The Regime Switching Portfolios

In this paper we develop a portfolio selection theory under regime switching means and volatilities. We use log mean-variance as the portfolio selection criteria and, as a result, the theory is made substantially easier to implement than other existing theories. Moreover, the estimated regimes are easy to interpret as one of the regimes corresponds to the business cycle turning points. Finally, we conduct an asset allocation simulation and obtain reasonable results by introducing an idea of switching volatility targets.     

The Efficient Use of Conditioning Information in Portfolios

We study the properties of unconditional minimum-variance portfolios in the presence of conditioning information. Such portfolios attain the smallest variance for a given mean among all possible portfolios formed using the conditioning information. We provide explicit solutions for n risky assets, either with or without a riskless asset. Our solutions provide insights into portfolio management problems and issues in conditional asset pricing.     

The Estimation of Realizable Holding Gains

The present paper outlines rules for estimating realizable holding gains within a current cost framework. The foundation for the procedures lies with a theorem properly named for Edwards and Bell (1961). The theorem is stated and proved and then employed to derive the relevant quadrature rules. Estimates of the holding gains applicable to U.K. manufacturing industry are then made. The estimates are found to be highly sensitive to the quadrature rule used.     

Improving Skewness of Mean-Variance Portfolios

Abstract

The widely accepted belief that asset returns and insurance product line margins are not normally distributed has motivated the use of skewness (or higher than second-order moments) in the context of optimal risk-reward portfolio allocation. Here we propose an optimization-based methodology to substantially improve the skewness of portfolios in the mean-variance efficient frontier. Unlike other related methods, the proposed methodology is very intuitive, noniterative, and simple to implement, and it can be readily and efficiently carried out using state-of-the-art optimization solvers. These characteristics should be very appealing to risk managers.     

Diversified Portfolios in Continuous Time

We study a financial market containing an infinite number ofassets, where each asset price is driven by an idiosyncraticrandom source as well as by a systematic noise term. Introducing"asymptotic assets" which correspond to certain infinitely welldiversified portfolios we study absence of (asymptotic) arbitrage,and in this context we obtain continuous time extensions ofatemporal APT results. We also study completeness and derivativepricing, showing that the possibility of forming infinitelywell diversified portfolios has the property of completing themarket. It also turns out that models where the all risk isof diffusion type are qualitatively quite different from modelswhere one risk is of diffusion type and the other is of Poissontype. We also present a simple martingale based theory for absenceof asymptotic arbitrage. JEL Classification: G12, G13,     

Diversified Portfolios in Continuous Time

We study a financial market containing an infinite number of assets, where each asset price is driven by an idiosyncratic random source as well as by a systematic noise term. Introducing asymptotic assets which correspond to certain infinitely well diversified portfolios we study absence of (asymptotic) arbitrage, and in this context we obtain continuous time extensions of atemporal APT results. We also study completeness and derivative pricing, showing that the possibility of forming infinitely well diversified portfolios has the property of completing the market. It also turns out that models where the all risk is of diffusion type are qualitatively quite different from models where one risk is of diffusion type and the other is of Poisson type. We also present a simple martingale based theory for absence of asymptotic arbitrage.     

Bond Selection for Managed Portfolios

Abstract:   Investors in coupon bonds evaluate them based upon financial considerations such as coupon rate, time‐to‐maturity, callability, convertibility, and financial condition of the issuer. These investors regard promised yield as only a rough measure of the reward a bond offers to compensate them for the pure time‐value‐of‐money and the financial risks to which they are exposed. Hence, they need a more meaningful measure of reward to facilitate comparisons among coupon bonds. The purpose of this paper is to describe an alternative heuristic approach to the task of making such comparisons. The approach produces a simple ordinal measure of reward, called the 'indifference spread,' that considers implicitly the potential sources of return to, as well as many of the risks associated with, investment in coupon bonds. For any coupon bond, the indifference spread method permits assessment of relative reward offered for the combined exposures to price and call risks, while also reasonably accommodating possible sale anytime prior to maturity. Once an investor (e.g., money manager) identifies indifference spreads for all bonds under consideration as of any moment in time, he/she can then draw conclusions regarding their relative values at that time based, in large part, on these spreads.     

Currency Hedging for International Portfolios

This paper examines the benefits from currency hedging, both for speculative and risk minimization motives, in international bond and equity portfolios. The risk-return performances of globally diversified portfolios are compared with and without forward contracts. Over the period 1974 to 1990, inclusion of forward contracts results in statistically significant improvements in the performance of unconditional portfolios containing bonds. Conditional strategies are also implemented, both in sample and out of sample, and are shown to both significantly improve the risk-return tradeoff of global portfolios and to outperform unconditional hedging strategies.     

Volatility‐Managed Portfolios

Managed portfolios that take less risk when volatility is high produce large alphas, increase Sharpe ratios, and produce large utility gains for mean‐variance investors. We document this for the market, value, momentum, profitability, return on equity, investment, and betting‐against‐beta factors, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in volatility are not offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions. This rules out typical risk‐based explanations and is a challenge to structural models of time‐varying expected returns.     

Risk-Based Capital and Credit Insurance Portfolios

This paper analyzes the risk-management practices of a vulnerable credit insurer by studying the effects of time-varying correlations, asset risks and loan maturities on the risk-based capital that backs credit insurance portfolios. Since asset correlations may change over a business cycle, we have analyzed these effects by means of a one-factor Gaussian stochastic model as part of an extended contingent claims analysis. Our results show the need to account for cyclical changes to correlations in the pricing of credit insurance. When compared with the reserve of risk-based capital recommended by the Basel II Internal Ratings-Based (IRB) approach, our model provides a better capital buffer against extreme credit losses, especially in times of recession and/or in a risky business environment. Using a risk-adjusted performance metric (RAPM), we find insurers perform better when insuring relatively short-term loans. We also make several policy recommendations on creating a reserve of risk-based capital to protect against possible loan losses.     

Optimal Portfolios with Credit Default Swaps

Using a continuous-time, stochastic, and dynamic framework, this study derives a closed-form solution for the optimal investment problem for an agent with hyperbolic absolute risk aversion preferences for maximising the expected utility of his or her final wealth. The agent invests in a frictionless, complete market in which a riskless asset, a (defaultable) bond, and a credit default swap written on the bond are listed. The model is calibrated to market data of six European countries and assesses the behaviour of an investor exposed to different levels of sovereign risk. A numerical analysis shows that it is optimal to issue credit default swaps in a larger quantity than that of bonds, which are optimally purchased. This speculative strategy is more aggressive in countries characterised by higher sovereign risk. This result is confirmed when the investor is endowed with a different level of risk aversion. Finally, we solve a static version of the optimisation problem and show that the speculative/hedging strategy is definitely different with respect to the dynamic one.     

Mimicking Portfolios and Exact Arbitrage Pricing

We characterize the sets of mimicking positions with returns that can serve in place of factors in an exact K-factor arbitrage-pricing relation for a set of N assets. All of the sets are K-dimensional nonsingular linear transformations of each other. We interpret three examples of such transformations and discuss empirical considerations. We provide conditions under which the mimicking positions can be expressed as portfolios, and we characterize the relation between mimicking portfolios and the minimum-variance frontier.     

The Optimal Construction of Internationally Diversified Equity Portfolios Hedged Against Exchange Rate Uncertainty

Much of the empirical work on hedging exchange rate exposure in portfolios of financial assets has used a unitary hedge ratio, or a currency overlay. Alternatively, the currencies themselves can be treated as assets and the position in them optimized. This study empirically tests whether the ex post results of recent studies, which conclude that currencies should themselves be optimized, stand up under parameter uncertainty. It may very well be that ex ante, when parameter inputs must be estimated from historical data, the attempt to determine the optimal currency weights results in inferior performance in comparison to using a simple unitary hedging strategy, or even unhedged international investment. The results suggest that a local currency return unitary hedging strategy works best in the presence of parameter uncertainty.     

Evidence of Early Withdrawal in Time Deposit Portfolios

The embedded options found in some securities are known to have significant impact on product pricing, secondary market valuation, and risk measurement and management. The option to withdraw commonly found in bank deposits is one of the least studied of these. We help to fill this gap by examining the level and interest rate sensitivity of early withdrawals of retail time deposits using panel data from the Thrift Financial Report. We find that longer-maturity time deposit portfolios commonly experience early withdrawals at economically significant levels. Further, we find that depositors respond positively, with increased levels of early withdrawal, to the reinvestment incentive they face when new deposit rates rise. These findings increase our understanding of consumer behavior with regard to financial products and have significant implications for the competitive pricing of deposit products and the management of bank interest rate risk.