Volume 3, No. 1, First Quarter 2005

Practitioner’s Digest • Vol. 3, No. 1

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

A Markov Chain Monte Carlo Method for Derivative Pricing and Risk Assessment

by: Sanjiv R. Das and Alistair Sinclair

Derivative security pricing and risk measurement relies increasingly on lattice representations of stochastic processes, which are a discrete approximation of the movement of the underlying securities. Pricing is undertaken by summation of node values on the lattice. When the lattice is large (which is the case when high accuracy is required), exhaustive enumeration of the nodes becomes prohibitively costly. Instead, Monte Carlo simulation is used to estimate the lattice value by sampling appropriately from the nodes. Most sampling methods become extremely error-prone in situations where the node values vary widely. This paper presents a Markov chain Monte Carlo scheme, adapted from Sinclair and Jerrum (Information and Computation 82 (1989)), that is able to overcome this problem, provided some partial (possibly very inaccurate) information about the lattice sum is available. This partial information is used to direct the sampling, in similar fashion to traditional importance sampling methods. The key difference is that the algorithm allows backtracking on the lattice, which acts in a "self-correcting" manner to minimize the bias in the importance sampling.

Asset/Liability Management and Enterprise Risk Management of an Insurer

by: Sanjiv R. Das and Alistair Sinclair

Risk management techniques used in banks and trading floors are generally not applicable to insurance companies. Risk measures and risk monitoring approaches must be developed to respond to the challenges to the insurance industry. This paper describes the current risk management practices for both life and general insurance businesses, and proposes the corporate model approach that extends the present approaches to provide corporate management solutions, enterprise risk management in particular, for insurers.

Design of Financial Systems: Towards a Syntheses of Function and Structure

by: Robert C. Merton and Zvi Bodie

This paper proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities. It is a synthesis of the neoclassical, neo-institutional, and behavioral perspectives. Neoclassical theory is an ideal driver to link science and global practice in finance because its prescriptions are robust across time and geopolitical borders. By itself, however, neoclassical theory provides little prescription or prediction of the institutional structure of financial systems-that is, the specific kinds of financial intermediaries, markets, and regulatory bodies that will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms. The neoclassical model therefore offers important, but incomplete, guidance to decision makers seeking to understand and manage the process of institutional change. In accomplishing this task, the neo-institutional and behavioral perspectives can be very useful. In this proposed synthesis of the three approaches, functional and structural finance (FSF), institutional structure is endogenous. When particular transaction costs or behavioral patterns produce large departures from the predictions of the ideal frictionless neoclassical equilibrium for a given institutional structure, new institutions tend to develop that partially offset the resulting inefficiencies. In the longer run, after institutional structures have had time to fully develop, the predictions of the neoclassical model will be approximately valid for asset prices and resource allocations. Through a series of examples, the paper sets out the reasoning behind the FSF synthesis and illustrates its application.

Implications of Correlated Default for Portfolio Allocation to Corporate Bonds

by: Mark B. Wise and Vineer Bhansali

This article deals with the problem of optimal allocation of capital to corporate bonds in fixed income portfolios when there is the possibility of correlated defaults. Using a multivariate normal Copula function for the joint default probabilities we show that retaining the first few moments of the portfolio default loss distribution gives an extremely good approximation to the full solution of the asset allocation problem. We provide detailed results on the convergence of the moment expansion and explore how the optimal portfolio allocation depends on recovery fractions, level of diversification and investment time horizon. Numerous numerical illustrations exhibit the results for simple portfolios and utility functions.

Investors Like Firms That Expense Employee Stock Options and They Dislike Firms

by: Fayez A. Elayan, Kuntara Pukthuanthong and Richard Roll

During 2002 and 2003, 140 publicly traded US firms announced their intention to recognize an accounting expense when stock options are granted to employees. Many similar firms elected not to expense options. We study the stock market's reaction. There is no evidence whatsoever that expensing options reduces the stock price. To the contrary, around announcement dates, we find significant price increases for firms electing to expense options and significant price declines for industry/size/performance-matched firms that did not announce expensing at the same moment. The average relative change in market values is 3.65% during a 6 day window around the announcement. The magnitude of the market's reaction to expensing depends on agency costs, the magnitude of option expenses, and financial reporting costs. The market's reaction does not seem to be affected by contracting costs (e.g. induced by debt covenants), growth opportunities, or potential political repercussions. Moreover, the decision to expense and the magnitude of the market's reaction are not signals of future operating performance. The market seems to react favorably to transparent reporting while it penalizes firms that give the appearance of having something to hide.

The Year-End Price of Risk in a Market for Liquidity

by: Mark D. Griffiths and Drew B. Winters

Musto (1997, Journal of Finance 52(4), 1861-1882) identifies a year-end effect in commercial paper (CP) and suggests that the price of risk may increase at the year-end. Griffiths and Winters (2003, Journal of Business, forthcoming) show that the timing of the year-end effect in CP is consistent with a preferred habitat for liquidity. However, Griffiths andWinters use data from only one risk class, so we extend their analysis by using spreads between different risk classes to determine if the price of risk does increase at the year-end. Using daily spreads between two risk classes of 7 day, 15 day, and 30 day non-financial CP, we find that the spread does increase at this time. However, the timing of the spread increases and decreases aligns with expectations consistent with a preferred habitat for liquidity at the year-end. This suggests that when liquidity is tight at the year-end, money market investors increase the price of risk.

Betting on Management

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

Recovery Risk

by: Sanjiv R. Das

I survey a selection of recent working papers on recovery rates, providing a framework for extant research. Simpler versions of models are also presented with a view to aid accessibility and pedagogical presentation. Despite the obvious empirical difficulties encountered with recovery rate data, modeling advances are making possible better quantification and measurement of recovery, and will result in innovative contracts to span this risk.

Credit Risk Modeling

by: David Lando • reviewed by: Mark Kritzman

My Life As A Quant Reflections on Physics and Finance

by: Emanuel Derman • reviewed by: Mark Kritzman

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.