Pricing and capital requirements for with profit contracts: modelling considerations

The aim of this paper is to provide an assessment of alternative frameworks for the fair valuation of life insurance contracts with a predominant financial component, in terms of impact on the market consistent price of the contracts, the embedded options, and the capital requirements for the insurer. In particular, we model the dynamics of the log-returns of the reference fund using the so-called Merton (1976 Merton, RC. 1976. Option pricing when underlying stock returns are discontinuous. J. Finan. Econ., : 125–144.  [Google Scholar]) process, which is given by the sum of an arithmetic Brownian motion and a compound Poisson process, and the Variance Gamma (VG) process introduced by Madan and Seneta (1990 Madan, DB and Seneta, E. 1990. The variance gamma (VG) model for share market returns. J. Bus., 63: 511–524. [Crossref], [Web of Science ®] , [Google Scholar]), and further refined by Madan and Milne (1991 Madan, DB and Milne, F. 1991. Option pricing with VG martingale components. Math. Finan., 1: 39–45. [Crossref] , [Google Scholar]) and Madan et al. (1998 Madan, DB, Carr, P and Chang, E. 1998. The variance gamma process and option pricing. Eur. Finan. Rev., 2: 79–105. [Crossref] , [Google Scholar]). We conclude that, although the choice of the market model does not affect significantly the market consistent price of the overall benefit due at maturity, the consequences of a model misspecification on the capital requirements are noticeable.     

Regression-based algorithms for life insurance contracts with surrender guarantees

We present a general framework for pricing life insurance contracts embedding a surrender option. The model allows for several sources of risk, such as uncertainty in mortality, interest rates and other financial factors. We describe and compare two numerical schemes based on the Least Squares Monte Carlo method, emphasizing underlying modeling assumptions and computational issues.     

Determinants of financial covenants and pricing of debt in private debt contracts: the UK evidence

This paper presents details of financial covenants given by a sample drawn from the largest 200 non-financial quoted firms in the UK in private debt contracts and analyses these data to see whether there are relationships between the nature of the covenants given and firm characteristics. Data were obtained from 72 firms, of which 17 gave no financial covenants. Firm size was found to be the only significant factor influencing whether firms did or did not give covenants as well as the only factor which influenced the margin given on debt. Some types of covenants given were found to be different from those found in previous research. In particular, there is greater use of EBITDA as a base for both interest cover and gearing covenants. This shows the importance of cash flow based lending as opposed to asset based lending for general financing for large firms.     

Government contracts and US bond yield spreads: A study on costs and benefits of materialized political connections

In a 1991–2013 sample of bonds issued by US public firms, we find that the cost of debt (yield spread relative to comparable Treasuries) of suppliers to government agencies is contingent on the strategic importance of the supplier's industry. The yield spreads for strategically unimportant government suppliers are higher than for firms that are not government suppliers. If government contracts serve as tangible evidence of political connections, these higher yield spreads indicate that weaker corporate governance as a cost of political connections outweighs the benefits of said connections. For the subsample of government suppliers from strategically important industries, where the benefits of implicit bailout guarantees and revenue stability outweigh the corporate governance problems, the cost of debt is lower than for firms that are not government suppliers. The higher (lower) cost of debt for strategically unimportant (strategically important) suppliers is confined to contracting with the federal government. Our findings are robust to alternative variable and sample specifications, and to endogeneity concerns.     

Pricing mortgage insurance contracts under housing price cycles with jump risk: evidence from the U.K. housing market

Previous studies have investigated the determinants of housing price cycles in the housing market; however, we observed the phenomenon of housing price jumps in the 2007 subprime crisis. This paper presents a discussion on the housing price cycle and abnormal price jumps to describe the behavior of housing prices in the United Kingdom. The empirical results show that the impact factors of housing cycles are market risk and the switching factor. Furthermore, the impact factors of jump risks include the bursting of the housing bubble and financial crises. Therefore, in this paper, we employ the Markov switching model with jump risks to value the MI contracts and analyze the influences of housing price cycles, jump risks, risks of market interest rate, and the prepayment risks on MI premiums. The results of sensitivity analysis show that more volatile housing price index returns, as well as longer periods of higher volatility in housing prices, raise MI premiums. Moreover, the MI premium is positively related to the absolute value of the average jump amplitude and the shock frequency of abnormal events. There is the tradeoff between the market interest rate and the prepayment risk. The influences of market interest rate are different on MI premium with/without prepayment risks.     

The certification value of private debt renegotiation and the design of financial contracts: Empirical evidence from Europe

By using a sample of bank loan renegotiations by European firms, I show that the renegotiation of financial contracts bears a certification value, while deeply changing the contractual features of the loan over time, to the benefit of shareholders. I find that amendments to financial covenants and to loan amounts increase the cumulative abnormal returns of a borrowing firm by 10–15%. Early and less frequent renegotiations of bilateral loans with short maturities also imply a positive stock market reaction. Amendments signaling the early accrual of new and positive information allow increasing firm value.     

Labor market reform and price stability: An application to the Euro Area

Central bankers frequently suggest that labor market reform may be beneficial for inflation management. This paper investigates this topic by simulating the effects of reductions in firing costs and unemployment benefits on inflation volatility in the Euro Area, using an estimated New Keynesian model with search and matching frictions. Qualitatively, changes in labor market policies alter the volatility of inflation in response to shocks, by affecting the volatility of the three components of real marginal costs (hiring costs, firing costs and wage costs). Quantitatively, we find, however, that neither policy is likely to have an important effect on inflation volatility, due to the small contribution of hiring and firing costs to inflation dynamics.     

New development: The application of incomplete contract theory to documenting Social Impact Bonds

ABSTRACT

Nobel laureate Oliver Hart’s work in developing a theory of incomplete contracting is relevant to explaining the evolution of the pay for success contracts that undergird Social Impact Bonds (SIBs). By its very nature, a pay for success contract that supports a SIB is likely to be functionally incomplete in that it is unable to describe and differentiate in the initial contract all relevant future states of the world in which the contract is to operate. Navigating this incomplete world can be particularly challenging when it comes to government contracting for quality outcomes in social services. Accordingly, Hart’s incomplete contracting framework can help us to think more clearly about how to document a pay for success contract that best supports a SIB transaction.     

Capital Structure in an Industry Equilibrium with Endogenous Liquidation Values

This paper investigates the interaction between financial structure,liquidation values and product market equilibrium. Liquidation values depend on how many firms are liquidated, and therefore on the industry equilibrium of capital structures and of technology choices.We show that firms using a technology with high liquidation value issue lessdebt than those with low liquidation value even if these ones may beinefficiently liquidated. With respect to the equilibrium in the industry,we obtain that even if in equilibrium all firms use the same technology,firms will use widely different capital structures.     

L-performance with an application to hedge funds

This paper introduces a new parametric fund performance measure, called the L-performance. The L-performance is an alternative to the Sharpe performance, which is commonly used in practice despite its inability to account for skewness and heavy tails of unconditional return distributions. The L-performance improves upon the Sharpe measure in this respect. Technically, it resembles the Sharpe measure in that it is defined as a ratio of the first- and second-order moments, which are the trimmed L-moments instead of the conventional (power) moments. The trimming parameters allow for focusing the L-performance on specific risk levels of interest, according to financial risk criteria. For illustration, a set of L-performances is computed for a variety of hedge funds. The empirical study shows the use of L-performance for fund ranking and return smoothing (manipulation) control.     

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.     

Efficiency tests with overlapping data: an application to the currency options market

This paper presents the results of an empirical study into the efficiency of the currency options market. The methodology derives from a simple model often applied to the spot and forward markets for foreign exchange. It relates the historic volatility of the underlying asset to the implied volatility of an option on the underlying at a specified prior time and then proceeds to test obvious hypotheses about the values of the coefficients. The study uses panel regression to address the problem of overlapping data which leads to dependence between observations. It also uses volatility data directly quoted on the market in order to avoid the biases which may occur when ‘backing out’ volatility from specific option pricing models. In general, the evidence rejects the hypothesis that the currency option market is efficient. This suggests that implied volatility is not the best predictor of future exchange rate volatility and should not be used without modification: the models presented in this paper could be a way of producing revised forecasts.     

Discrete games with flexible information structures: an application to local grocery markets

Game‐theoretic models are frequently employed to study strategic interaction between agents. Empirical research has focused on estimating payoff functions while maintaining strong assumptions regarding the information structure of the game. I show how to relax informational assumptions to enhance the credibility of empirical analysis in discrete games. I apply the method to data on the entry and exit patterns of grocery stores. The model provides useful bounds on equilibrium outcomes. In addition, the empirical analysis indicates that more restrictive informational assumptions can generate qualitatively misleading counterfactual outcomes.     

Simultaneous borrowing of information across space and time for pricing insurance contracts: An application to rating crop insurance policies

Changing climate and technology can often lead to nonstationary losses across both time and space for a variety of insurance lines including property, catastrophe, health, and life. As a result, naive estimation of premium rates using past losses will tend to be biased. We present three successively flexible data‐driven methodologies to nonparametrically smooth across both space and time simultaneously, thereby appropriately incorporating possibly nonidentically distributed data into the rating process. We apply these methodologies in estimating U.S. crop insurance premium rates. Crop insurance, with global premiums totaling $4.1 trillion in 2018, is an interesting application as losses exhibit both temporal and spatial nonstationarity. We find significant borrowing of information across both time and space. We also find all three methodologies improve both the stability and accuracy of crop insurance premium rates. The proposed methods may be of relevance for other lines of insurance characterized by spatial and/or temporal nonstationary losses.     

Modelling illiquidity spillovers with Hawkes processes: an application to the sovereign bond market

Modelling the dynamics of (il)liquidity across assets is an important yet complicated task, especially when considering significant deteriorations of liquidity conditions. Here, we propose a peak-over-threshold method to identify abrupt liquidity drops from limit order book data and we model the time-series of these illiquidity events across multiple assets as a multivariate Hawkes process. This allows us to quantify both the self-excitation of extreme changes of liquidity in the same asset (illiquidity spirals) and the cross-excitation across different assets (illiquidity spillovers). Applying the method to the MTS sovereign bond market, we find significant evidence for both illiquidity spillovers and spirals. The proportion of shocks explained by illiquidity spillovers roughly doubles from 2011 to 2015, suggesting an increased synchronization of extreme illiquidity across assets.     

Aggregating risk capital, with an application to operational risk

We describe a numerical procedure to obtain bounds on the distribution function of a sum of n dependent risks having fixed marginals. With respect to the existing literature, our method provides improved bounds and can be applied also to large non-homogeneous portfolios of risks. As an application, we compute the VaR-based minimum capital requirement for a portfolio of operational risk losses. JEL Classification G20 · 60E15 · 91B30     

Pro-poor indirect tax reforms,with an application to Mexico

This paper proposes a methodology for testing for whether tax reforms are pro-poor. This is done by extending stochastic dominance techniques to identify tax reforms that will be deemed absolutely or relatively pro-poor by a wide spectrum of poverty analysts. The statistical properties of the various estimators are also derived in order to make the method implementable using survey data. The methodology is used to assess the pro-poorness of possible reforms to Mexico’s indirect tax system. This leads to the identification of several possible pro-poor tax reforms in that country. It also shows how the pro-poorness of a tax reform depends on one’s conception of poverty as well as on the revenue and efficiency impact of the reform.     

High-speed rail construction and labor investment efficiency: Evidence from an emerging market

This study investigates the association between high-speed rail (HSR) construction and labor investment efficiency. Using unique hand-collected data on HSR construction over the period 2008–2019, we find that HSR construction can significantly decrease inefficient labor investment in China. In addition, we find that this negative relationship is (a) strong in state-owned companies and in firms located in big cities and (b) weak in financially constrained firms and in firms located in areas with a strong religious atmosphere. Consistent with the theoretical prediction, we find that the HSR construction mitigates inefficient labor investment by reducing information asymmetry between managers and investors and enhancing labor mobility. Overall, our findings are robust to alternative measurements, additional controls, fixed effects, and endogeneity concerns. Our findings have implications for firms’ top management to make strategic decisions and for government’s bodies/policymakers in relevance to HSR investment decisions.     

Latent liquidity: A new measure of liquidity,with an application to corporate bonds

We present a new measure of liquidity known as “latent liquidity” and apply it to a unique corporate bond database. Latent liquidity is defined as the weighted average turnover of investors who hold a bond, in which the weights are the fractional investor holdings. It can be used to measure liquidity in markets with sparse transactions data. For bonds that trade frequently, our measure has predictive power for both transaction costs and the price impact of trading, over and above trading activity and bond-specific characteristics thought to be related to liquidity. Additionally, this measure exhibits relationships with bond characteristics similar to those of other trade-based measures.     

A moment inequality with an application to the central limit theorem

Abstract

Consider a sequence of independent random variables (r.v.) X ₁ X ₂, …, X_n , … , with the same distribution function (d.f.) F(x). Let E (X_n ) = 0, _E , E (?(X)) denoting the mean value of the r.v. ? (X). Further, let the r.v. where have the d.f. F _n (x). It was proved by Berry [1] and the present author (Esseen [2], [4]) that Φ(x) being the normal d.f.