An analysis of risk-based asset allocation and portfolio insurance strategies

This paper compares traditional portfolio insurance strategies with modern risk-based dynamic asset allocation strategies within a currency portfolio context for reserve management. Given the objective of preserving reserve value, the evaluation of the hedging performances of various strategies focuses on four perspectives regarding, in particular, the return distribution of the hedged portfolio. In terms of the Sharpe Ratio, the constant proportional portfolio insurance is the best performer due to having the lowest volatility, while the Value at Risk strategy based upon the normal distribution is the worst due to its having the smallest return. From the perspective that the return distribution of the hedged portfolio is shifted to the right, the synthetic put performs the best, with the expected shortfall strategy the second best. In terms of the cumulative portfolio return across years, the expected shortfall strategy using the historical distribution ranks first, as a result of its participation in upward markets. Furthermore, the expected shortfall-based strategy results in a lower turnover within the investment horizon, thereby saving transaction costs.     

A moment computation algorithm for the error in discrete dynamic hedging

This paper develops a computational approach to determining the moments of the distribution of the error in a dynamic hedging or payoff replication strategy under discrete trading. In particular, an algorithm is developed for portfolio affine trading strategies, which lead to portfolio dynamics that are affine in the portfolio variable. This structure can be exploited in the computation of moments of the hedging error of such a strategy, leading to a lattice based backward recursion similar in nature to lattice based pricing techniques, but not requiring the portfolio variable. We use this algorithm to analyze the performance of portfolio affine hedging strategies under discrete trading through the moments of the hedging error.     

Effects of Price of Gold on Bombay Stock Exchange Sectoral Indices: New Evidence for Portfolio Risk Management

Using daily data, this paper examines the relationship between the returns of gold and seven sectoral indices in the Bombay Stock Exchange (BSE) for the period from January 2000 to May 2018. Given the importance of gold in India, there are significant issues in a portfolio selection in that country. By addressing the hedged robust portfolio problems, this paper focuses on three vanilla portfolio problems: the maximum return portfolio allocation, the global minimum variance portfolio problem, and the Markowitz portfolio allocation by using various multiple generalized autoregressive conditional heteroskedasticity (GARCH) models. The paper finds that gold returns are significantly independent of the returns of the BSE sectoral indices. Besides, gold returns can help predict the future returns of the Consumer Durables and the Fast-Moving Consumer Goods indices as well as the Oil & Gas equity indices. Finally, the findings also show that gold hedges against the information technology stock index and serves as a robust portfolio diversification tool. With these new results, this paper offers several implications for investors and risk management purposes.     

Dynamic hedging with futures: a copula-based GARCH model with high-frequency data

Modeling the joint distribution of spot and futures returns is crucial for establishing optimal hedging strategies. This paper proposes a new class of dynamic copula-GARCH models that exploits information from high-frequency data for hedge ratio estimation. The copula theory facilitates constructing a flexible distribution; the inclusion of realized volatility measures constructed from high-frequency data enables copula forecasts to swiftly adapt to changing markets. By using data concerning equity index returns, the estimation results show that the inclusion of realized measures of volatility and correlation greatly enhances the explanatory power in the modeling. Moreover, the out-of-sample forecasting results show that the hedged portfolios constructed from the proposed model are superior to those constructed from the prevailing models in reducing the (estimated) conditional hedged portfolio variance. Finally, the economic gains from exploiting high-frequency data for estimating the hedge ratios are examined. It is found that hedgers obtain additional benefits by including high-frequency data in their hedging decisions; more risk-averse hedgers generate greater benefits.     

Swap variance hedging and efficiency: The role of high moments

In this article, we propose a new theoretical approach for developing hedging strategies based on swap variance (SwV). SwV is a generalized risk measure equivalent to a polynomial combination of all moments of a return distribution. Using the S&P 500 index and West Texas Intermediate (WTI) crude oil spot and futures price data, as well as simulations by varying the distribution of asset returns, we investigate the dynamic differences between hedge ratios and portfolio performances based on SwV (with high moments) and variance (without high moments). We find that, on average, the minimizing-SwV hedging suggests more short futures contracts than minimizing-variance hedging; however, when market conditions deteriorate, the minimizing-SwV hedging suggests fewer short positions in futures. The superior posthedge performances of the mean-SwV hedged portfolios over the mean-variance hedged portfolios in highly volatile or extremely calm markets confirm the efficiency of the mean-SwV hedging strategy.     

The performance of model based option trading strategies

This paper analyzes returns to trading strategies in options markets that exploit information given by a theoretical asset pricing model. We examine trading strategies in which a positive portfolio weight is assigned to assets which market prices exceed the price of a theoretical asset pricing model. We investigate portfolio rules which mimic standard mean-variance analysis is used to construct optimal model based portfolio weights. In essence, these portfolio rules allow estimation risk, as well as price risk to be approximately hedged. An empirical exercise shows that the portfolio rules give out-of-sample Sharpe ratios exceeding unity for S&P 500 options. Portfolio returns have no discernible correlation with systematic risk factors, which is troubling for traditional risk based asset pricing explanations.     

Timing and diversification: A state-dependent asset allocation approach

Abstract

The influence of changing economic environment leads the distribution of stock market returns to be time-varying. A conditionally optimal investment hence requires a dynamic adjustment of asset allocation. In this context, this paper examines the improvement in portfolio performance by simulating portfolio strategies that are conditioned on the Markov regime switching behaviour of stock market returns. Including a memory effect eliminates the empirical shortcoming of discrete state models, namely that they produce a standard and an extreme state in stock returns. So far, this has prevented the regimes from being used as a valuable conditioning variable. Based on a discrete state indicator variable, is presented evidence of considerable performance improvement relative to the static model due to optimal shifting between aggressive and well diversified portfolio structures.     

A generalized approach to optimal hedging with option contracts

In this paper, we develop a theoretical model in which a firm hedges a spot position using options in the presence of both quantity (production) and basis risks. Our optimal hedge ratio is fairly general, in that the dependence structure is modeled through a copula function representing the quantiles of the hedged position, and hence any quantile risk measure can be employed. We study the sensitivity of the exercise price which minimizes the risk of the hedged portfolio to the relevant parameters, and we find that the subjective risk aversion of the firm does not play any role. The only trade-off is between the effectiveness and cost of the hedging strategy.     

International diversification with securitized real estate and the veiling glare from currency risk

This paper analyzes diversification benefits from international securitized real estate in a mixed-asset context. We apply regression-based mean-variance efficiency tests, conditional on currency-unhedged and fully hedged portfolios to account for systematic foreign exchange movements. From the perspective of a US investor, it is shown that, first, international diversification is superior to a US mixed-asset portfolio, second, adding international real estate to an already internationally diversified stock and bond portfolio results in a further significant improvement of the risk-return trade-off and, third, considering unhedged international assets could lead to biased asset allocation decisions not realizing the true diversification benefits from international assets.     

Country and currency diversification of bond investments: do they really make sense for Swiss investors?

The inclusion of hedged or unhedged foreign currency bonds within a strategic asset allocation is a crucial decision which should be analyzed carefully. The goal of this paper is to provide a contribution to this analysis by focusing particularly on the time horizon of the investment. Results are analyzed from the perspective of a Swiss investor. We find that over the last 21 years, investing in bonds denominated in Swiss Francs has been clearly less efficient in terms of risk-adjusted returns than investing in a hedged global bond portfolio. For short-term investors, we find robust evidence against the hypothesis of investing in unhedged foreign currency bonds. The picture changes dramatically, however, when we consider an investment horizon of 6 years and the normal case of balanced portfolios including also equities and domestic bonds. In this case, the optimal strategy for the period we analyzed would have been to hedge only the exposure to US dollar bonds.      

Arbitrage Asset Pricing under Exchange Risk

This paper extends the APT to an international setting. Specifying a linear factor return-generating model in local currency terms, we show that the usual risk-diversification rule in the APT does not yield a riskless portfolio unless currency fluctuations obey the same factor model as asset returns. We then consider an arbitrage portfolio whose exchange risk is hedged by foreign riskless bonds. Under the resulting no-arbitrage conditions, the expected returns are not on the same hyperplane, unlike the closed-economy APT, unless they are adjusted by the cost of exchange risk hedging.     

The accrual anomaly: Australian evidence

This paper investigates whether there is evidence of the accrual anomaly ( Sloan, 1996 ) in Australia, whereby investors overestimate the impact of accruals on the persistence of earnings. While our results provide general support for the existence of the anomaly in Australia, there are a number of idiosyncrasies. First, there is evidence of Australian investors underestimating the persistence of earnings. Second, there is evidence of investors incorrectly assessing the implications of accruals and cash flows for the persistence of earnings (i.e. an accrual anomaly and a cash‐flow anomaly). Third, returns to a hedged portfolio trading strategy based on reported accruals are decreasing over the three‐year period subsequent to portfolio formation. Furthermore, they are statistically significant only in the first year. Additional analysis of the hedge portfolio results indicates that these results are primarily attributable to a limited number of firm‐year observations in the extreme positive tail of returns.     

Currency returns, market regimes and behavioral biases

Covered interest rate parity assumes that there is no risk premium on the hedged returns on currencies. However, empirical evidence indicates that risk premiums are not identically zero, and this is referred to as the forward premium puzzle. We show that there exist market regimes, within which behavioral biases affect decisions, and a type of parity holds within regimes. The foreign exchange market switches between regimes where there is a premium. This paper presents various tests for the hypotheses of currency regimes and regime dependent risk premiums. Based on the existence of regimes, a diversified currency portfolio is created with a mean-variance criterion. Using the Federal Exchange Rate Index as a proxy for the currency benchmark and the U.S. T-Bill as the risk free asset, the similarity between the benchmarks and the implied equilibrium hedged and unhedged portfolios provides evidence for regimes and decision bias. Within each regime interest rate parity is appropriate for modeling currency returns.     

Pricing and static hedging of American-style knock-in options on defaultable stocks

This paper applies the static hedge portfolio approach (SHP) of Chung et al. (2013) in two new directions. First, the SHP approach is generalized from the constant elasticity of variance (CEV) model of Cox (1975) to the jump to default extended CEV (JDCEV) framework of Carr and Linetsky (2006). For this purpose, the recovery value of the American-style down-and-in put is hedged through the one attached to a European-style plain-vanilla contract whereas for an up-and-in put it is necessary to use the recovery component of the corresponding European-style up-and-in option. Second, the SHP methodology is adapted from single to double barrier American-style knock-in options by matching the value of the hedging portfolio along both lower and upper barriers. Finally, and to benchmark the accuracy of the novel SHP pricing solutions, the optimal stopping approach of Nunes (2009) is also extended to price American-style double knock-in options under the JDCEV framework. Such extension highlights the relevant credit derivative component embedded in American-style knock-in equity puts.     

Cross-hedging foreign currency risk

This paper provides empirical evidence on the effectiveness of cross-hedging to reduce foreign exchange risk. Simple cross-hedges for currencies with and without futures contracts, multiple cross-hedges, portfolio hedges, and commodity cross-hedges are examined. Cross-hedges are found to be less effective than traditional similar-asset hedges. In some instances inter-temporal instability causes hedged positions to be riskier than unhedged ones although on the whole cross-hedging is shown to be a useful risk reduction technique.     

HEDGING FIXED-RATE PREFERRED STOCK INVESTMENTS

Corporations seeking to maximize the return on their cash reserve resources have an incentive to invest in traditional preferred stock because of their right to exclude 70% of the dividends from taxation. Nevertheless, fixed-rate preferred stock investments may contribute significantly to the return volatility of a cash portfolio and cause unacceptable losses to the corporate investors. As a result, many corporations might consider such higher-return investments only if they can hedge away a sufficient amount of risk. The research presented in this article seeks to evaluate how much of the return variation of fixed-rate preferred equity portfolios can be reduced with various hedging strategies.
This research shows that it is possible to reduce the risk of preferred stock investments significantly through the use of hedges employing some combination of fixed income futures and/or options. Although some risk remains even with the hedged preferred stock portfolio, the author demonstrates that money market assets can be combined with a hedged preferred stock portfolio to create a position that has no material chance of loss but expected after-tax returns higher than those on money market investments. In addition, the article also shows the high level of profitability associated with a strategy of increasing the size of liquid reserves in order to allow for losses related to an unhedged preferred stock component of those reserves.     

The world ex ante risk premium: an empirical investigation

A number of recent papers have focused on testing the linearity restrictions implied by international asset pricing models. The tests, however, have not addressed an additional restriction implied by the models; namely, that the risk premium on the world portfolio is positive. This study provides a direct assessment of this restriction. The evidence indicates that the ex ante world market risk premium can be negative. The results are robust to market proxies that are hedged and unhedged with respect to currency risk. Subperiod analysis indicates that the rejection of the positive risk premium restriction is driven by the first half of the sample period.     

The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives’ Equity Portfolios

We offer evidence that the use of relative performance evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk‐taking incentives on both the magnitude and composition of firm risk. We find that, when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.     

Relevance of the disposition effect on the options market: New evidence

A moneyness‐based propensity to sell (MPS) measure, at the aggregate level, determines the propensity of option holders to exercise their winning relative to losing positions. Using data on individual stock and S&P 500 Index options, we find that the MPS measure has significant predictive power over the cross section of delta‐hedged option returns. We test the disposition effect in the options market based on a long–short strategy that exploits price distortions induced by the disposition bias. More pronounced evidence of the disposition bias is found for individual at‐the‐money call options than put options where the significance of abnormal returns remains robust across different subsamples even after we control for the portfolio option greeks and market‐based risk factors. The profitability of the long–short strategy is related to limit‐to‐arbitrage proxies suggesting that behavioral explanations help explain the positive relation between the MPS measure and delta‐hedged option returns.     

Portfolio optimization with stochastic dominance constraints

We consider the problem of constructing a portfolio of finitely many assets whose return rates are described by a discrete joint distribution. We propose a new portfolio optimization model involving stochastic dominance constraints on the portfolio return rate. We develop optimality and duality theory for these models. We construct equivalent optimization models with utility functions. Numerical illustration is provided.