JOIM: 2009
Volume 7, No. 1, First Quarter 2009
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Article
Performance-Based Fees and Risk Shifting with the Knockout Barrier
Many investment firms reward portfolio managers based on their performance. This article investigates a manager's optimal active risk policy using stochastic programming techniques. Our multiple-period model incorporates the most common incentive-fee structures, and captures the risk that the manager is fired for underperformance. In contrast to single-stage models, the manager shows remarkable prudence as he strives to safeguard future fee flows. We observe that if the client is too intolerant of underperformance, the manager will be incentivized to reduce active risk despite earning active fees.We also observe that capping fees too early will causes a lock-in effect.
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Insight
Stockholder Rights and Carl Icahn
One might conject that shareholder activism should be praised and welcomed by shareholders. This paper suggests that actions, alleged to be on behalf of shareholders, can be shown to be on behalf of a small group of activist investors, and not for the broader group of stock owners. To investigate the issue the actions of Carl Icahn are studied. His strategies are likely to be rewarding for Carl Icahn and his fellow investors.
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Article
The Clustering of Extreme Movements: Stock Prices and the Weather
One striking feature of the United States stock market is the tendency of days with very large movements of stock prices to be clustered together. We define an extreme movement in stock prices as one that can be characterized as a three sigma event; that is, a daily movement in the broad stock-market index that is three or more standard deviations away from the average movement. We find that such extreme movements are typically preceded by unusually large stock-price movements in previous trading days. Interestingly, a similar clustering of extreme observations of temperature in New York City can be observed. A particularly robust finding in this paper is that extreme movements in stock prices and temperature are usually preceded by large average daily movements during the preceding three-day period. This suggests that investors might fashion a market timing strategy, switching from stocks to cash in advance of predicted extreme negative stock returns. In fact, we have been able to simulate market timing strategies that are successful in avoiding nearly eighty percent of the negative extreme move days, yielding a significantly lower volatility of returns. We find, however, that a variety of alternative strategies do not improve an investor's long-run average return over the return that would be earned by the buy-and-hold investor who simply stayed fully invested in the stock market.
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Article
Shorting Demand and Predictability of Returns
We examine the link between shorting and future returns in the equities market using a proprietary dataset of stock loan fees and quantities. We find that separating supply and demand shifts provides a richer view of the information contained in the securities lending market. Specifically, when separating into supply and demand shifts, we find that increases in shorting demand predict large negative abnormal returns next month (−2.98%), while changes in supply exhibit only modest predictive ability. The returns to a strategy exploiting the information in these demand shifts is large and significant even after: risk adjusting, taking into account the explicit costs of shorting, and taking into account additional transaction costs of the strategy. Collectively these results suggest that understanding more deeply the dynamics of the securities lending market can help us to make better predictions of future stock returns.
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Article
Optimal Rebalancing: A Scalable Solution
Institutional investors usually employ mean-variance analysis to determine optimal portfolio weights. Almost immediately upon implementation, however, the portfolio's weights become sub-optimal as changes in asset prices cause the portfolio to drift away from the optimal targets. We apply a quadratic heuristic to address the optimal rebalancing problem, and we compare it to a dynamic programming solution as well as to standard industry heuristics. The quadratic heuristic provides solutions that are remarkably close to the dynamic programming solution. Moreover, unlike the dynamic programming solution, the quadratic heuristic is scalable to as many as several hundreds assets.
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Case Study
Never Look a Gift Horse In the Mouth
“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
The Housing Bubble and Resulting Mortgage Crisis
In the late 1990s, United States house prices began a long boom that peaked in mid 2006. The subsequent reversal of the housing boom has spawned a major crisis in the credit markets. This paper reviews the financial developments that stimulated the house price bubble and the financial repercussions of it bursting.
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Book Review
Plight of the Fortune Tellers: Why We Need to Manage Risk Differently
“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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Practitioner's Digest
Practitioner’s Digest • Vol. 7, 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.
Volume 7, No. 2, Second Quarter 2009
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Practitioner's Digest
Practitioner’s Digest • Vol. 7, 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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Article
Liquidity Risk and Limited Arbitrage: Are Taxpayers Helping Hedge Funds Get Rich?
Hedge funds facing capital constraints during market-wide liquidity shocks use bank credit lines to reduce the limits to arbitrage. During shocks, government-protected bank deposits receive inflows and this exclusive low cost funding enables banks to lend to hedge funds. In effect, banks compete away the government subsidy while tax-avoiding hedge funds reap the lion share of the benefits. After the advent of hedge funds, the existing government safety net protecting banks is no longer optimal in the sense of maximizing social surplus.
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Article
A Structural Analysis of the Default Swap Market – Part II (Relative Value)
We evaluate several long/short strategies for managing a portfolio of default swaps. The strategies are based on a ranking of credits by residuals, which are the differences between market spreads and spreads generated by the iSpread structural model. Investment grade portfolios for the United States and Europe earned an average of 70 basis points for each long dollar notional between January 2004 and December 2006. Noninvestment grade portfolios earned 321 basis points averaged over the same regions and time period. Transaction cost estimates based on scenario analysis ranged from 19 to 27 basis points for investment grade and 26 to 54 basis points for noninvestment grade portfolios. Strategies that aim to mitigate transaction cost by holding trades with little profit showed mixed results.
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Article
A Simple Model for Time-Varying Expected Returns on the S&P 500 Index
This paper presents a parsimonious, implementable model for the estimation of the short and long-term expected rates of return on the S&P 500 stock market Index. Sufficient statistics for the expected return on the S&P 500 Index consist of the risk-free rate of interest, the option market's (priced) implied volatility on the S&P 500 Index, and a measure of the economy's wealth level.
The short- and long-term risk-free rates of interest reflect the impact of the level and slope of the risk-free term structure. The implied volatility captures a forward-looking measure of uncertainty. Utility-function assumed decreasing relative risk aversion gives rise to an increased willingness to invest in risky assets when current wealth level is "high". The model's empirical parameters are estimated using Livingston/Philadelphia Fed growth rates substituted into a dividend-discount model. -
Article
The Value Spread as a Market Timing Signal: Evidence from Asia
Using monthly data from 1992-2006, we show the value premium in Asia ex Japan is positively related to the cross-sectional dispersion of four common value ratios. The book-to-price and cash flow-to-price spreads exhibit the strongest relationship. Typical month-to-month variation in these two value spreads is often associated with a 0.4-1.0% per annum change in the value premium. Short-side positions are typically solely responsible for the positive relationship, particularly in recent years. Our results provide out of sample support for previous findings for the US market, but cast doubt on whether mean reversion alone can explain the observed value premium-spread relationship.
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Survey & Crossover
Dealing With Dimension: Option Pricing on Factor Trees
We present a scheme for pricing derivatives on M assets on K -factor recombining trees with N periods. The computational complexity of these trees is O(NK +1), i.e. polynomial in N, making it possible to price a wide range of derivatives without resorting to Monte Carlo simulation. Numerical implementation examples are provided, along with a discussion of the issues that arise when these models are implemented on multicore processors. A calibration example is provided that shows how individual assets may be embedded on a multi-factor tree.
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Case Study
The Liquidation of Amaranth
“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
Enough. True Measures of Money, Business and Life
“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 7, No. 3, Third Quarter 2009
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Practitioner's Digest
Practitioner’s Digest • Vol. 7, 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
Market Crises-Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?
This paper addresses aspects of the current financial market crisis by drawing analogies from the physics of phase transitions. If such an analogy is indeed appropriate, then the evolving dynamics of financial markets might have characteristics that the traditional models of finance will not be able to handle, requiring the need for a fresh perspective on modeling and investment decision making.
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Article
Valuation of Credit Contingent Claims: An Arbitrage-Free Credit Model
This study extends the generalized Ho-Lee model to the credit derivative swap (CDS) curve movements that ensures the hazard rate movement is arbitrage-free for any given CDS curve. This study shows that the generalized Ho-Lee model is not limited to pricing the interest contingent claims. The Ho-Lee model can be equally applicable to pricing the credit contingent claims. This model can value a broad range of credit contingent claims. These credit contingent claims include the American and the Bermudan CDS options, make-whole and callable bonds. This model features the separation of the specification of volatilities of the hazard rate from the fitting of the model to the CDS curve. Our model has several advantages over other models because of this separation feature. For example, we can use the model to depict the credit performance profile of a bond, by plotting the credit contingent claim values over a range of hazard curves. The performance profiles can identify the impact of the credit risks on the contingent claims.
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Article
Jumping the Gates: Using Beta-Overlay Strategies to Hedge Liquidity Constraints
In response to the current financial crisis, a number of hedge funds have implemented gates on their funds that restrict withdrawals when the sum of redemption requests exceeds a certain percentage of the funds total assets. To reduce the investors risk exposures during these periods, we propose a futures overlay strategy designed to hedge out or control the common factor exposures of gated assets. By taking countervailing positions in stock, bond, currency, and commodity exposures, an investor can greatly reduce the systematic risks of their gated assets while still enjoying the benefits of manager-specific alpha. Such overlay strategies can also be used to reposition the betas of an investors entire portfolio, effectively rebalancing asset-class exposures without having to trade the less liquid underlying assets during periods of market dislocation. To illustrate the costs and benefits of such overlays, we simulate the impact of a simple beta-hedging strategy applied to long/short equity hedge funds in the TASS database.
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Article
The 4% Rule At What Price?
The 4% rule is the advice many retirees follow for managing spending and investing. We examine this rules inefficiencies - the price paid for funding its unspent surpluses and the overpayments made to purchase its spending policy. We show that a typical rule allocates 10%-20% of a retirees initial wealth to surpluses and an additional 2%-4% to overpayments. Further, we argue that even if retirees were to recoup these costs, the 4% rules spending plan remains wasteful, since many retirees actually prefer a different, cheaper spending plan.
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Article
Which Explains an Equity Index’s Return Better, the Change in Its Own Implied Volatility or That for a Broader Index?
This paper examines the proper risk proxy for an equity index. For each of nine indexes, an implied volatility index (VI) is computed from its options. For each, it determines whether the indexes return is explained better by the contemporaneous change in its own VI or that for a broader index. Overall, the broader indexes VI explains the indexes contemporaneous return better. We also find that the difference between the broader indexes VI and the individual indexes VI contributes to explaining the indexes contemporaneous return. Finally, we determine that the forward return differential between the indexes returns associated with high and low VI quintiles ranked by both the indexes VI and the broader indexes VI is positive. We also find that the differential is higher when ranked by the broader indexes VI.
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Case Study
St. Xavior Parish Church
“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
Managing Interest Rate Risk: The Next Challenge?
Are the managers of financial institutions ready for the small but increasingly significant risk of inflation in the near future, due to the unprecedented fiscal and monetary responses of the US government to prevent an economic collapse? This paper addresses this important issue by reviewing important findings in the area of interest rate risk management. We discuss five classes of models in the fixed income literature that deal with hedging the risk of large, nonparallel yield curve shifts. These models are given as (i) M-absolute/M-square models, (ii) duration vector/M-vector models, (iii) key rate duration models, (iv) principal component duration models, and (v) extensions of these models for fixed income derivatives, for valuing and hedging bonds, loans, demand deposits, and other fixed income instruments. These models can be used for designing various hedging strategies such as portfolio immunization, bond index replication, duration gap management, and contingent immunization, to protect against changes in the height, slope, and curvature of the yield curve. We argue that the current regulatory models proposed by the US Federal Reserve, the Office of Thrift Supervision, and the Bank of International Settlements may understate the true interest rate risk exposure of financial institutions, if sharp increases in interest rates lead to higher default risk and quickening of the pace of deposit withdrawals.
Volume 7, No. 4, Fourth Quarter 2009
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Practitioner's Digest
Practitioner’s Digest • Vol. 7, 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.
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Insight
The 7 Habits of Highly Suspicious Hedge Funds
“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.
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Article
The Risk That Risk Will Change
Standard approaches to risk management focus on short run risks, yet many positions are held for longer periods. Over such holding periods there is a risk that risks will change. In this note several easily implemented approaches to estimating the term structure of risk are proposed based on either statistical or economic criteria. It is argued that some portion of the financial crisis of 2007-2008 was due to the use of short run risk measures to assess long term risks.
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Article
The Dynamics of Leveraged and Inverse Exchange-Traded Funds
Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have leverage explicitly embedded as part of their product design. While these funds are primarily used by short-term traders, they are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs. This note provides a unified framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. We show that the daily re-leveraging of these funds can exacerbate volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.
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Article
Striking Regulatory Irons While Hot
We are in the midst of what might end up as the most significant change to financial regulations since the Great Depression. This is because the financial and economic crisis that continues to engulf us is the most severe crisis since the Great Depression. The markets for houses, mortgages, and derivatives linked to them have played critical roles in the crisis, and debates about the shape of future financial regulation have led to intense focus on these markets. In this paper we place the current debate about regulatory changes within a larger frame. We present a framework based on capture theory and fairness where regulatory irons are heated by changes in financial markets such as a plunge from exuberant booms to frightening crashes, changes in the economy such as a fall from heady job creation to dispiriting unemployment, changes in technology such as an innovation in information technology which enables banks to substitute the Internet for tellers, changes in politics, such as one party displacing another, or new rulings by the Supreme Court, such as the one that opened the door to interstate banking. We discuss the fires that heat regulatory irons, the craftsmen standing ready to strike them, and the process by which they are struck, in credit card and bank regulations, insider trading regulations, Regulation FD, trading halts, the Global Settlement, and the Sarbanes-Oxley Act. We conclude with our prescriptions.
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Case Study
Case Studies
“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
Financial Applications with Parallel R
The use of statistical packages in finance has two functions. One, econometric analysis of large volumes of data, and two, programming financial models. A popular package for these purposes is R. In this article we will examine two canonical applications of parallel programming for option pricing. We use the ParallelR package developed by REvolution Computing. We price options using trees and Monte Carlo simulation. Both these approaches are commonly used for option pricing and are amenable to parallelization and grid computing. In this paper we demonstrate the application using the widely used mathematical/statistical R package.
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Book Review
The Ascent of Money: A Financial History of the World
“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.