Asset-liability management under time-varying investment opportunities

Stochastic linear programming is a suitable numerical approach for solving practical asset-liability management problems. In this paper, we consider a multi-stage setting under time-varying investment opportunities and propose a decomposition of the benefits in dynamic re-allocation and predictability effects. We use a first-order unrestricted vector autoregressive process to model asset returns and state variables and include, in addition to equity returns and dividend-price ratios, Nelson/Siegel parameters to account for the evolution of the yield curve. The objective is to minimize the Conditional Value at Risk of shareholder value, i.e., the difference between the mark-to-market value of (financial) assets and the present value of future liabilities.     

Market Value Margin für die Fair Value-Bilanzierung versicherungstechnischer Verpflichtungen : Ableitung auf Basis des CAPM

The International Accounting Standards Board (IASB) started a project on Insurance Accounting to apply the principles of fair value to insurance businesses. The so called ?asset and liability approach“ would focus on the balance sheet, with both assets and liabilities being reported at fair values, while income and expenses are defined in terms of changes in the values of those assets and liabilities. Indeed, there are no deep and liquid markets for insurance liabilities. Thus, the fair value has to be calculated as a theoretical value, using assumptions concerning future events, risk provisions and discount rates. Both in theory and in practice a generally accepted modelling of fair value is missing. Particularly with regard to the deviation of a Market Value Margin (MVM), which reflects the premium that a marketplace participant would demand for bearing the uncertainty inherent in the cash flows, there is a need for adequate modelling. Transforming the CAPM for determining risk loads in insurance will mean measuring the correlation between insurance companies’ returns from underwriting and market returns on its shareholders’ equity. The criticism on an underwriting beta focuses on (a) the basic assumptions of the CAPM, (b) the absence of active markets for insurance liabilities and (c) the unreliability of estimating underwriting betas.     

Efficient Stochastic Modeling for Large and Consolidated Insurance Business: Interest Rate Sampling Algorithms

Abstract

One of the challenges of stochastic asset/liability modeling for large insurance businesses is the run time. Using a complete stochastic asset/liability model to analyze a large block of business is often too time consuming to be practical. In practice, the compromises made are reducing the number of runs or grouping assets into asset categories. This paper focuses on the strategies that enable efficient stochastic modeling for large and consolidated insurance business blocks. Efficient stochastic modeling can be achieved by applying effective interest rate sampling algorithms that are presented in this paper. The algorithms were tested on a simplified asset/liability model ASEM (Chueh 1999) as well as a commercial asset/liability model using assets and liabilities of the Aetna Insurance Company of America (AICA), a subsidiary of Aetna Financial Services. Another methodology using the New York 7 scenarios is proposed and could become an enhancement to the Model Regulation on cash flow testing, thus requiring all companies to do stochastic cash flow testing in a uniform, nononerous manner.     

Non-linear dynamics in international stock market returns

Recent empirical finance research has reported non-linear dynamics within asset returns. However, much of this extant research has focussed upon asset markets within the US and UK. This paper examines whether such dynamics are also present in a series of six international equity index returns. Using empirical models which are consistent that the theoretical behavioural finance noise trader motivation of non-linearity, whereby market dynamics differ between small and large returns, our results suggest these models improve the in-sample fit and out-of-sample forecast over linear alternatives. Further, the point of regime transition differs between positive and negative returns indicating that noise traders are more likely to engage in trend-chasing behaviour in up markets and anchoring behaviour in down markets. Finally, the forecast gain in the Asia-Pacific markets is greater than in the European markets suggestive that limits to arbitrage are greater perhaps as fundamental traders knowledge of market dynamics and noise trader behaviour is still evolving.     

Mean-Variance Asset Liability Management with State-Dependent Risk Aversion

This article investigates the asset liability management problem with state-dependent risk aversion under the mean-variance criterion. The investor allocates the wealth among multiple assets including a risk-free asset and multiple risky assets governed by a system of geometric Brownian motion stochastic differential equations, and the investor faces the risk of paying uncontrollable random liabilities. The state-dependent risk aversion is taken into account in our model, linking the risk aversion to the current wealth held by the investor. An extended Hamilton-Jacobi-Bellman system is established for the optimization of asset liability management, and by solving the extended Hamilton-Jacobi-Bellman system, the analytical closed-form expressions for the time-inconsistent optimal investment strategies and the optimal value function are derived. Finally, numerical examples are presented to illustrate our results.     

The currency composition of firms' balance sheets,asset value correlations,and capital requirements

We extend the Tasche (2007) model on the asset correlation bias caused by a currency mismatch between assets and liabilities to the more realistic situation where just some assets and liabilities are denominated in a foreign currency. To test the significance of the remaining bias we rely on a unique database constructed by the Inter-American Development Bank (IADB) containing time-series of the asset and liability currency composition of firms in some Latin American countries. We find that the asset correlation bias and associated underestimations of Basel II capital charges are economically significant even when we account for the actual (partial) currency mismatch.     

Asymmetric Volatility,Skewness, and Downside Risk in Different Asset Classes: Evidence from Futures Markets

This study examines the cross‐sectional variation of futures returns from different asset classes. The monthly returns are positively correlated with downside risk and negatively correlated with coskewness. The asymmetric volatility effect generates negatively skewed returns. Assets with high coskewness and low downside betas provide hedges against market downside risk and offer low returns. The high returns offered by assets with low coskewness and high downside betas are a risk premium for bearing downside risk. The asset pricing model that incorporates downside risk partially explains the futures returns. The results indicate a unified risk perspective to jointly price different asset classes.     

Style investing,comovement and return predictability

Barberis and Shleifer (2003) argue that style investing generates momentum and reversals in style and individual asset returns, as well as comovement between individual assets and their styles. Consistent with these predictions, in some specifications, past style returns help explain future stock returns after controlling for size, book-to-market and past stock returns. We also use comovement to identify style investing and assess its impact on momentum. High comovement momentum portfolios have significantly higher future returns than low comovement momentum portfolios. Overall, our results suggest that style investing plays a role in the predictability of asset returns.     

Do Islamic Bond (Sukuk) Prices Reflect Financial and Policy Uncertainty? A Quantile Regression Approach

We studied the relationship between Islamic bond (sukuk) prices and financial and policy uncertainty conditions using a quantile regression approach. Our empirical results for the period 2010–2014 show that US bond prices had a negative impact and causality effects on sukuk prices, whereas European Monetary Union bond prices only co-moved with sukuk prices. We also show that financial uncertainty had a negative effect that was limited to intermediate sukuk quantiles; moreover, sukuk prices were not affected by economic policy uncertainty or stock market returns. Therefore, although Islamic bonds are distinctive assets, their price dynamics are dependent on other bond-related asset prices and so incorporate financial market uncertainty.     

Asset market linkages: Evidence from financial, commodity and real estate assets

We use a general Markov switching model to examine the relationships between returns over three different asset classes: financial assets (US stocks and Treasury bonds), commodities (oil and gold) and real estate assets (US Case-Shiller index). We confirm the existence of two distinct regimes: a “tranquil” regime with periods of economic expansion and a “crisis” regime with periods of economic decline. The tranquil regime is characterized by lower volatility and significantly positive stock returns. During these periods, there is also evidence of a flight from quality - from gold to stocks. By contrast, the crisis regime is characterized by higher volatility and sharply negative stock returns, along with evidence of contagion between stocks, oil and real estate. Furthermore, during these periods, there is strong evidence of a flight to quality - from stocks to Treasury bonds.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

Covariance complexity and rates of return on assets

This paper considers the estimation of the expected rate of return on a set of risky assets. The approach to estimation focuses on the covariance matrix for the returns. The structure in the covariance matrix determines shared information which is useful in estimating the mean return for each asset. An empirical Bayes estimator is developed using the covariance structure of the returns distribution. The estimator is an improvement on the maximum likelihood and Bayes–Stein estimators in terms of mean squared error. The effect of reduced estimation error on accumulated wealth is analyzed for the portfolio choice model with constant relative risk aversion utility.     

Measuring systemic risk: A risk management approach

This paper proposes a new method to measure and monitor the risk in a banking system. Standard tools that regulators require banks to use for their internal risk management are applied at the level of the banking system to measure the risk of a regulator’s portfolio. Using a sample of international banks from 1988 until 2002, I estimate the dynamics and correlations between bank asset portfolios. To obtain measures for the risk of a regulator’s portfolio, I model the individual liabilities that the regulator has to each bank as contingent claims on the bank’s assets. The portfolio aspect of the regulator’s liability is explicitly considered and the methodology allows a comparison of sub-samples from different countries. Correlations, bank asset volatility, and bank capitalization increase for North American and somewhat for European banks, while Japanese banks face deteriorating capital levels. In the sample period, the North American banking system gains stability while the Japanese banking sector becomes more fragile. The expected future liability of the regulator varies substantially over time and is especially high during the Asian crisis starting in 1997. Further analysis shows that the Japanese banks contribute most to the volatility of the regulator’s liability at that time. Larger and more profitable banks have lower systemic risk and additional equity capital reduces systemic risk only for banks that are constrained by regulatory capital requirements.     

A comparison among various dimensions of illiquidity effect: A case study of Finland

We study different dimensions of the illiquidity effect on asset returns in the Finnish market. The market illiquidity is measured as unexpected rises and falls in average monthly zero returns across all stocks. We find that for the returns on the specific class of assets, a flight to the liquidity effect is the most important systematic risk among all dimensions of the illiquidity effect. In other words, higher returns for illiquid assets in good times compensate for a pronounced drop in those returns in bad times and vice versa. Furthermore, only one illiquidity-related factor has a similar pricing capacity as Fama and French's (1993) three-factor model and Carhart's (1997) four-factor model in the context of this study.     

Keep on smiling? The pricing of Quanto options when all covariances are stochastic

The paper introduces a model for the joint dynamics of asset prices which can capture both a stochastic correlation between stock returns as well as between stock returns and volatilities (stochastic leverage). By relying on two factors for stochastic volatility, the model allows for stochastic leverage and is thus able to explain time-varying slopes of the smiles. The use of Wishart processes for the covariance matrix of returns enables the model to also capture stochastic correlations between the assets. Our model offers an integrated pricing approach for both Quanto and plain-vanilla options on the stock as well as the foreign exchange rate. We derive semi-closed form solutions for option prices and analyze the impact of state variables. Quanto options offer a significant exposure to the stochastic covariance between stock prices and exchange rates. In contrast to standard models, the smile of stock options, the smile of currency options, and the price differences between Quanto options and plain-vanilla options can change independently of each other.     

Bank liquidity,the maturity ladder,and regulation

We investigate the liquidity management of 62 Dutch banks between January 2004 and March 2010, when these banks were subject to a liquidity regulation that is very similar to Basel III’s Liquidity Coverage Ratio (LCR). We find that most banks hold more liquid assets against their stock of liquid liabilities, such as demand deposits, than strictly required under the regulation. More solvent banks hold fewer liquid assets against their stock of liquid liabilities, suggesting an interaction between capital and liquidity buffers. However, this interaction turns out to be weaker during a crisis. Although not required, some banks consider cash flows scheduled beyond 1 month ahead when setting liquidity asset holdings, but they seldom look further ahead than 1 year.     

Asset pricing: A tale of two days

We show that asset prices behave very differently on days when important macroeconomic news is scheduled for announcement. In addition to significantly higher average returns for risky assets on announcement days, return patterns are much easier to reconcile with standard asset pricing theories, both cross-sectionally and over time. On such days, stock market beta is strongly related to average returns. This positive relation holds for individual stocks, for various test portfolios, and even for bonds and currencies, suggesting that beta is after all an important measure of systematic risk. Furthermore, a robust risk–return trade-off exists on announcement days. Expected variance is positively related to future aggregated quarterly announcement day returns, but not to aggregated non-announcement day returns. We explore the implications of our findings in the context of various asset pricing models.     

Collateralizing liquidity

I develop a dynamic model of optimal funding to understand why financial assets are used as collateral instead of being sold to raise funds. Firms need funds to invest in risky projects with nonobservable returns. Since holding these assets allows firms to raise these funds, investing firms value the asset more than noninvesting ones. When assets are less than perfectly liquid and investment opportunities are persistent, collateralized debt minimizes asset transfers from investing to noninvesting firms and thus is optimal. Frictions in asset markets lead to an illiquidity discount and a collateral premium, which increase with the asset’s illiquidity.     

Valuation and systemic risk consequences of bank opacity

We examine the effects of opacity on bank valuation and synchronicity in bank equity returns over the years 2000–2006 prior to the 2007 financial crisis. As expected, investments in opaque assets are more profitable than investments in transparent assets, and taking profitability into account, have larger valuation discounts relative to transparent assets. The valuation discounts on opaque asset investments decline over the 2000–2006 period only to be followed by a sharp reversal in 2007. The decline is coincident with a rise in bank equity share prices, decrease in transparent asset holdings by banks, and greater return synchronicity – evidence consistent with a feedback effect.     

基于资产负债表的货币当局绩效分析

在货币当局资产负债表中,资产项目影响货币政策方向,负债项目反映调控手段及资金流向。各项资产将预期为货币当局带来现金流入,采用不同配置方式将获得不同的资产收益。各项负债需要货币当局如期支付资金占用成本,不同融资方式产生不同的利息费用,影响货币政策调控总成本。虽然货币当局没有盈利需求,但站在货币当局资产利用率及货币政策成本角度考量货币当局绩效,将促使货币当局在货币政策制定及执行中降本增收、提高效率。