Option hedging theory under transaction costs

The problem of option hedging in the presence of proportional transaction costs can be formulated as a singular stochastic control problem. Hodges and Neuberger [1989. Optimal replication of contingent claims under transactions costs. Review of Futures Markets 8, 222–239] introduced an approach that is based on maximization of the expected utility of terminal wealth. We develop a new algorithm to solve the corresponding singular stochastic control problem and introduce a new approach to option hedging which is closer in spirit to the pathwise replication of Black and Scholes [1973. The pricing of options and corporate liabilities. Journal of Political Economy 81, 637–654]. This new approach is based on minimization of a Black–Scholes-type measure of pathwise risk, defined in terms of a market delta, subject to an upper bound on the hedging cost. We provide an efficient backward induction algorithm for the problem of cost-constrained risk minimization, whose associated singular stochastic control problem is shown to be equivalent to an optimal stopping problem. This algorithm is then modified to solve the singular stochastic control problem associated with utility maximization, which cannot be reduced to an optimal stopping problem. We propose to choose an optimal parameter (risk-aversion coefficient or Lagrange multiplier) in either approach by minimizing the mean squared hedging error and demonstrate that with this “best” choice of the parameter, both approaches have similar performance. We also discuss the different notions of risk in both approaches and propose a volatility adjustment for the risk-minimization approach, which is analogous to that introduced by Zakamouline [2006. European option pricing and hedging with both fixed and proportional transaction costs. Journal of Economic Dynamics and Control 30, 1–25] for the utility maximization approach, thereby providing a unified treatment of both approaches.     

A note on the fundamental theorem of exact aggregation

If individual i's demands for a commodity are a function of prices, p, income M_i and a vector of attributes A_i, then aggregate demand is

This paper derives the necessary and sufficient conditions of f_i, F and a system of functions g_k(M₁,…,M_N,A₁,…,A_N) symmetric in the M's and A's such that F can be written in the form F(p, g, (M₁,…,M_n,A₁,…,A_N),…, g_n(M₁,…,M_n,A₁,… ,A_n)) for all values of its arguments.     

On modeling the agricultural sector in developing economies: An integrated approach of micro and macroeconomics

The paper introduces a theoretically consistent and empirically implementable method for the construction of general equilibrium models of the agricultural sector in a developing economy. The point of departure is the agricultural household, for which the microeconomic behavioral relations are formulated based on the assumption of utility and profit maximization. These relations are estimated from microeconomic data. In the second step the estimated microeconomic behavioral relations are aggregated across households into the macroeconomic behavioral relations, i.e., the supply and demand functions for the agricultural sector. Third, the linkage equations between the agricultural sector and the rest of the economy are specified on the basis of alternative assumptions on environmental and institutional characteristics and they are estimated from macroeconomic data. Finally, the macroeconomic behavioral relations and linkage equations are combined to provide a general equilibrium solution of the agricultural sector. The solution of the alternative equilibrium models can be used for comparative statics analysis of government policies and of changes in other exogenous variables. The illustrative application of the model is based on Indian data.     

International briefing 7: Training and development in Singapore

Singapore’s only resource is its people. It has made HRD as a key strategy for economic development since its inception. Its economic success story is entwined with the training and development of its workforce. A national manpower development infrastructure has been put in place to facilitate training and lifelong learning of its people for the twenty‐first century under a master plan called Manpower 21. Continuous training and skills development has been possible through close cooperation between the state, employers and the unions through unique working relationships between several policy‐making institutions, such as the National Manpower Council and the National Wages Council.     

A pragmatic decision model for inventory management with heterogeneous suppliers

For enterprises, it is imperative that the trade-off between the cost of inventory and risk implications is managed in the most efficient manner. To explore this, we use the common example of a wholesaler operating in an environment where suppliers demonstrate heterogeneous reliability. The wholesaler has partial orders with dual suppliers and uses lateral transshipments. While supplier reliability is a key concern in inventory management, reliable suppliers are more expensive and investment in strategic approaches that improve supplier performance carries a high cost. Here we consider the operational strategy of dual sourcing with reliable and unreliable suppliers and model the total inventory cost where the likely scenario lead-time of the unreliable suppliers extends beyond the scheduling period. We then develop a Customized Integer Programming Optimization Model to determine the optimum size of partial orders with multiple suppliers. In addition to the objective of total cost optimization, this study takes into account the volatility of the cost associated with the uncertainty of an inventory system.     

Do active fund managers care about capital gains tax efficiency?

This study investigates the tax efficiency of actively managed equity funds by conducting a previously unaddressed natural experiment. Specifically, we examine whether asset sales were timed to take advantage of the introduction of a substantial discount to realized capital gains when the holding period was at least 1 year. Institutional equity fund management in Australia is principally focused on the pre-fee and pre-tax performance surveys of leading asset consultants. Given this industry setting, our study is important because tax efficiency is not accounted for directly in the reported performance numbers, and is thus opaque. We find that active fund managers overall have significantly increased the proportion of long-term capital gains realized after the change in taxation code, although there are significant variations across funds. We also find that active fund managers realize more long-term gains on both large capitalization and low volatility stocks.     

An exploratory study of factors affecting the failure of local small and medium enterprises

There is increasing recognition of the potential contribution of local small and medium enterprises (SMEs) towards employment and economic growth in Singapore. Unfortunately, SMEs tend to have a high mortality rate. A survey was conducted among owners or managers of local SMEs to identify factors perceived as important in affecting business failures. The research results indicate that endogenous factors were viewed by respondents as more critical in causing SME failures than exogenous factors. Important exogenous and endogenous factors in specific areas were identified.Lau Geok Theng is Senior Lecturer, Department of Marketing, National University of Singapore, 10 Kent Ridge Crescent, Singapore 0511, tel: (65) 772-3179, fax: (65) 779-5941. Jasmine Lim Wang Boon is with the United Overseas Bank, Singapore.     

The Pacific basin in world trade an analysis of changing trade patterns, 1955–1975

In two previous papers by the same authors the data basis for the trade flows and the export prices in the Pacific Basin has presented and documented. In this third report the changing pattern of Pacific Basin trade over the period 1955–1975 is analyzed, using as tools export growth decomposition indexes, trend analysis, and regression analysis of the price elasticity of import market shares.     

A method for constructing an intertemporal utility function from a Friedmanian consumption function

It is shown that the intertemporal utility function can be reconstructed from data on demands if they are restricted to be linear in wealth, or Friedmanian.