Optimal Portfolio Allocation under Higher Moments

We evaluate how departure from normality may affect the allocation of assets. A Taylor series expansion of the expected utility allows to focus on certain moments and to compute the optimal portfolio allocation numerically. A decisive advantage of this approach is that it remains operational even for a large number of assets. While the mean‐variance criterion provides a good approximation of the expected utility maximisation under moderate non‐normality, it may be ineffective under large departure from normality. In such cases, the three‐moment or four‐moment optimisation strategies may provide a good approximation of the expected utility.     

Optimal Asset Allocation Over the Business Cycle

Utilizing a broadly diversified portfolio of nine equity and debt assets, we show our portfolio's in-sample Markowitz return/risk profile considerably improved by keying asset proportions to cyclical changes in economic activity. For comparative purposes, we use the same assets in a hypothetical buy-and-hold benchmark portfolio. We find the variance/covariance structure of our portfolio to be considerably altered by the phase of the business cycle, with the diversification benefits enjoyed during expansions substantially diluted during recessions. Thus, cyclical reallocation appears to be more important in maintaining Markowitz efficiency during recessions vis-a-vis expansions. In the latter case we find expansion reallocation producing a 3.53% increase in our portfolio's return-to-risk ratio (relative to a buy-and-hold position), while for recessions optimal reallocation leads to a 79.14% increase.     

Asset allocation using flexible dynamic correlation models with regime switching

The asset allocation decision is often considered as a trade-off between maximizing the expected return of a portfolio and minimizing the portfolio risk. The riskiness is evaluated in terms of variance of the portfolio return, so that it is fundamental to consider correctly the variance of its components and their correlations. The evidence for the heteroskedastic behaviour of the returns and the time-varying relationships among the portfolio components have recently shifted attention to the multivariate GARCH models with time varying correlation. In this work we insert a particular Markov Switching dynamics in some Dynamic Correlation models to consider the abrupt changes in correlations affecting the assets in different ways. This class of models is very general and provides several specifications, constraining some coefficients. The models are applied to solve a sectorial asset allocation problem and are compared with alternative models.     

International capital market equilibrium with investment barriers

This paper outlines models of capital market equilibrium when there are explicit barriers to international investment in the form of a tax on holdings of assets in one country by residents of another country. There is a corresponding subsidy on short positions in foreign assets. Asset prices deviate from the predictions of the world capital asset pricing model. Investors do not hold a mixture of national market portfolios, but the mix of risky assets is the same for every investor in a country. Optimal portfolios tend to be heavy in domestic assets, and light in foreign assets. Tax free investors, however, tend to hold assets anywhere in the world that are taxed heavily. Estimates of the magnitude of the average tax (or the magnitude of effective barriers to international investment) can be made by comparing the average return on the minimum variance zero β portfolio, z, with the average across countries and time of the short-term interest rate. When barriers are ineffective, the expected return on portfolio z will be the average short-term interest rate, and the world capital asset pricing model will hold.     

Portfolio reallocation and exchange rate dynamics

This paper explains exchange rate dynamics by linking financial customers’ foreign exchange order flow with their dynamic portfolio reallocation. For any currency pair in a particular period, one currency has higher assets return than the other and can be considered the high-return-currency (HRC). Financial institutions attempt to hold more HRC assets when they become more risk-loving or the relative return of the assets is expected to increase. Such a portfolio reallocation generates buy order toward the HRC and the currency appreciates. As the HRC changes over time, the direction that the relative return and risk appetite affect the exchange rate varies in different regimes.     

Short Sales Restrictions and Kinks on the Mean Variance Frontier

With a short sales restriction, there may be switching points along the mean variance frontier corresponding to changes in the set of assets held. Traditional wisdom holds that each switching point corresponds to a kink, while Ross has claimed that kinks never occur. This paper shows that the truth lies between the two views, since the efficient frontier may or may not be kinked at a switching point. There is some indication that kinks are rare, since a kink corresponds to a portfolio in which all assets have the same expected return.     

Who survives? A cross-country comparison

How capital structure, dividend policy, and corporate governance vary across countries has been the focus of recent studies, but how resources are reallocated in response to poor performance has not received as much attention. This paper argues that the market for corporate control and the formal bankruptcy/liquidation processes of a country are two key mechanisms through which corporate assets are reallocated. Ideally, an economy would only allow the best users of economic resources to retain the right to use those assets and any sub-optimal use would result in either a take-over by a more proficient owner or an asset sale. We present evidence that equity market delistings occur more frequently in countries with strong shareholder rights. Furthermore, both strong creditor and shareholder rights increase the use of bankruptcy, relative to acquisitions, as a mechanism to resolve financial distress. We also present some evidence that these mechanisms are not as effective in Japan.     

The adoption of IFRS in Australia: The case of AASB 138 (IAS 38) Intangible Assets

AASB 138 Intangible Assets, adopted by reporting entities in Australia for annual reporting periods beginning on or after 1 January 2005, required derecognition of internally generated intangible assets. Prior to its adoption, the standard was widely expected to have a substantial impact on the reports of affected listed entities. On the basis of information available in the 2004/05 annual reports, this paper projects the expected effects of AASB 138 on reported intangible assets and on key financial measures. It compares these projected measures to the realised measures, reported under both Australian GAAP and AIFRS in the 2005/06 reports. While reported intangible assets and the debt to equity ratio were expected to change significantly as a result of AASB 138, the reported AIFRS results show a significant change in only the debt to equity ratio. The paper considers reasons why the pre-adoption expected changes did not eventuate, and also how the actual changes were reported to stakeholders in the management discussion sections of the annual reports. The conclusion draws implications regarding the transparency of communication in annual reports.     

ANALYSIS OF FEDERAL FUNDS RATE CHANGES AND VARIANCE PATTERNS

We analyze Fed funds rate changes in GARCH‐in‐mean (GARCH‐M) models and find that daily rate change and variance patterns differ with the timing of the rate observation, but that all patterns are generally consistent with optimal reserve account management. We also find that Fed funds daily and intraday variances exhibit trends and persistence, and that daily variance effects differ when using marginal rates versus daily weighted average rates. Furthermore, we find that conditional variances do not provide information about daily or intraday rate changes. Our results provide support for the use of GARCH models for studies on other financial assets. JEL classification: G21, G28     

International diversification gains and home bias in banking

This paper studies international diversification in banking, exploiting a bank-level dataset that covers the operations of 38 global banks and their subsidiaries overseas during 1995–2004. The paper finds that banks with a larger share of assets allocated to subsidiaries in emerging market countries were able to attain higher risk-adjusted returns. These gains were somewhat reduced by the concentration of bank subsidiaries in specific geographical regions, which is typical of the observed international expansion strategies. The paper also finds a substantial home bias in the international allocation of bank assets relative to the results of a mean–variance portfolio optimization model.     

Modeling and forecasting expected shortfall with the generalized asymmetric Student-t and asymmetric exponential power distributions

Financial returns typically display heavy tails and some degree of skewness, and conditional variance models with these features often outperform more limited models. The difference in performance may be especially important in estimating quantities that depend on tail features, including risk measures such as the expected shortfall. Here, using recent generalizations of the asymmetric Student-t and exponential power distributions to allow separate parameters to control skewness and the thickness of each tail, we fit daily financial return volatility and forecast expected shortfall for the S&P 500 index and a number of individual company stocks; the generalized distributions are used for the standardized innovations in a nonlinear, asymmetric GARCH-type model. The results provide evidence for the usefulness of the general distributions in improving fit and prediction of downside market risk of financial assets. Constrained versions, corresponding with distributions used in the previous literature, are also estimated in order to provide a comparison of the performance of different conditional distributions.     

THE GEOMETRY OF ASSET ADJUSTMENT WITH ADJUSTMENT COSTS

This paper provides a geometric analysis of asset adjustment behavior in response to changes in expected return and wealth. The analysis permits discussion of the role of different adjustment cost and risk attitude assumptions within a unified framework. It is shown that changes in expected return generally induce portfolio revision only if the marginal rate of substitution between assets is less than their relative marginal costs of adjustment. Wealth disturbances may induce sequential, rather than simultaneous, asset adjustment if marginal adjustment costs are constant or decreasing and the investor is risk neutral.     

Expected long-term rates of return when short-term returns are serially correlated

When short-term returns are serially uncorrelated, expected long-term and short-term returns are equal. However, we show that negative serial correlation among the short-term returns make the expected long-term returns lower than the short-term ones. Such serial correlation is likely to arise, for example, for an investor whose portfolio is invested abroad in assets denominated in foreign currencies, but who wants to make withdrawals in proportion to the fund's value in the domestic currency, and the exchange rate obeys long-term purchasing-power parity. Small-country sovereign wealth funds are leading examples of such investors. For the Norwegian GPFG, the expected annualized long-term rate of return in Norwegian kroner may be 0.7 to 1.8 percentage points lower than the expected short-term return. Negative contemporaneous correlation between global returns and changes in the real exchange rate may dampen and even reverse this result. Empirical evidence suggests that this may be the case for investors in USD-denominated assets domiciled in the United Kingdom, but not for investors domiciled in Norway or Germany. Empirically, we furthermore find that long-term annualized returns may fall short of short-term returns even when evaluated in real USD. Although negative serial correlation also shrinks the long-term variance, funds such as the GPFG should calibrate withdrawals to the expected long-term returns rather than the short-term ones.     

Bank Relationships and Firms' Financial Performance: The Italian Experience

We examine the connection between the number of bank relationships and firms' performance using a unique data set on Italian small firms for which banks are a major source of financing. Our evidence indicates that return on equity and return on assets decrease as the number of bank relationships increases with a stronger effect on small firms than large firms. We also find that interest expense over assets increases as the number of relationships increases. Particularly for small firms, these results are consistent with analyses suggesting that fewer bank relationships reduce information asymmetries and agency problems and outweigh hold‐up problems.     

Non‐additivity in Accounting Valuation: Theory and Applications

This paper has three objectives. First, to introduce a theoretical solution to the issue of non‐additivity between assets in place, relying on an accounting‐based valuation approach. Second, to explain how such an approach can be implemented empirically by measuring synergies between assets. Third, to present the properties of this non‐additive valuation technique. We use Choquet capacities, that is, non‐additive aggregation operators, to measure the interactions between assets and apply our methodology to a sample of US firms from the capital goods industry. To operationalize our approach we examine the relationships between synergies—captured by Choquet capacities—and the market‐to‐book ratio (proxying for growth options), and show how interactions between assets are consistently linked to a firm’s market‐to‐book ratio. We also measure firm‐specific productive efficiency relative to the industry and firm size. For large firms, efficiency, as defined by our approach, is positively associated with higher future operating cash flows. For small firms, efficiency is positively associated with higher future sales growth. We document that the non‐additive approach appears to be better able to identify expected relationships between efficiency and future performance than a simpler approach based on the market‐to‐book ratio.     

The implied Sharpe ratio

In an incomplete market, including liquidly traded European options in an investment portfolio could potentially improve the expected terminal utility for a risk-averse investor. However, unlike the Sharpe ratio, which provides a concise measure of the relative investment attractiveness of different underlying risky assets, there is no such measure available to help investors choose among the different European options. We introduce a new concept—the implied Sharpe ratio—which allows investors to make such a comparison in an incomplete financial market. Specifically, when comparing various European options, it is the option with the highest implied Sharpe ratio that, if included in an investor's portfolio, will improve his expected utility the most. Through the method of Taylor series expansion of the state-dependent coefficients in a nonlinear partial differential equation, we also establish the behaviour of the implied Sharpe ratio with respect to an investor's risk-aversion parameter. In a series of numerical studies, we compare the investment attractiveness of different European options by studying their implied Sharpe ratio.     

Risk and capital asset prices

This paper is an empirical examination of the statistical significance of the residual variance of individual assets as compared with the covariance of returns with various market portfolio proxies in predicting expected return. The data and analysis we present suggest that measures of covariance are no more significant than residual variance in predicting expected return. In this sense our paper is not supportive of the Sharpe-Lintner or Black versions of the capital asset pricing model.     

Community Asset Valuations by Non‐profit Government Entities

This paper examines an implication of applying International Financial Reporting Standards to the government sector in Australia. We posit both a self‐interest and a transparency motivation for local governments effecting revaluations of both infrastructure assets and community land. The self‐interest motivation was expected to manifest as a relationship between the amount of revaluation and CEO (or management team) remuneration. The transparency motivation was expected to result in a relationship between revaluation and the extent of spending on these assets, measured as both the quantum of materials and contracts expense, and as the quantum of contracts awarded by the entity above the disclosure threshold. We also speculated that revaluations may be used to signal to state governments a need for additional funds through capital and/or operating grants. At conventional levels of significance, we find no support for these relationships, suggesting that agency motivations at the local government level are either more subtle or non‐existent. As local government authorities in our study follow a reporting framework and standardised accounting procedures prescribed by the state government (in compliance with applicable AASB/IFRS standards), financial and public accountabilities are also likely to be a driver for the valuation of local infrastructure assets at fair value, and this is not likely to be undermined by the opportunistic incentives we have considered.     

Tests of the multiperiod two-parameter model

Although investors face multiperiod decision problems, there are conditions under which the results of the one-period two-parameter model apply period by period. In addition to the assumptions made in the development of the two-parameter model itself (a perfect capital market, investor risk aversion, and normal distributions of one-period portfolio returns), the critical assumption in a multiperiod context is that, for any t, returns on portfolio assets from t?1 to t are independent of stochastic elements of the state-of-the-world at time t that affect investor tastes for given levels of wealth to be obtained at t.One such element of the state-of-the-world is the nature of investment opportunities to be available at t. For example, if the level of expected returns on investment portfolios to be available at time t is uncertain at time t?1, and if the returns from t?1 to t on some investment assets are more strongly related to the level of expected returns at t than returns on other assets, then the former assets are better vehicles for hedging against the level of expected returns at t. This can affect the demands for assets and their prices in such a way that the simple results of the one-period two-parameter model do not hold.The empirical tests of this paper reveal no evidence of measurable relationships between the returns on portfolio assets from t?1 to t and the level of expected returns to be available at t. Indeed, in our opinion there is no reliable evidence that the level of expected returns changed during the 1953–1972 period.     

Diversification and generalized tracking errors for correlated non‐normal returns

Abstract

The probability distribution for the relative return of a portfolio constructed from a subset n of the assets from a benchmark, consisting of N assets whose returns are multivariate normal, is completely characterized by its tracking error. However, if the benchmark asset returns are not multivariate normal then higher moments of the probability distribution for the portfolio's relative return are not related to its tracking error. We discuss the convergence of generalized tracking error measures as the size of the subset of benchmark assets increases. Assuming that the joint probability distribution for the returns of the assets is symmetric under their permutations we show that increasing n makes these generalized tracking errors small (even though n « N). For n » 1 the probability distribution for the portfolio's relative return is approximately symmetric and strongly peaked about the origin. The results of this paper generalize the conclusions of Dynkin et al (Dynkin L, Hyman J and Konstantinovsky V 2002 Sufficient Diversification in Credit Portfolios (Lehman Brothers Fixed Income Research)) to more general underlying asset distributions.