JOIM: 2005
Volume 3, No. 1, First Quarter 2005
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Practitioner's Digest
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.
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Article
A Markov Chain Monte Carlo Method for Derivative Pricing and Risk Assessment
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.
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Article
Asset/Liability Management and Enterprise Risk Management of an Insurer
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.
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Article
Design of Financial Systems: Towards a Syntheses of Function and Structure
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.
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Article
Investors Like Firms That Expense Employee Stock Options and They Dislike Firms
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.
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Article
The Year-End Price of Risk in a Market for Liquidity
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.
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Case Study
Betting on Management
“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.
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Survey & Crossover
Recovery Risk
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.
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Book Review
Credit Risk Modeling
My Life As A Quant Reflections on Physics and Finance
“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.
Volume 3, No. 2, Second Quarter 2005
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Practitioner's Digest
Practitioner’s Digest • Vol. 3, 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.
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Insight
The Lorenz Curve
For a century, the critics' favorite example of the failures of capitalism has been the Lorenz curve. They rank households from poorest to richest and then plot cumulative wealth against the cumulative number of households. The critics argue that, if capitalism were fair, the Lorenz curve would be a straight line: the poorest 10% of the households would own 10% of the wealth, the poorest 20% would own 20%, etc. Actual Lorenz curves are not straight. Instead, they are sharply curved, showing that much of society's wealth is owned by the richest households. Economics textbooks (e.g., Samuelson) display these curves for actual countries, citing them as examples of "market failure." This paper develops a theory of the economic forces that shape the Lorenz curve. It explains why actual curves have the shape they have.
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Article
Developing Better Fee Structures for Mutual Funds
This paper presents a management decision model for setting mutual fund fees. The model pairs information obtained from a conjoint analysis, designed to uncover investors' preferences for different fee structures, with information on the expected revenue generated from various fee structures to suggest a set of "efficient" fees to mutual fund managers. Companies that market mutual funds can use this model to refine the fees they impose. We demonstrate our modeling approach using data collected from mutual fund investors. Finally, we show how this same data, and the conjoint analysis methodology, can be used to uncover price discrimination opportunities in this marketplace.
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Article
How New Entry in Options Markets Affected Market Making and Trading Costs
A significant competition for order flow in options markets occurred in August 1999. Before the competition, the majority of option volume arose from exclusive listings. By the end of September 1999, entry by existing option exchanges had shifted the majority of option volume to multiple-listing status. Both effective and quoted bid-ask spreads decrease significantly after entry with spreads remaining at lower levels 1 year later. A pooled regression analysis shows that new inter-exchange competition reduces option trading costs. This analysis also rejects the view that economies of scale in market making or lower hedging costs contribute significantly to the decrease in spreads.
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Article
The Kiss Of Death: A 5-Star Morningstar Mutual Fund Rating?
We examine the effect that an initial 5-starMorningstar mutual fund rating has on future fund performance, strategy, risk-taking, expenses, and portfolio turnover. Using a sample of diversified domestic equity funds from the 1990s we find that during the 3 years after a fund received its initial 5-star rating, fund performance severely falls off. This result is robust across different performance measures and different samples of funds. We also find that after receiving their initial 5-star rating, the risk levels of funds rise and the funds are not able to load on momentum stocks as well as they did before receiving the 5-star rating. These results suggest that funds, to some degree, alter their portfolios after receiving a 5-star rating and that investors should be very wary about using the 5-star rating as a signal of future 3-year performance.
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Article
Global Diversification
Correlations between the returns of US stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between US and international stocks and doubt the benefits of global diversification. We argue that the benefits of global diversification remain high and that the correlation between US and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of US and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation, and dispersion.
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Article
Motivation and Performance Following Open-Ending of Closed-End Funds
This study investigates the motives for open-ending closed-end funds, and performance of closed-end funds following open-ending announcements. We find that the propensity to open end is higher for funds that are larger, have high expense ratios, exhibit high volatility, and whose prices reflect large discounts from net asset value. The total wealth effects of open-ending announcements are stronger for smaller closed-end funds, and in periods when market conditions are relatively weak. There is no observable evidence that the governance-related factors found to predict future open ending are being successfully used to extract higher gains.
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Case Study
Financial Literacy
“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.
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Survey & Crossover
Genetic Algorithms
“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.
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Book Review
Neoclassical Finance
Experimental Economics
“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.
Volume 3, No. 3, Third Quarter 2005
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Practitioner's Digest
Practitioner’s Digest • Vol. 3, No. 3
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.
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Article
Call Protection in Convertible Bonds: How Much and Why?
This article is drawn largely from "Convertible Bond Design and Capital Investment: The Role of Call Provisions," published by the authors in the Journal of Finance, Volume 59, 2004, pp. 391-405. The authors are indebted to colleagues at the University of South Carolina for helpful comments and guidance, as well as Rick Green, Jeremy Stein, and Jeff Woolridge. We are grateful for comments from participants at a 2002 joint seminar of the Swedish School of Economics and Business and the Helsinki School of Economics. Many thanks to Ellen Roueche for her expert help in preparing and editing this manuscript.
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Article
Regulation Fair Disclosure and Volatility: An Intraday Analysis
Regulation Fair Disclosure (Reg FD) prohibits selective disclosure policies by companies. This study uses a sample of earning announcements before and after Reg FD to examine the impact on trade size, share volume, number of transactions per day, intraday return volatility, and bid-ask spread. Our methodology avoids biases induced by changes in tick size present in previous studies. Overall our results suggest that Reg FD has been successful in its goal of reducing the level of asymmetric information surrounding firm earnings announcements. In particular we find that intraday return volatility, volume, number of transactions, and spreads are lower under the general disclosure regime provided by Reg FD than under the previous selective disclosure regime. The univariate results are unchanged by controlling for factors not associated with Reg FD.
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Article
NASDAQ-100 Index Futures: Intraday Momentum or Reversal?
This paper explores the intraday behavior of the NASDAQ-100 futures index for momentum and reversals. A multiple regression model simultaneously (1) relates today's intraday returns to yesterday's and last night's returns, and (2) estimates how the relationship changes with the signs of yesterday's and last night's return, whether today is in a bull or bear market, and the day of the week. A simplistic view of momentum and reversal proves untenable. There appear to be both momentum and reversal effects and they appear to depend on the signs of yesterday's and last night's returns, and whether today is a Monday. Yesterday's return is associated with both momentum and reversals. Last night's return is predominately associated with reversals. An efficient forecast model is in favor on four intraday periods. This result suggests that there is a structural feature of the futures market in the opening hours.
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Article
Investment Banker Directors and Affiliated Analysts’ Forecasts
Equity research analysts of investment banks have been subjected to significant regulatory scrutiny and enforcement action in recent years. Specifically, two major issues have attracted legal attention: (1) whether analysts favorably bias their forecasts to secure investment-banking business, and (2) whether selective disclosure to analysts worsens the firm's information environment. In this paper, we address the justification for the regulatory actions concerning these two issues. We use a hand-collected sample of firms with investment banker directors, and hypothesize that the conflicts of interests are likely to be most severe in these firms. Our evidence provides little support for the concerns of the regulators. We do not find that affiliated analysts forecasts are more biased or less accurate than forecasts of other analysts. We do find that firms with investment banker directors have a superior information environment. If analysts affiliated with the investment banker director are more likely to receive selective information, this evidence is not supportive of the contention that firms use selective disclosure to gain favors from these analysts.
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Case Study
Cereal Mergers
“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.
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Survey & Crossover
Power Laws
We provide a brief survey of two areas in finance in which power laws may play an important role—one, in better describing the tails of return distributions; and two, in market microstructure modeling. While the existing literature in finance is not extensive, we have surveyed a collection of papers in finance, as well as in other areas, attempting to highlight cross-disciplinary connections.
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Book Review
Fischer Black and the Revolutionary Idea of Finance
The Sociology of Financial Markets
“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.
Volume 3, No. 4, Fourth Quarter 2005
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Article
Revisiting the Slope of the Credit Curve
The term structure of interest rates contains information about the market's expectations of the direction of future interest rates. Similarly, the term structure of credit spreads contains information about the market's perception of future credit spreads. The term structure of credit spreads is closely linked with conditional default probabilities and this link suggests a downward sloping term structure of credit spreads for high risk issuers, whose default probability conditional on survival is likely to decrease. This paper shows that for sufficiently low credit quality, as defined by the level of credit spreads, this holds true most of the time when spreads are taken from credit default swap (CDS) markets. We also discuss why CDS markets give a better way of analyzing this problem than bond price data.
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Article
Default Correlation in Reduced-Form Models
Reduced-form models have proven to be a useful tool for analyzing the dynamics of credit spreads. However, some have recently questioned their ability to match the level of empirical default correlation. The key concern appears to be the assumption that defaults are independent conditional on the state variables driving the default intensity. In this paper, I use a "thought experiment" as well as numerical examples calibrated to recent studies to show that the model-implied default correlation can be quite sensitive to the common factor structure imposed on the default intensity. Therefore, the "inability" of reduced-form models to generate sufficient default correlation has more to do with a restrictive common factor structure than the assumption of conditional independence.
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Article
Reduced Form vs. Structural Models of Credit Risk: A Case Study of Three Models
In this paper, we empirically compare two structural models (basic Merton and Vasicek- Kealhofer (VK)) and one reduced-form model (Hull-White (HW)) of credit risk. We propose here that two useful purposes for credit models are default discrimination and relative value analysis. We test the ability of the Merton and VK models to discriminate defaulters from non-defaulters based on default probabilities generated from information in the equity market. We test the ability of the HW model to discriminate defaulters from non-defaulters based on default probabilities generated from information in the bond market. We find the VK and the HW models exhibit comparable accuracy ratios as well as substantially outperform the simple Merton model. We also test the ability of each model to predict spreads in the credit default swap (CDS) market as an indication of each model's strength as a relative value analysis tool. We find the VK model tends to do the best across the full sample and relative sub-samples except for cases where an issuer has many bonds in the market. In this case, the HW model tends to do the best. The empirical evidence will assist market participants in determining which model is most useful based on their purpose in hand. On the structural side, a basic Merton model is not good enough; appropriate modifications to the framework make a difference. On the reduced-form side, the quality and quantity of data make a difference; many traded issuers will not be well modeled in this way unless they issue more traded debt. In addition, bond spreads at shorter tenors (less than two years) tend to be less correlated with CDS spreads. This makes accurate calibration of the term-structure of credit risk difficult from bond data.
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Article
Decomposing and Managing Multivariate Risks: The Case of Variable Annuities
The market of variable annuities has grown tremendously in recent years and has become a significant part of our capital markets. These equity and interest rate structured products offer a broad range of guarantees, whose risks are typically borne by the insurers' balance sheets. The limited risk capital of the life insurance industry may constrain the future growth of the market, and therefore the management of the risk of these guarantees is an urgent problem to address. In this paper, we apply a decomposition methodology to identify the risks of these guarantees. We then discuss the hedging strategies in managing them within the context of an investment process. Finally, we discuss the broad applications of the methodology.
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Article
Great Moments in Financial Economics: IV. The Fundamental Theorem (Part I)
This is the fourth in a series of articles in this Journal examining the historical origins of key ideas in the history of financial economics. The fundamental theorem asserts: there are no arbitrage opportunities if and only if state-prices exist. Like Newton's laws of motion, though highly abstract, it underlies the most important results in financial economics. The paper starts with some necessary background, explaining the related trio of ideas, subjective probabilities, risk-neutral probabilities and state-prices. Our search for the origins of the concept of state-prices will take us back several centuries to some work of Edmund Halley and Christiaan Huygens, who were financial economists on the side. In a Great Moment in the history of financial economics in 1953, the first clear and general application of state-prices to economics appears in the work of Kenneth Arrow. Less well known is some early important commentary by the economist Jacques Dreze. In the middle 1970's Mark Rubinstein and Stephen Ross may have been the first financial economists to appreciate the link between arbitrage and state-prices in incomplete markets, with the first completely clear statement and proof of the theorem provided by Ross. I then show how starting with the theorem, the important results of asset price theory (in particular, the CAPM) can be derived.
An extension of the fundamental theorem which anticipates modern option pricing will be discussed in Part II of this article which will appear in the next issue of the Journal. -
Case Study
Quiz for Fed Candidates
“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.
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Book Review
Freakonomics
The Future for Investors: Why the Tried and True Triumph over the Bold and the New
“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.
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Case Study
Answers to Quiz for Fed Candidates
“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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 3, No. 4
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.