The sensitivity of beta to the time horizon when log prices follow an Ornstein–Uhlenbeck process

This paper provides a new theoretical approach to investigate the sensitivity of the familiar beta of the capital asset pricing model to the length of the return measurement interval; a phenomenon known as the intervalling effect. By setting the problem in a continuous time setting, and using exact results, we are able to generalize existing results in the literature. We derive an expression for beta as a function of the time horizon h, conditional on current time t. We show that beta is monotonic in h and derive conditions for it to be increasing or decreasing.     

Is the information obtained from European options on equally weighted baskets enough to determine the prices of exotic derivatives such as worst-of options?

In recent years there has been a remarkable growth of multi-asset options. These options exhibit sensitivity to the volatility of the underlying assets, as well as to their correlations. The call versus call is a product commonly used to trade correlation within the inter-dealer broker markets. The buyer of correlation buys a European call on the equally weighted basket option and sells a weighted average of European calls on each asset. In this case, the following important question arises: Is the information provided by equally weighted basket options enough to price other European multi-asset exotic derivatives such as worst-of or outperformance options? This article investigates this issue under a stochastic correlation framework. Importantly, this article shows that, when pricing multi-asset exotic derivatives, matching the prices of European equally weighted basket options, quoted in the market, does not guaranty the absence of model risk even in the case where the exotic payoff is observed only at maturity.     

A comment on De Grauwe's, “The legacy of the Eurozone crisis and how to overcome it”

De Grauwe (2016) argues that it has been the asymmetric economic policies of the European Commission where credit nations have benefited at the expense of debtor nations that have fueled the Euro Crisis. In this short comment I provide an alternative explanation for the amplification and persistence experienced by the Eurozone economy during the double-dip recessions of 2008 to 2009 and 2011 to 2013. The Euro crisis can be traced back to contractionary monetary policies made by the European Central Bank at a time when the Eurozone required expansionary monetary policy.     

A nonparametric approach to measuring the sensitivity of an asset’s return to the market

In the market model the return on an asset is modeled as a linear function of the return on a market index with slope parameter beta. The coefficient beta is often used as a measure of the sensitivity of the asset’s return to the market and to measure the component of the variance of the return that is explained by the market. However, both of these interpretations require the additional assumption that the error term in the market model has mean 0 conditional on the return on the market index, an assumption that is often difficult to verify in practice. In this paper, a nonparametric version of the market model is proposed that does not require such an assumption. This nonparametric model replaces the beta coefficient of the market model with a “beta curve” describing the relationship between the asset’s return and that of the market locally near a given value of the market return. The proposed model is applied to stock returns, as well as to returns on mutual funds. Corresponding tests of the market model are given and it is shown that the nonparametric model often provides an improvement over the standard parametric market model.     

A functional coefficient model view of the Feldstein–Horioka puzzle

What does the saving–investment (SI) relation really measure and how should the SI relation be measured? These are two of the most discussed issues triggered by the so-called Feldstein–Horioka puzzle. Based on panel data we introduce a new variant of functional coefficient models that allows to separate long and short to medium run parameter dependence. The new modeling framework is applied to uncover the determinants of the SI relation. Macroeconomic state variables such as openness, the age dependency ratio, government current and consumption expenditures are found to affect the SI relation significantly in the long run.     

A class of Lévy process models with almost exact calibration to both barrier and vanilla FX options

Vanilla (standard European) options are actively traded on many underlying asset classes, such as equities, commodities and foreign exchange (FX). The market quotes for these options are typically used by exotic options traders to calibrate the parameters of the (risk-neutral) stochastic process for the underlying asset. Barrier options, of many different types, are also widely traded in all these markets but one important feature of the FX options markets is that barrier options, especially double-no-touch (DNT) options, are now so actively traded that they are no longer considered, in any way, exotic options. Instead, traders would, in principle, like to use them as instruments to which they can calibrate their model. The desirability of doing this has been highlighted by talks at practitioner conferences but, to our best knowledge (at least within the realm of the published literature), there have been no models which are specifically designed to cater for this. In this paper, we introduce such a model. It allows for calibration in a two-stage process. The first stage fits to DNT options (or other types of double barrier options). The second stage fits to vanilla options. The key to this is to assume that the dynamics of the spot FX rate are of one type before the first exit time from a ‘corridor’ region but are allowed to be of a different type after the first exit time. The model allows for jumps (either finite activity or infinite activity) and also for stochastic volatility. Hence, not only can it give a good fit to the market prices of options, it can also allow for realistic dynamics of the underlying FX rate and realistic future volatility smiles and skews. En route, we significantly extend existing results in the literature by providing closed-form (up to Laplace inversion) expressions for the prices of several types of barrier options as well as results related to the distribution of first passage times and of the ‘overshoot’.     

Evaluating the effectiveness of the new EU bank regulatory framework: A farewell to bail-out?

In response to the economic and financial crisis, the EU has adopted a new regulatory framework of the banking sector. Its central elements consist of new capital requirements, the single rulebook, and rules for bank recovery and resolution. These legislations have been adopted to reduce the call for government bail-out of distressed banks in future crises.The present study performs a detailed quantitative assessment of the reduction in public finance costs brought about by the introduction of these rules. We use a microsimulation portfolio model, which implements the Basel risk assessment framework, to estimate the joint distribution of bank losses at EU level. The approach incorporates the complete safety-net set up in EU legislation to absorb these losses, explicitly modelling enhanced Basel III capital rules, the bail-in tool and the resolution funds.Using a near-full sample of commercial, cooperative and savings banks in the EU, we quantify the cumulative effects of this safety-net and the contribution of each individual tool to the total effect. Considering a crisis of a similar magnitude as the recent one, our results show that potential costs for public finances decrease from roughly 3.7% of EU GDP (before the introduction of any new tool) to 1.4% with bail-in, and finally to 0.5% when all the elements we model are in place. This latter amount is very close to our estimate of leftover resolution funds and the size of the Deposit Guarantee Scheme.This exercise extends the quantitative analyses performed by the European Commission in its Economic Review of the Financial Regulation Agenda by developing additional scenarios, crucial robustness checks, simulations for different annual data vintages, and by implementing some methodological improvements.     

“Rookies to the stock market: A portrait of new shareholders”

This study examines individuals entering the stock market, “rookies.” The study uses unique ownership data, containing investor holdings of all listed Swedish firms over the sample period from 2004 to 2010, to examine rookies’ stock portfolios. In addition, this study explores investor sophistication among rookies, based on individual characteristics and portfolio composition. Although the average shareholder is aging and leaving the stock market, this study shows there are signs of rejuvenation, with rookies entering the stock market. The results show that the majority of rookies hold under-diversified stock portfolios and choose one large firm as their first stock market investment. Rookie characteristics display gender differences, in which the average female rookie has lower income, is older, but holds a larger stock portfolio than her male counterpart.     

Back to the basics in banking? A micro-analysis of banking system stability

This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.     

A Rejoinder to Commentaries on ‘Integrated Reporting: A Review of Developments and their Implications for the Accounting Curriculum’

This auditing case study focuses on a company presenting significant audit risk for an incoming audit firm. By presenting a variety of audit risks, hence audit implications, the case demonstrates the holistic approach to audit required in order to avoid an inappropriate audit opinion. The case is aimed at undergraduate students of auditing in the final year of their studies and students of the ACCA Paper 6 or equivalent. The case provides an efficient and original vehicle for instruction in auditing and can be used to complement other teaching aids.     

Base independence in the analysis of tax policy effects: with an application to Norway 1992–2004

The analysis contrasts results of two recently expounded microlevel data approaches to derive robust intertemporal characterizations of redistributional effects of income tax schedules; the fixed-income procedure of Kasten et al. (Tax progressivity and Income Inequality, Cambridge University Press, 1994) and the transplant-and-compare method of Dardanoni and Lambert (J. Public Econ. 86:99–122, 2002). Our study is normative in that the Blackorby and Donaldson (Can. J. Econ. 17:683–694, 1984) index of tax progressivity is employed. This enables contributions from vertical redistribution and horizontal inequity also to be assessed, using for the latter one classical measure and one no reranking measure. When the competing methodologies are applied to Norwegian data for 1992–2004, their respective strengths and weaknesses are revealed. The transplant-and-compare procedure is found to have a number of advantages.      

A potential benefit of increasing book–tax conformity: evidence from the reduction in audit fees

Our study explores a possible benefit of conforming book income to taxable income. We expect that increased book–tax conformity can reduce audit fees by simplifying tax accruals and increasing tax authorities’ monitoring, which reduce audit workload and audit risk, respectively. Consistent with our expectations, we find that a higher country level of required book–tax conformity leads to lower audit fees. Moreover, firm-level book–tax differences are positively associated with audit fees. We also find that the negative association between country level of required book–tax conformity and audit fees is mitigated among firms with larger book–tax differences. Our findings are robust to including country-level legal investor protection or other extra-legal institutions. Overall, our results suggest that one benefit of increasing book–tax conformity is the reduction in audit fees.     

Does Convergence of Accounting Standards Lead to the Convergence of Accounting Practices?: A Study from China

In this empirical study we examine whether China's efforts to converge domestic accounting standards with International Financial Reporting Standards (IFRS) over the past 15 years have resulted in the successful convergence of Chinese listed firms. This study is unique in that we evaluate convergence of firms' accounting practices from three perspectives: (1) the level of compliance with Chinese GAAP and IFRS, (2) the consistency of accounting choices under Chinese GAAP and IFRS, and (3) identification of significant differences in the net incomes produced under Chinese GAAP and IFRS (earnings gap).Using the 1999 and 2002 annual reports of 79 Chinese listed firms we find improvement in both compliance with IFRS and in the consistency of the accounting methods used in annual reports prepared under Chinese GAAP and IFRS. We also find a reduction in the earnings gap from 1999 to 2002. However, interestingly we observed that Chinese listed firms' compliance with IFRS is significantly lower than their compliance with Chinese GAAP. Overall we believe that our findings suggest that in China the convergence of accounting standards has been a conduit to the convergence of accounting practices.     

Optimal time to sell a stock in the Black–Scholes model: comment on ‘Thou shalt buy and hold’, by A. Shiryaev,Z. Xu and X.Y. Zhou

We reconsider the problem of the optimal time to sell a stock studied by Shiryaev et al. (2008 Shiryaev, A, Xu, Z and Zhou, XY. 2008. Thou shalt buy and hold. Quant. Finan., 8: 765–776. [Taylor & Francis Online], [Web of Science ®] , [Google Scholar]) (following in this issue of Quantitative Finance) using path integral methods. These methods allow us to confirm the results obtained by these authors and extend them to the entire parameter region. We also obtain the full distribution of the time t_m at which the maximum of the price is reached for arbitrary values of the drift.     

A Standard setter’s framework for selecting between fair value and historical cost measurement attributes: a basis for discussion of “Does fair value accounting for nonfinancial assets pass the market test?”

This paper describes an income-statement-focused framework for selecting between between the fair value and historical cost measurement attributes that differs from the balance-sheet-focused relevance versus reliability tradeoff perspective that is common to most academic research. This income-statement-focused framework is then applied to the Christensen and Nikolaev setting in Rev Account Stud 18(3), (2013) to suggest that most of the study’s findings are not surprising and can be explained by differences in the income-relevance of fair value and historical cost measures for nonfinancial assets rather than issues with the reliability of fair value measurements, which is the perspective taken by the authors. The paper closes by suggesting additional research on the use of fair value and historical cost measures for nonfinancial assets that would be most relevant to current standard-setting activities of the Financial Accounting Standards Board.