Aggregation of exponential smoothing processes with an application to portfolio risk evaluation

In this paper we propose a unified framework to analyse contemporaneous and temporal aggregation of a widely employed class of integrated moving average (IMA) models. We obtain a closed-form representation for the parameters of the contemporaneously and temporally aggregated process as a function of the parameters of the original one. These results are useful due to the close analogy between the integrated GARCH (1, 1) model for conditional volatility and the IMA (1, 1) model for squared returns, which share the same autocorrelation function. In this framework, we present an application dealing with Value-at-Risk (VaR) prediction at different sampling frequencies for an equally weighted portfolio composed of multiple indices. We apply the aggregation results by inferring the aggregate parameter in the portfolio volatility equation from the estimated vector IMA (1, 1) model of squared returns. Empirical results show that VaR predictions delivered using this suggested approach are at least as accurate as those obtained by applying standard univariate methodologies, such as RiskMetrics.     

Financial contagion in the laboratory: The cross-market rebalancing channel

We present the results of the first experimental study of financial markets contagion. We develop a model of financial contagion amenable to be tested in the laboratory. In the model, contagion happens because of cross-market rebalancing, a channel for transmission of shocks across markets first studied by Kodres and Pritsker (2002). Theory predicts that, because of portfolio rebalancing, a negative shock in one market transmits itself to the others, as investors adjust their portfolio allocations. The theory is supported by the experimental results. The price observed in the laboratory is close to that predicted by theory, and strong contagion effects are observed. The results are robust across different market structures. Moreover, as theory predicts, lower asymmetric information in a (“developed”) financial market increases the contagion effects in (“emerging”) markets.     

The introduction of the Euro and its effects on portfolio decisions

Examining investment behavior related to the Euro introduction, we address the relevance of different investment determinants. With the advent of the currency union two potential sources of portfolio reallocation can be distinguished: First, the diminishment of exchange rate risk and transaction costs within the EMU. Second, the increase of correlation of EMU returns so that diversification benefits decreased. We test for structural breaks in the holdings of German investors and estimate a market model to account for the two effects. A significant decrease in national and an increase in EMU and rest-of-the-world investments can be observed. Comparing the observed holdings with benchmark portfolios, we find that investment home bias has diminished since the Euro introduction.     

Shadow prices,fractional Brownian motion,and portfolio optimisation under transaction costs

The present paper accomplishes a major step towards a reconciliation of two conflicting approaches in mathematical finance: on the one hand, the mainstream approach based on the notion of no arbitrage (Black, Merton & Scholes), and on the other hand, the consideration of non-semimartingale price processes, the archetype of which being fractional Brownian motion (Mandelbrot). Imposing (arbitrarily small) proportional transaction costs and considering logarithmic utility optimisers, we are able to show the existence of a semimartingale, frictionless shadow price process for an exponential fractional Brownian financial market.     

The effects of loan portfolio concentration on Brazilian banks’ return and risk

This paper tests whether diversification of the credit portfolio at the bank level leads to better performance and lower risk. We employ a new high frequency (monthly) panel data for the Brazilian banking system with information at the bank level for loans by economic sector. We find that loan portfolio concentration increases returns and also reduces default risk; the impact of concentration on bank’s return is decreasing on bank’s risk; there are significant size effects; foreign and state-owned banks seem to be less affected by the degree of diversification. An important additional finding is that there is an increasing concentration trend after the breakout of the recent international financial crisis, specially after the failure of Lehman Brothers.     

Household response to a money rain: Real and portfolio balance effects reconsidered

In order for changes in the stock of money to lead to changes in economic activity, production and spending units such as households and firms must respond to changes in the money supply. With respect to wealth effects on households, the real balance effect on consumption is thought to be empirically small. This puts the burden on portfolio balance and labor supply effects. Labor supply is shown to decrease in response to an increase in the money supply, and depending on the extent of markets, portfolio balance effects may be nonexistent.     

The delegated portfolio management problem: Reputation and herding

We study the relationship between financial intermediaries’ reputation and herding in a delegated portfolio management problem context. We identify conditions under which equilibria exist such that intermediaries with good reputation invest in private information, whereas those with poor reputation herd. The model’s empirical predictions are discussed and found to be consistent with previous evidence. From a normative stand, our work points out the possible existence of a policy trade-off between protecting investors by demanding more transparency from intermediaries and encouraging herding by free-riders for whom imitating portfolio decisions would be easier under tighter regulation, such as more frequent portfolio disclosure.     

The smoothing of pension expenses: a panel analysis

The main purpose of this paper is to utilize recent developments in panel data techniques to evaluate whether the smoothing of pension expenses is neutral in its long-term effect on reported earnings. Adopting a long-term perspective, the empirical analysis also identifies sources of potential deviations. Results suggest that the current smoothing mechanism tends to induce significant biases in the recognized pension expenses. For a majority of the sample firms, the tendency is to overstate the sponsoring firms’ earnings in the long run. To a large extent, such biases reflect the combination of both ineffective amortization of the deferred gains and losses and questionable latitude in pension rate discretions.     

Portfolio risk,adjustment costs,and security dealers' bid/ask spreads

This article notes that dealers' bid/ask spreads should vary directly with their costs of adjusting to inventory imbalances. Thus, well-diversified dealers are expected to quote lower bid/ask spreads on stocks with substantial total risk caused by undiversifiable risk. Furthermore, the effect of systematic risk on bid/ask spreads should be negligible if dealers are compensated for systematic risk by market returns. This article shows that, empirically, bid/ask spreads of OTC stocks are insensitive to the systematic risk of individual stocks—even when only stocks with stable betas are considered. Furthermore, bid/ask spreads are not sensitive to changes in market variance, as would be expected if systematic risk affected spreads. While unsystematic risk affects bid/ask spreads, its effect is pronounced for stocks traded by small, undiversified dealers. If stocks are only traded by large dealers with low diversification costs, unsystematic risk does not affect bid/ask spreads.     

The effects of external financing costs on investment timing and sizing decisions

We develop a dynamic model in which a firm exercises an option to expand production on either a small or large scale with cash reserves and costly external funds. An intermediate level of cash reserves, which is insufficient for the large-scale investment but sufficient for the small-scale investment, provides an incentive for the firm to invest early in the small-scale project. These results fill the gap between two types of results: (i) empirical findings of a U-shaped relation between the investment volume and internal funds and (ii) empirical predictions of a U-shaped relation between the investment timing and internal funds. In addition, our results have real-world implications for investment in alternative projects.     

Stock price effects and costs of secondary distributions

This study does not support the view that a large number of shares can be sold at the prevailing market price and at a small cost. A significant stock price decrease is observed at the initial announcement of secondary distributions. The price declines are greater for offerings by officers and directors and for larger offerings, but are significant for all types of sellers and for large and small offerings. There is no significant price decline at the offering when secondaries are announced in advance. Underwriting and other selling costs are substantial and are positively related to relative offering size.     

The dynamics of portfolio management contracts

We consider the multiperiod relationship between a client anda portfolio manager and the resulting problem of motivatinga manager of unknown ability to acquire valuable information.We explore the contractual form and the optimal retention policyof the client and find that the optimal initial set of contractsfeatures a smaller performance based fee component paid to themanager than in a first-best contract, and the contract choiceelicits only partial information about the manager. As a result,ex post performance measurement is critical to future recontracting.In general, managers are retained only if the returns on theirportfolio exceed the benchmark by an appropriate amount.     

The significance of the market portfolio

Arguments for creating a market to allow trading the portfolioof all endowments in the entire world, the 'market portfolio',are considered. This world share market would represent a radicalinnovation, since at the present time only a small fractionof world endowments are traded. Using a stochastic endowmenteconomy where preference are mean variance, it is shown thatcreating such a market may be justified in terms of its contributionto social welfare. It is also argued that creating a marketfor world shares is attractive for certain reasons of robustnessand simplicity.     

Diversification and portfolio theory: a review

Financial Markets and Portfolio Management - Diversification is one of the major components of investment decision-making under risk or uncertainty. However, paradoxically, as the 2007–2009...     

The numeraire portfolio: a new perspective on financial theory

The numeraire portfolio, also called the optimal growth portfolio, allows simple derivations of the main results of financial theory. The prices of self financing portfolios, when the optimal growth portfolio is the numeraire, are martingales in the ‘true’ (historical) probability. Given the dynamics of the traded securities, the composition of the numeraire portfolio as well as its value are easily computable. Among its numerous properties, the numeraire portfolio is instantaneously mean variance efficient. This key feature allows a simple derivation of standard continuous time CAPM, CCAPM, APT and contingent claim pricing. Moreover, since the Radon-Nikodym derivatives of the usual martingale measures are very simple functions of the numeraire portfolio, the latter provides a convenient link between the standard Capital Market Theory a la Merton and the probabilistic approach a la Harrison-Kreps-Pliska.     

Bank capital buffer and portfolio risk: The influence of business cycle and revenue diversification

The relationship between macroeconomic developments and bank capital buffer and portfolio risk adjustments is relevant to assess the efficacy of newly created countercyclical buffer requirements. Using the U.S. bank holding company data over the period 1992:Q1–2011:Q3, we find a negative relationship between the business cycle and capital buffer. Our results offer some support for the Basel III agreements that countercyclical capital buffer in the banking sector is necessary to help the performance of the real economy during recessions. We find a robust evidence of inverse relationship between business cycle and bank default risk. Our analysis provides evidence of diversification benefits. The probability of insolvency risk decreases for diversified banks and banks with high revenue diversity achieve capital savings.     

WTI crude oil Futures in portfolio diversification: The time-to-maturity effect

The aim of the paper is to analyze the diversification effect brought by crude oil Futures contracts, the most liquid commodity Futures, into a portfolio of stocks. The studies that have documented the very low- and essentially negative-correlations between commodities and equities typically rely on normally distributed returns, which is not the case for crude oil Futures and stocks indexes. Moreover, the particular time-to-maturity chosen for the Future contract used as an investment vehicle is an important matter that needs to be addressed, in presence of forward curves switching between backwardation and contango shapes.Our goal in this paper is twofold: (a) we introduce copula functions to have a better representation of the dependence structure of oil Futures with equity indexes; (b) using this copula representation, we are able to analyze in a precise manner the “maturity effect” in the choice of crude oil Future contract with respect to its diversification benefits. Our finding is that, in the case of distant maturities Futures, e.g., 18 months, the negative correlation effect is more pronounced whether stock prices increase or decrease. This property has the merit to avoid the hurdles of a frequent roll over while being quite desirable in the current trendless equity markets. Empirical evidence is exhibited on a database comprising the NYMEX WTI crude oil Futures and S&P 500 index over a 15 year-time period.     

The effectiveness of the VaR-based portfolio insurance strategy: An empirical analysis

This paper proposes an approach to constructing the insured portfolios under the VaR-based portfolio insurance strategy (VBPI) and provides a comprehensive analysis of its hedging effectiveness in comparison with the buy-and-hold (B&H) as well as the constant proportion portfolio insurance (CPPI) strategies in the context of the Chinese market. The results show that both of the insurance strategies are able to limit the downward returns while retaining certain upside returns, and their capabilities of reshaping the return distributions increase as the guarantee or the confidence level rises. In general, the VBPI strategy tends to outperform the CPPI strategy in terms of both the degree of downside protection and the return performance.