐sector asset allocation decisions are one of the most fundamental issues in international equity portfolio management. Equity returns exhibit higher volatilities and correlations, and lower expected returns, in bear markets compared to bull markets. However, static mean–variance analysis fails to capture this salient feature of equity returns. We accommodate the nonlinearity of returns using a regime switching model across both regions and sectors. The regime‐dependent asset allocation potentially adds value to the traditional static mean–variance allocation. In addition, optimal allocation across sectors provide greater benefits compared to international diversification, which is characterized by higher returns, lower risks, lower correlations with the world market and a higher Sharpe ratio.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Determinants of Cross‐Border Mergers and Acquisitions

The vast majority of cross‐border mergers involve private firms outside of the United States. We analyze a sample of 56,978 cross‐border mergers between 1990 and 2007. We find that geography, the quality of accounting disclosure, and bilateral trade increase the likelihood of mergers between two countries. Valuation appears to play a role in motivating mergers: firms in countries whose stock market has increased in value, whose currency has recently appreciated, and that have a relatively high market‐to‐book value tend to be purchasers, while firms from weaker‐performing economies tend to be targets.     

Regulatory Arbitrage and Cross‐Border Bank Acquisitions

We study how differences in bank regulation influence cross‐border bank acquisition flows and share price reactions to cross‐border deal announcements. Using a sample of 7,297 domestic and 916 majority cross‐border deals announced between 1995 and 2012, we find evidence of a form of “regulatory arbitrage” whereby acquisition flows involve acquirers from countries with stronger regulations than their targets. Target and aggregate abnormal returns around deal announcements are positive and larger when acquirers come from more restrictive bank regulatory environments. We interpret this evidence as more consistent with a benign form of regulatory arbitrage than a potentially destructive one.     

套期保值与金融衍生品风险管理研究

套期保值是企业经营的重要工具,能够锁定企业的经营成本,规避企业的经营风险。但是,如果套期保值运用不当,则会使企业遭受巨额的损失。本文首先对套期保值的原理及其作用进行基本的介绍,然后,结合我国央企巨亏事件,对套期保值巨亏动因进行深入的分析,以揭示套期保值的潜在风险及其认识误区。最后,对我国企业的套期保值风险控制提出若干建议。     

Investment and the Cross‐Section of Equity Returns

The data show that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets, reducing the risk faced by shareholders and the returns that they are likely to demand. In the one‐factor production‐based asset pricing model, when the frictions to capital adjustment are shaped to respect the evidence on investment, the model‐generated cross‐sectional dispersion of returns is only a small fraction of that documented in the data. Our conclusions hold even when operating or labor leverage is modeled in ways shown to be promising in the extant literature.     

Nonfinancial Firms as Cross‐Market Arbitrageurs

I demonstrate that nonfinancial corporations act as cross‐market arbitrageurs in their own securities. Firms use one type of security to replace another in response to shifts in relative valuations, inducing negatively correlated financing flows in different markets. Net equity repurchases and net debt issuance both increase when expected excess returns on debt are particularly low, or when expected excess returns on equity are relatively high. Credit valuations affect equity financing as much as equity valuations do, and vice versa. Cross‐market corporate arbitrage is most prevalent among large, unconstrained firms, and helps account for aggregate financing patterns.