A Simple Induction Approach and an Efficient Trinomial Lattice for Multi-State Variable Interest Rate Derivatives Models

This paper presents an alternative approach for interest rate lattice construction in the Ritchken and Sankarasubramanian (1995) framework. The proposed method applies a parsimonious induction technique to represent the distribution of auxiliary state variables and value interest rate derivatives. In contrast to other approaches, this technique requires no numerical interpolations, approximations and iterative procedures for pricing interest rate options using a simple backward induction and, therefore, provides significant computational advantages and flexibility with respect to existing implementations. Also, the proposed trinomial interest rate lattice specification provides for a further reduction in computational costs with additional flexibility. The results of this work can be extended to a class of derivatives pricing models with path dependent state variables and generalized to multi-factor models.     

外汇期权定价:VG模型与BS模型谁更适用

本文运用方差GAMMA模型对外汇收益分布特征进行对比拟合分析,并结合几种被选汇率数据对模型参数进行估计。KS检验和卡方拟合优度检验的实证结果表明V.G.模型比Black-Schloes模型有更高的拟合度,说明了V.G.模型比Black-Schloes模型更好地模拟汇率收益动态运动过程。     

The Distributional Efficiency of Alternative Regulatory Regimes: A Real Option Approach

This paper studies the effects of regulatory constraints on firm's irreversible investment decisions. The RPI–x rule is compared to a profit sharing rule, which increases the x factor in case profits go beyond a given level.When the firm has an option to delay investment, these rules have the same impact on investment choices. As profit sharing has a greater ability to extract rents, however, it is more efficient than the RPI–x rule.     

Interest Rate Derivatives in a Duffie and Kan Model with Stochastic Volatility: An Arrow-Debreu Pricing Approach

Simple analytical pricing formulae have been derived, by different authors and for several derivatives, under the Gaussian Langetieg (1980) model. The purpose of this paper is to use such exact Gaussian solutions in order to obtain approximate analytical pricing formulas under the most general stochastic volatility specification of the Duffie and Kan (1996) model. Using Gaussian Arrow-Debreu state prices, first order stochastic volatility approximate pricing solutions will be derived only involving one integral with respect to the time-to-maturity of the contingent claim under valuation. Such approximations will be shown to be much faster than the existing exact numerical solutions, as well as accurate.     

A Note on Option Pricing for the Constant Elasticity of Variance Model

We study the arbitrage free optionpricing problem for the constant elasticity of variance (CEV) model. To treatthestochastic aspect of the CEV model, we direct attention to the relationship between the CEV modeland squared Bessel processes. Then we show the existence of a unique equivalentmartingale measure and derive the Cox's arbitrage free option pricing formulathrough the properties of squared Bessel processes. Finally we show that the CEVmodel admits arbitrage opportunities when it is conditioned to be strictlypositive.     

Korean Currency Crisis and Regime Change:A Multivariate GARCH Model with Bayesian Approach

Regarding the question of when the Korean currency crisis actually started,several financial time series areexamined in a multivariate time series framework with the GeneralizedAutoregressive Conditional Heteroskedastic (GARCH) process.The likelihood ratio (LR) test is used to find a structural break with aselection of breakpoints.The posterior probability function of a breakpoint is also derived.Individual time series data show the existence of several breaks since July1997.A statistically significant structural break using the multivariate GARCHmodelwas found prior to 8 November 1997, the date when the domestic currencystarted to massively devalue.     

A New Prepayment Model (with Default): An Occupation-time Derivative Approach

A new prepayment model is developed, which improves the modeling of the borrowers decision process by incorporating an occupation-time derivative in the valuation framework of a fixed-rate mortgage. This option-theoretic mortgage valuation model is based on stochastic house-price and interest-rate models, and requires a particularly subtle technique to incorporate a new type of occupation-time derivative, where the barrier (which activates the derivative) is in the value process and not the underlying process (as it is in standard occupation-time derivatives). This new model simulates a delay in prepayment by the borrower (beyond the time simple ruthless prepayment dictates), thus increasing the value of the mortgage to the lender, compared to the value gained using more basic models. This allows for a more advanced borrower decision process, where a rational exercise structure is retained in a modified form. Empirical evidence supports this theory, which should be beneficial for accurate mortgage-backed security pricing. The results in this paper explore thoroughly the effect on the mortgage value of a delay in prepayment by the borrower on the embedded options held and on the insurance component.

The Effects of Transaction Costs and Different Borrowing and Lending Rates on the Option Pricing Model: A Note

This paper modifies the Black-Scholes option pricing model to include the effects of transaction costs and different borrowing and lending rates. The paper demonstrates that these market imperfections tend to offset each other yielding a bounded range of prices for each option. The paper also shows that under some conditions the option pricing hedge may be society's lowest cost financial intermediary.     

Cointegration Analysis of Audit Pricing Model: A Panel Unit Root Test Approach

In this study, we provide evidence on the stationarity of real audit fees and the major explanatory variables frequently used in the audit pricing models from a pooled data set, using panel unit root tests developed by Im et al. (1997). The panel unit root test supports the hypothesis of non‐stationarity of audit fees and their major determinants. We demonstrate that variables in the audit pricing model that were previously found to have impact on audit fees may turn out to be useless when more powerful tests like panel tests are applied to these variables. Our evidence implies that failing to employ appropriate procedure to test cointegration and to specify the appropriate model for audit fees and their determinants would generate results that may have exaggerated the effects of some variables on audit fees.     

U.S. Banking Sector Risk in an Era of Regulatory Change: A Bivariate GARCH Approach

This paper assesses the impact of regulatory change on the risk and returns of the U.S. banking industry. The impact of five major regulatory changes on banking sector risk was assessed using daily data for eighteen major U.S. regional banks, money center banks and savings and loan type depository institutions. Risk in this case was proxied via the use of an M-GARCH model which generates time dependent conditional beta estimates. The evidence obtained suggests that the impact of deregulation and reregulation on banking sector risk is case specific. Further, the results obtained show that the market model incorporating dummy variables, which has proven so popular amongst existing studies, discards important information about the variability of beta which the time varying conditional betas capture.     

A Comparison of Option Prices Under Different Pricing Measures in a Stochastic Volatility Model with Correlation

This paper investigates option prices in an incomplete stochastic volatility model with correlation. In a general setting, we prove an ordering result which says that prices for European options with convex payoffs are decreasing in the market price of volatility risk.As an example, and as our main motivation, we investigate option pricing under the class of q-optimal pricing measures. The q-optimal pricing measure is related to the marginal utility indifference price of an agent with constant relative risk aversion. Using the ordering result, we prove comparison theorems between option prices under the minimal martingale, minimal entropy and variance-optimal pricing measures. If the Sharpe ratio is deterministic, the comparison collapses to the well known result that option prices computed under these three pricing measures are the same.As a concrete example, we specialize to a variant of the Hull-White or Heston model for which the Sharpe ratio is increasing in volatility. For this example we are able to deduce option prices are decreasing in the parameter q. Numerical solution of the pricing pde corroborates the theory and shows the magnitude of the differences in option price due to varying q.JEL Classification: D52, G13     

The Pricing of Initial Public Offerings: A Dynamic Model with Information Production

This paper presents an information-theoretic model of IPO pricing in which insiders sell stock in both the IPO and the secondary market, have private information about their firm's prospects, and outsiders may engage in costly information production about the firm. High-value firms, knowing they are going to pool with low-value firms, induce outsiders to engage in information production by underpricing, which compensates outsiders for the cost of producing information. The information is reflected in the secondary market price of equity, giving a higher expected stock price for high-value firms.     

The Association Between Market and Exchange Rate Risks and Accounting Variables: A GARCH Model of the Japanese Banking Institutions

This study has two purposes. First, it estimates the market, interest rate, and exchange rate sensitivities (betas) of the Japanese banking institutions. Second, it investigates the relationship between the market-based measures of risk and accounting-based financial ratios. We extend the literature in three important ways. First, we employ a multi-factor GARCH model to estimate the betas. This framework incorporates non-linearities in the bank stock return modeling and allows for time-varying risk premia. Second, we investigate the determinants of market and exchange rate risk in terms of bank financial ratios. To this end, we regress the beta measures derived from the GARCH model against the corporate decision variables to determine the direction and the magnitude of the impact of the latter on the market and exchange rate risk exposures. Third, by using data on the Japanese banking institutions, we provide a comparison of the bank interest rate and exchange rate sensitivities and the strength of the links between the risk measure and the corporate decision variables between the U.S. and the Japanese banking institutions. This comparison sheds light on the robustness of the results concerning interest rate and exchange rate risk, and their determinants, across the two countries. Several interesting results are obtained. First, empirical results indicate that interest rate is only occasionally significant while market and exchange rate variables are significant for all the banks in the sample. Second, market and exchange rate risk measures do impound information in the financial ratios with the explanatory power of the market beta model being higher than that of the exchange rate beta model. Third, the association of the market-based risk measures and the financial ratios is weaker for the Japanese banks than those found for their U.S. counterparts in the existing literature.JEL Classification: G21, F37     

The role of credit in the Great Moderation: A multivariate GARCH approach

During the Great Moderation, financial innovation in the US increased the size and scope of credit flows supporting the growth of wealth. We hypothesize that spending out of wealth came to finance a wider range of GDP components such that it smoothed GDP. Both these trends combined would be consistent with a decrease in the volatility of output. We suggest testable implications in terms of both growth of credit and output and volatility of growth. In a multivariate GARCH framework, we test this view for home mortgages and residential investment. We observe unidirectional causality in variance from total output, residential investment and non-residential output to mortgage lending before, but not during the Great Moderation. These findings are consistent with a role for credit dynamics in explaining the Great Moderation.     

The Determinants of Implied Volatility: A Test Using LIFFE Option Prices

This paper presents and tests a model of the volatility of individual companies' stocks, using implied volatilities derived from option prices. The data comes from traded options quoted on the London International Financial Futures Exchange. The model relates equity volatilities to corporate earnings announcements, interest-rate volatility and to four determining variables representing leverage, the degree of fixed-rate debt, asset duration and cash flow inflation indexation. The model predicts that equity volatility is positively related to duration and leverage and negatively related to the degree of inflation indexation and the proportion of fixed-rate debt in the capital structure. Empirical results suggest that duration, the proportion of fixed-rate debt, and leverage are significantly related to implied volatility. Regressions using all four determining variables explain approximately 30% of the cross-sectional variation in volatility. Time series tests confirm an expected drop in volatility shortly after the earnings announcement and in most cases a positive relationship between the volatility of the stock and the volatility of interest rates.     

The performance of insolvency prediction and credit risk models in the UK: A comparative study

Theoretically-driven, market-based contingent claims models have recently been applied to the field of corporate insolvency prediction in an attempt to provide the art with a theoretical methodology that has been lacking in the past. Limited studies have been carried out in order directly to compare the performance of these models with that of their accounting number-based counterparts. We use receiver operating characteristic curves to assess the efficacy of thirteen selected models using, for the first time, post-IFRS UK data; and investigate the distributional properties of model efficacy. We find that the efficacy of the models is generally less than that reported in the prior literature; but that the contingent claims models outperform models which use accounting numbers. We also obtain the counter-intuitive finding that predictions based on a single variable can be as efficient as those which are based on models which are far more complicated – in terms of variable variety and mathematical construction. Finally, we develop and test a naïve version of the down-and-out-call barrier option model for insolvency prediction and find that, despite its simple formulation, it performs favourably compared alongside other contingent claims models.     

Pricing derivatives of American and game type in incomplete markets

In this paper the neutral valuation approach is applied to American and game options in incomplete markets. Neutral prices occur if investors are utility maximizers and if derivative supply and demand are balanced. Game contingent claims are derivative contracts that can be terminated by both counterparties at any time before expiration. They generalize American options where this right is limited to the buyer of the claim. It turns out that as in the complete case, the price process of American and game contingent claims corresponds to a Snell envelope or to the value of a Dynkin game, respectively.On the technical level, an important role is played by -sub- and -supermartingales. We characterize these processes in terms of semimartingale characteristics.Received: June 2003, Mathematics Subject Classification (2000):   91B24, 60G48, 91B16, 91A15, 60G40JEL Classification:   G13, D52, C73The authors want to thank PD Dr. Martin Beibel for the idea leading to the proof of Proposition A.4 and both anonymous referees for many valuable comments. The second author gratefully acknowledges financial support by the Deutsche Forschungsgemeinschaft through the Graduiertenkolleg Angewandte Algorithmische Mathematik at Munich University of Technology and by the Fonds zur Förderung der wissenschaftlichen Forschung at Vienna University of Technology.     

The Transmission of International Shocks: A Factor-Augmented VAR Approach

The empirical literature on the transmission of international shocks is based on small -scale VARs. In this paper, we use a large panel of data for 17 industrialized countries to investigate the international transmission mechanism, and revisit the anomalies that arise in the empirical literature. We propose a factor augmented VAR (FAVAR) that extends the model in Bernanke, Boivin, and Eliasz (2005) to the open economy. The main results can be summarized as follows. First, the dynamic effects on the UK economy of an unanticipated fall of short-term interest rates in the rest of the world are: real house price inflation, investment, GDP and consumption growth peak after 1 year, wages peak after 2 years, and CPI and GDP deflator inflation peak during the third year. Second, a positive international supply shock makes the distribution of the components of the UK consumption deflator negatively skewed. Third, in response to a domestic monetary shock, we find little evidence of the exchange rate and liquidity puzzles and little evidence of the forward discount and price anomalies.     

The BDS Test as a Test for the Adequacy of a GARCH(1,1) Specification: A Monte Carlo Study

In this study we examine the widely used Brock, Dechert, andScheinkman (BDS) test when applied to the logarithm of the squaredstandardized residuals of an estimated GARCH(1,1) model as atest for the adequacy of this specification. We review the conditionsderived by De Lima (1996; Econometric Reviews 15, 237–259)for the nuisance-parameter-free property to hold and addressthe issue of their necessity, using the flexible framework offeredby the GARCH(1,1) model in terms of moment, memory, and timeheterogeneity properties. By means of Monte Carlo simulations,we show that the BDS test statistic still approximates the standardnull distribution even for mildly explosive processes that violatethe majority of the conditions. Thus the test performs reasonablywell, its empirical size being rather close to the nominal one.As a by-product of this study, we also shed light on the relatedissue of the consistency of the QML estimators of the conditionalvariance parameters under various parameter configurations andalternative distributional assumptions on the innovation process.