How to make Dupire’s local volatility work with jumps

There are several (mathematical) reasons why Dupire’s formula fails in the non-diffusion setting. And yet, in practice, ad-hoc preconditioning of the option data works reasonably well. In this note, we attempt to explain why. In particular, we propose a regularization procedure of the option data so that Dupire’s local vol diffusion process recreates the correct option prices, even in manifest presence of jumps.     

Bridging the Gap between Interest Rates and Investments

The links between interest rates, cost of capital, hurdle rates, and capital allocation have been remarkably weak during the last few years. For instance, whereas the current yield on the World Government Bond Index is a paltry 1.2%, survey evidence suggests that the median reported investment hurdle rate of S&P 100 companies is as high as 18%. In this report, members of J.P Morgan's corporate finance advisory group explain why the cost of capital for most companies is unlikely to increase materially even if interest rates rise as projected. This suggests that companies have room to lower their hurdle rates. Moreover, as the authors argue, a reduction in hurdle rates is likely to be beneficial since excessively high hurdle rates can have the effect of reducing value by sacrificing profitable growth opportunities and increasing the firm's risk profile. The report concludes with a framework for corporate hurdle rates and capital allocation strategies designed to help companies make better investment decisions.     

From risk analysis in Europe to European risk analysis: the first ten years of SRA-E (1987-97)

Risk analysis has both a long past and a short history. This latter is written in the past 30 years. Technology's potential to create sometimes irreversible damage, as well as unprecedented improvement in standard of living, prompted the need for risk analysis. The Society for Risk Analysis (SRA) was created in the United States at the end of the 1970s. Its purpose was and is to bring together scientists and professionals concerned by issues of risk to health, safety and the environment, on an international and interdisciplinary basis. This article traces European participation in the SRA and recounts the founding of the chapter Society for Risk Analysis- Europe (SRA-E) in 1987. The composition of founding, Advisory and Executive Committees is given, as are themes and Directors of the seven Conferences held by SRA-E to date. SRA in 1987 counted 69 Europe-based members in 13 countries; in 1997, 25 countries are represented in SRA-Europe by 317 members. A trend is seen from a mainly geographic extension of SRA towards a more specific identity springing from risk research and management as practised today in Europe. The multicultural and multilingual experience of members, and their capacity for collaboration across national and disciplinary lines, are among European risk analysis' strongest assets. The present Journal of Risk Research can provide a forum for reinforcing new currents in risk analysis. The creation of a European university cursus in risk studies is recommended, as is a stronger role for SRA-E as a body of expertise. A call is made for risk analysis sustainable in national and cultural contexts removed from those that have developed today's art and practice: needed are appropriate conceptualizations of risk, management methods, and indicators of success. The Mediterranean basin and North Africa are targeted as areas for development and new learning for risk analysts, communicators, managers and researchers in the 21st century.     

A transform approach to compute prices and Greeks of barrier options driven by a class of Lévy processes

In this paper we propose a transform method to compute the prices and Greeks of barrier options driven by a class of Lévy processes. We derive analytical expressions for the Laplace transforms in time of the prices and sensitivities of single barrier options in an exponential Lévy model with hyper-exponential jumps. Inversion of these single Laplace transforms yields rapid, accurate results. These results are employed to construct an approximation of the prices and sensitivities of barrier options in exponential generalized hyper-exponential Lévy models. The latter class includes many of the Lévy models employed in quantitative finance such as the variance gamma (VG), KoBoL, generalized hyperbolic, and the normal inverse Gaussian (NIG) models. Convergence of the approximating prices and sensitivities is proved. To provide a numerical illustration, this transform approach is compared with Monte Carlo simulation in cases where the driving process is a VG and a NIG Lévy process. Parameters are calibrated to Stoxx50E call options.     

Accuracy of Premium Calculation Models for CAT Bonds—An Empirical Analysis

CAT bonds are of significant importance in the field of alternative risk transfer. Because the market of CAT bonds is not complete, the application of an appropriate pricing model is of high relevance. We apply different premium calculation models to compare them with regard to their predictive power. Without taking the financial crisis into account, a version of the Wang transformation model and the linear model are the most accurate ones. In contrast, under consideration of the financial crisis, all analyzed models are approximately equivalent. Furthermore, we find that CAT bond specific information does not improve out‐of‐sample results.     

Meeting in the middle: joining reflection and action in complex public sector projects

In order for co-production to become a viable way of working in public sector management and policy-making, practitioners need to be more reflective and researchers need to be more action oriented. This article discusses reflective practice, action research and the idea of a community of inquiry in which both practice and science work together. The authors illustrate their ideas with an example from their own practice and explain the advantages of their approach.     

Why Managers Use Cost Allocations: A Research Note

Using an experimental design, this paper investigates empirically the conditions under which managers use cost allocations for decision-making purposes. The paper focuses on decision-risk in the context of short-term decision-making when most capacity costs are unavoidable. Decision-risk is determined in this paper by a combination of two factors: uncertainty and irreversibility. Cost allocations can serve as a reference point for a decision maker to deal with decision-risk. Three hypotheses are formulated: (1) the combination of both uncertainty and decision irreversibility induces the use of cost allocations. However, (2) certainty or (3) decision reversibility alone are not expected to induce the use of cost allocations. The hypotheses were tested in an experiment, in which senior managers participated. The experimental results supported the hypotheses.     

Competition in the presence of individual demand uncertainty

This article offers a tractable model of (oligopolistic) competition in differentiated product markets characterized by individual demand uncertainty. The main result shows that, in equilibrium, firms offer advance purchase discounts and that these discounts are larger than in the monopolistic benchmark. Competition reduces welfare by increasing the fraction of consumers who purchase in advance, that is, without (full) knowledge of their preferences.