Profit Multiplier in Covered Currency Trading with Leverage

Currency trading, fully hedged with forward contracts and propelled by leverage, is enunciated within a microstructure of trade in foreign exchange with real-time data from Reuters data banks, and verified with banks and exchange dealers, first without and then with transactions costs. It is shown that iterative trading operations compound net profits significantly, and the existing academic maxim on arbitrage is thus raised to a new height—both in terms of theory and practice.     

Optimum Capital Structure Redefined

Within a dynamic framework of capital growth and income generation, optimum capital structure of a firm is redefined under two alternative hypotheses. By the optimum control theory, it is shown that under conditions of perfect competition optimum equity/debt ratio of a firm can be uniquely determined in intertemporal maximization models of investor behavior. The result is new, but it is juxtaposed in the vast body of existing literature and finally compared with the Lintner-Sau and Modigliani-Miller models.     

Adapted hedging

Exponentials of squared returns in Gaussian densities, with their consequently thin tails, are replaced by the absolute return to form Laplacian and exponentially tilted Laplacian densities at unit time. Scaling provides densities at other maturities. Stochastic processes with these marginals are identified. In addition to a specific local volatility model the densities are consistent with the difference of compound exponential processes taken at log time and scaled by the square root of time. The underlying process has a single parameter, the constant variance rate of the process. Delta hedging using Laplacian and Asymmetric Laplacian implied volatilities are developed and compared with Black Merton Scholes implied volatility hedging.The hedging strategies are implemented for stylized businesses represented by dynamic volatility indexes. The Laplacian hedge is seen to be smoother for the skew trade. It also performs better through the financial crisis for the sale of strangles. The Laplacian and Gaussian models are then synthesized as special cases of a model allowing for other powers between unity and the square. Numerous hedging strategies may be run using different powers and biases in the probability of an up move. Adapted strategies that select the best performer on past quarterly data can dominate fixed strategies. Adapted hedging strategies can effectively reduce drawdowns in the marked to market value of businesses trading options.     

A note on sufficient conditions for no arbitrage

It is shown that the absence of call spread, butterfly spread and calendar spread arbitrages is sufficient to exclude all static arbitrages from a set of option price quotes across strikes and maturities on a single underlier.     

Financial equilibrium with non-linear valuations

Classical Arrow Debreu equilibria employ budget feasibility to require individuals to ensure excess supplies to be nonnegative in value using the single equilibrium price system for valuation purposes. Yet by the selection of state contingent prices, they seek excess supplies that are nonnegative in each component, and not just the value. A financial equilibrium, on the other hand, defines acceptable economic risks as excess supplies that are nonnegative in value for a number of prespecified valuation price systems. The collection of prespecified valuation price systems may be referred to as features for which clearing is sought. The number of features will generally be less than the number of states. It is then shown that by also defining budget feasibility nonlinearly one may construct a financial equilibrium with fewer securities than there are features to be cleared.     

Exchange Rate Exposure of Exporting and Importing Firms

Although economic theory and conventional wisdom suggest that U.S. multinationals and export-oriented firms are adversely affected by a strengthening dollar and benefit from a depreciating dollar, the research to date provides little evidence of any relationship between FX changes and the stock prices of such firms. The authors propose a "dual-effect" hypothesis that distinguishes between (1) the direct competitive effect of currency induced changes on the effective price to consumers of the firm's products and (2) an indirect effect stemming from the generally positive correlations between currency levels and the strength of the domestic economy. Thus, for example, while a strong dollar hurts exports, it also tends to be associated with a strong domestic market and higher domestic sales. For this reason, the net effect on exporters of a stronger dollar could be close to zero. On the other hand, a weak dollar tends to have a "doubly" negative effect on importers because of higher import prices and the associated weakness of the local economy. For this reason, importers—in contrast to exporters—are likely to have significant exposures to currency fluctuations.
Consistent with these arguments, the authors' econometric analysis reveals a significantly positive currency exposure for importers and insignificant exposure for exporters, based on correlations between stock returns and currency changes. But when the benchmark is non-exporting domestic firms instead of a marketwide index (which contains exporters), a stronger currency is associated with a significantly negative effect on exporters.