A multivariate Lévy process model with linear correlation

In this paper, we develop a multivariate risk-neutral Lévy process model and discuss its applicability in the context of the volatility smile of multiple assets. Our formulation is based upon a linear combination of independent univariate Lévy processes and can easily be calibrated to a set of one-dimensional marginal distributions and a given linear correlation matrix. We derive conditions for our formulation and the associated calibration procedure to be well-defined and provide some examples associated with particular Lévy processes permitting a closed-form characteristic function. Numerical results of the option premiums on three currencies are presented to illustrate the effectiveness of our formulation with different linear correlation structures.     

Explaining asset pricing puzzles associated with the 1987 market crash

The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features of individual stock options, equity returns, and interest rates.     

How does the market variance risk premium vary over time? Evidence from S&P 500 variance swap investment returns

We explore whether the market variance risk premium (VRP) can be predicted. We measure VRP by distinguishing the investment horizon from the variance swap’s maturity. We extract VRP from actual S&P 500 variance swap quotes and we test four classes of predictive models. We find that the best performing model is the one that conditions on trading activity. This relation is also economically significant. Volatility trading strategies which condition on trading activity outperform popular benchmark strategies, even once we consider transaction costs. Our finding implies that broker dealers command a greater VRP to continue holding short positions in index options in the case where trading conditions deteriorate.     

The impact of the French Tobin tax

We analyze the impact of the introduction of the French Tobin tax on the turnover and measures of the liquidity and volatility of the affected stocks with nonparametric tests on individual stocks, difference-in-difference tests and other robustness checks controlling for simultaneous month-of-the-year and size effects. Our findings indicate that the tax produces a significant reduction in turnover and volatility (measured in terms of stock price volatility and the high–low price range) and inconclusive effects on liquidity when the latter is evaluated under the two dimensions of the estimated bid–ask spread and the Amihud (2002) price impact ratio.     

Smoothing Mechanisms in Defined Benefit Pension Accounting Standards: A Simulation Study*

The accounting for defined benefit (DB) pension plans is complex and varies significantly across jurisdictions despite recent international convergence efforts. Pension costs are significant, and many worry that unfavorable accounting treatment could lead companies to terminate DB plans, a result that would have important social implications. A key difference in accounting standards relates to whether and how the effects of fluctuations in market and demographic variables on reported pension cost are “smoothed". Critics argue that smoothing mechanisms lead to incomprehensible accounting information and induce managers to make dysfunctional decisions. Furthermore, the effectiveness of these mechanisms may vary. We use simulated data to test the volatility, representational faithfulness, and predictive ability of pension accounting numbers under Canadian, British, and international standards (IFRS). We find that smoothed pension expense is less volatile, more predictive of future expense, and more closely associated with contemporaneous funding than is “unsmoothed” pension expense. The corridor method and market‐related value approaches allowed under Canadian GAAP have virtually no smoothing effect incremental to the amortization of actuarial gains and losses. The pension accrual or deferred asset is highly correlated with the pension plan deficit/surplus. Our findings complement existing, primarily archival, pension accounting research and could provide guidance to standard‐setters.