Volume 13, No. 2, Second Quarter 2015

Equity Indices’ Returns: Contingent Claims on GDP Stochastic Movements

by: Thomas S.Y. Ho and Sang Bin Lee

This paper proposes an equity index contingent claim model. The model assumes that the equity broad-based market indices’stochastic movements are contingent to macroeconomic risk factors that are derived from Ho et al.’s (HPS, 2012, 2013) and Ho and Lee’s (HL, 2015b, 2015c) theoretical models. The results show that these factors can explain the equity indices’ returns reasonably well.
Our model accounts for the complex lagged effect of GDP growth rate modeled by HPS and estimated by HL, and determines the sensitivities of a market index to the stochastic GDP multiple factors. We show that the S&P Index seems to have anticipated the Great Recession and the higher growth rate of the current recovery. The results also show that the market premiums of Dow Jones and NYSE indices move mostly in tandem with those of S&P. However, such as not the case with NASDAQ and Russell. The model can be used for asset allocation and hedging in investment strategies, and we have provided multiple hedging strategies in this paper to illustrate some applications of our model.

A Structural Macro-Financial Model an Macro-Risk Management

by: Thomas S. Y. Ho and Sang Bin Lee

This paper provides a structural macro-financial model that can be used for the cost and benefit analysis of alternative financial regulatory regimes. The model solves for the optimal financial sector size to the real aggregate asset (household leverage) and to the aggregate capital (financial leverage) that maximize the expected real output. This paper suggests that macro-risk management is necessary and managing the aggregate capital in the financial sector is important.

We illustrate the impact of some regulatory policies on the real outputs with some numerical examples. Our model shows that holding 2.39% in excess of the optimal capital ratio would lower theGDPgrowth rate by 0.61%. Since the model shows that higher financial leverage would result in higher expected growth rate and volatility of real outputs, we suggest that macro-risk management also needs to determine a risk and return tradeoff of real output.

Growth Optimal Portfolio Insurance for Long-Term Investors

by: Daniel Mantilla-García

We solve the growth-rate optimal multiplier of a portfolio insurance strategy in the general case with a locally risky reserve asset and stochastic state variables. The level of the optimal time-varying multiplier turns out to be lower than the standard constant multiplier of Constant Proportion Portfolio Insurance (CPPI) for common parameter values. As a consequence the outperformance of the growth-optimal portfolio insurance (GOPI) strategy does not come with higher risk. In the presence of mean reverting stock returns the average allocation to stocks increases with horizon and the optimal multiplier introduces a countercyclical “tactical” component to the strategy. Furthermore, we unveil a positive relationship between the value of the strategy and the correlation between the underlying assets.

Alternative Currency Hedging Strategies With Known Covariances

by: Wei Chen, Mark Kritzman and David Turkington

Informed investors understand that they should hedge at least some of their portfolios’currency exposure, but the best strategy for doing so remains an open question. We investigate a variety of currency hedging strategies, including linear strategies, non-linear strategies, and combinations thereof, for the purpose of helping investors determine which strategies best meet their objectives.

What Piketty Doesn’t Understand

by: Jack Treynor

“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.

Strategic Asset Allocation with Low-Risk Stocks: A Bootstrap Analysis

by: Wai Mun Fong and Timothy Koh

Traditional asset allocations such as the 60/40 portfolio of stocks/bonds are not as well diversified as many investors believe since almost all the portfolio’s returns are driven by the stock component. This paper examines a novel approach to strategic allocation by combining stocks with low betas and high dividend yield. Our “beta-yield” portfolio exploits the beta anomaly (low beta stocks have higher risk-adjusted returns than high-beta stocks) and the hedging property of high dividend yield stocks in declining markets.We use bootstrap simulations to analyze the long-term performance of the beta-yield portfolio and find that it outperforms 60/40, 70/30, and 80/20 stock/bond portfolios in terms of shortfall risk, Omega ratio, and Prospect Theory utility. The results hold even with relatively high loss-aversion, and when the beta-yield strategy is assumed to have counterfactually low average returns.

Practitioner’s Digest • Vol. 13, No. 2

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.

Think Like a Freak

by: Steven Levitt and Stephen Dubner • reviewed by: Javier Estrada

“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.

Failure of the Real Wage to Grow

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.