Smooth monotone covariance for elliptical distributions and applications in finance

Sample covariance is known to be a poor estimate when the data are scarce compared with the dimension. To reduce the estimation error, various structures are usually imposed on the covariance such as low-rank plus diagonal (factor models), banded models and sparse inverse covariances. We investigate a different non-parametric regularization method which assumes that the covariance is monotone and smooth. We study the smooth monotone covariance by analysing its performance in reducing various statistical distances and improving optimal portfolio selection. We also extend its use in non-Gaussian cases by incorporating various robust covariance estimates for elliptical distributions. Finally, we provide two empirical examples using Eurodollar futures and corporate bonds where the smooth monotone covariance improves the out-of-sample covariance prediction and portfolio optimization.     

On the game interpretation of a shadow price process in utility maximization problems under transaction costs

To any utility maximization problem under transaction costs one can assign a frictionless model with a price process S ^?, lying in the bid/ask price interval $[\underline{S}, \overline{S}]$ . Such a process S ^? is called a shadow price if it provides the same optimal utility value as in the original model with bid-ask spread. We call S ^? a generalized shadow price if the above property is true for the relaxed utility function in the frictionless model. This relaxation is defined as the lower semicontinuous envelope of the original utility, considered as a function on the set $[\underline{S}, \overline{S}]$ , equipped with some natural weak topology. We prove the existence of a generalized shadow price under rather weak assumptions and mark its relation to a saddle point of the trader/market zero-sum game, determined by the relaxed utility function. The relation of the notion of a shadow price to its generalization is illustrated by several examples. Also, we briefly discuss the interpretation of shadow prices via Lagrange duality.     

Optimal Diversification: Reconciling Theory and Evidence

In this paper we show that the main empirical findings about firm diversification and performance are consistent with the maximization of shareholder value. In our model, diversification allows a firm to explore better productive opportunities while taking advantage of synergies. By explicitly linking the diversification strategies of the firm to differences in size and productivity, our model provides a natural laboratory to investigate several aspects of the relationship between diversification and performance. Specifically, we show that our model can rationalize the evidence on the diversification discount ( Lang and Stulz (1994) ) and the documented relation between diversification and productivity ( Schoar (2002) ).     

Accounting rules,equity valuation,and growth options

In a model with irreversible capacity investments, we show that financial statements prepared under replacement cost accounting provide investors with sufficient information for equity valuation purposes. Under alternative accounting rules, including historical cost and value in use accounting, investors will generally not be able to value precisely a firm’s growth options and therefore its equity. For these accounting rules, we describe the range of valuations that is consistent with the firm’s financial statements. We further show that replacement cost accounting preserves all value-relevant information if the firm’s investments are reversible. However, the directional relation between the value of the firm’s equity and the replacement cost of its assets is different from that in the setting with irreversible investments.     

Hedging dairy production losses using weather-based index insurance

This article proposes a temperature–humidity index insurance product and examines whether this product can effectively protect against the risk of reduced milk production caused by heat stress. Results suggest that even when premiums are at higher than actuarially fair levels and the insurance purchaser is faced with both spatial and temporal basis risks, a temperature–humidity index insurance product would provide risk management benefits to a representative south‐central Georgia dairy producer.     

Forecasting stock market returns over multiple time horizons

In this paper, we seek to demonstrate the predictability of stock market returns and explain the nature of this return predictability. To this end, we introduce investors with different investment horizons into the news-driven, analytic, agent-based market model developed in Gusev et al. [Algo. Finance, 2015, 4, 5–51]. This heterogeneous framework enables us to capture dynamics at multiple timescales, expanding the model’s applications and improving precision. We study the heterogeneous model theoretically and empirically to highlight essential mechanisms underlying certain market behaviours, such as transitions between bull and bear markets and the self-similar behaviour of price changes. Most importantly, we apply this model to show that the stock market is nearly efficient on intraday timescales, adjusting quickly to incoming news, but becomes inefficient on longer timescales, where news may have a long-lasting nonlinear impact on dynamics, attributable to a feedback mechanism acting over these horizons. Then, using the model, we design algorithmic strategies that utilize news flow, quantified and measured, as the only input to trade on market return forecasts over multiple horizons, from days to months. The backtested results suggest that the return is predictable to the extent that successful trading strategies can be constructed to harness this predictability.     

ON UTILITY-BASED PRICING OF CONTINGENT CLAIMS IN INCOMPLETE MARKETS

We study the uniqueness of the marginal utility-based price of contingent claims in a semimartingale model of an incomplete financial market. In particular, we obtain that a necessary and sufficient condition for all bounded contingent claims to admit a unique marginal utility-based price is that the solution to the dual problem defines an equivalent local martingale measure.     

International entrepreneurship, venture capital networks, and reinvestment decisions

Prior research has established that venture capitalists (VCs) may face significant obstacles in financing ventures from emerging or transition economies. Such hurdles are usually attributed to the weaknesses of host countries’ institutional systems, especially regulatory. These institutional pitfalls may thwart VCs’ ability to exit a portfolio company leading to lower returns than expected. Developing this approach, we argue that exit strategies may also be difficult to execute when VCs expand into advanced economies although for different reasons. Thus, we show that both necessity entrepreneurship prevalent in emerging economies and opportunity entrepreneurship prevalent in advanced economies are positively associated with the number of investment rounds received by portfolio companies. In contrast, we establish that VC firm capital and network density are negatively associated with the number of rounds provided to portfolio companies across distinct institutional environments. This suggests that VCs may improve their performance by choosing an appropriate strategy to navigate unfamiliar institutional environments to minimize their liability of foreignness. Finally, we find that the interaction of VC capital and network density is positively related to the number of VCs’ investment rounds. Apparently, resource-rich VC firms may not fully realize the informational benefits of their dense “knowledge networks” due to insufficient collaboration with partners. At the same time, such VCs may no longer enjoy access to free information flows from prospective allies. Hence, network density and superior resources combined may lead to a greater number of investment rounds.     

Principal components analysis for correlated curves and seasonal commodities: The case of the petroleum market

This article presents a family of term structure models that can be applied to value contingent claims in multicommodity and seasonal markets. We apply the framework to the futures contracts on crude and heating oils trading on NYMEX. We show how to deal with the problem of having to value products depending on the “whole” market, such as spread options on contracts on a single commodity maturing at different times (time‐spreads) or spread options on the added value of the products derived from the raw commodity (crack spreads). Also, we show how to build term structure models for a commodity that experiences seasonality, such as heating oil. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1019–1035, 2002     

Inspiration vs. perspiration in economic development of the Former Soviet Union and China (ca. 1920–2010)

Here, we discuss the role of both perspiration factors (physical and human capital) and inspiration factors (Total Factor Productivity) in the economic development of the Former Soviet Union area (FSU) and China, ca. 1920–2010. Using a newly created dataset, we find that during the Socialist central‐planning period, economic growth in both countries was largely driven by physical capital accumulation. This finding follows logically from the development policies in place at that time. During their transition periods, (i.e., starting from the late 1970s in China and the late 1980s in the FSU), China managed to keep technical inefficiency of production factors in check, largely by massively increasing its human capital, thereby lowering the physical‐to‐human capital ratio. In contrast, the FSU accomplished a similar outcome largely through reducing its stock of physical capital. As a result, although there was little difference in technical efficiency between these two economies, China's emphasis on human capital formation made it easier for this country to improve its general productivity and to increase per capita growth. This changed in the late 1990s and early 2000s, when the FSU began to recover economically, regaining its 1990 levels of output and productivity.