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on Corporate Finance |
| By: | Jens Carsten Jackwerth (Department of Economics, University of Konstanz); George M. Constantinaides (University of Chicago and NBER); Stylianos Perrakis (Concordia University) |
| Abstract: | We document widespread violations of stochastic dominance in the one-month S&P 500 index options market over the period 1986-2002. These violations imply that a trader can improve her expected utility by engaging in a zero-net-cost trade. We allow the market to be incomplete and also imperfect by introducing transactions costs and bid-ask spreads. There is higher incidence of violations by OTM than by ITM calls, contradicting the common inference drawn from the observed implied volatility smile that the problem lies with the left-hand tail of the index return distribution. Even though pre-crash option prices conform to the BSM model reasonably well, they are incorrectly priced. Over 1997-2002, many options, particularly OTM calls, are overpriced irrespective of which time period is used to determine the index return distribution. These results do not support the hypothesis that the options market is becoming more rational over time. Finally, our results dispel another common misconception, that the observed smile is too steep after the crash: most of the violations by post-crash options are due to the options being either underpriced over 1988-1995, or overpriced over 1997-2002. |
| Keywords: | Derivative pricing; volatility smile, incomplete markets, transactions costs, index options, stochastic dominance bounds |
| Date: | 2005–10–10 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0509&r=cfn |
| By: | Bertram Düring (University of Mainz); Ansgar Jüngel (University of Mainz); S. Volkwein |
| Abstract: | Our goal is to identify the volatility function in Dupire's equation from given option prices. Following an optimal control approach in a Lagrangian framework, we propose a globalized sequential quadratic programming (SQP) algorithm with a modied Hessian { to ensure that every SQP step is a descent direction { and implement a line search strategy. In each level of the SQP method a linear{quadratic optimal control problem with box constraints is solved by a primal{dual active set strategy. This guarantees L1 constraints for the volatility, in particular assuring its positivity. The proposed algorithm is founded on a thorough rst{ and second{order optimality analysis. We prove the existence of local optimal solutions and of a Lagrange multiplier associated with the inequality constraints. Furthermore, we prove a sucient second-order optimality condition and present some numerical results underlining the good properties of the numerical scheme. |
| Keywords: | Dupire equation, parameter identication, optimal control, optimality conditions, SQP method, primal-dual active set strategy |
| Date: | 2006–03–29 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0602&r=cfn |
| By: | M. Ayhan Kose (International Monetary Fund); Eswar S. Prasad (International Monetary Fund and IZA Bonn); Marco E. Terrones (International Monetary Fund) |
| Abstract: | The influential work of Ramey and Ramey (1995) highlighted an empirical relationship that has now come to be regarded as conventional wisdom – that output volatility and growth are negatively correlated. We reexamine this relationship in the context of globalization – a term typically used to describe the phenomenon of growing international trade and financial integration that has intensified since the mid-1980s. Using a comprehensive new dataset, we document that, while the basic negative association between growth and volatility has been preserved during the 1990s, both trade and financial integration significantly weaken this negative relationship. Specifically, we find that the estimated coefficient on the interaction between volatility and trade integration is significantly positive. We find a similar, although less significant, result for the interaction of financial integration with volatility. |
| Keywords: | globalization, international trade and financial linkages, macroeconomic volatility and growth |
| JEL: | F41 F36 F15 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp2252&r=cfn |
| By: | Günter Franke (Department of Economics, University of Konstanz); Erik Lüders (Pinehill Capital and Laval University) |
| Abstract: | This paper analyzes the e¤ect of non-constant elasticity of the pricing kernel on asset return characteristics in a rational expectations model. It is shown that declining elasticity of the pricing kernel can lead to predictability of asset returns and high and persistent volatility. Also, declining elasticity helps to motivate technical analysis and to explain stock market crashes. Moreover, based on a general characterization of the pricing kernel, we propose analytical asset price processes which can be tested empirically. The numerical analysis reveals strong deviations from the geometric Brownian motion which are caused by declining elasticity of the pricing kernel. |
| Keywords: | Pricing Kernel, Viable asset price processes, Serial correlation, Heteroskedasticity, Stock market crashes |
| JEL: | G12 |
| Date: | 2005–08–18 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0405&r=cfn |
| By: | Günter Franke (Department of Economics, University of Konstanz); Jan Pieter Krahnen (Center for Financial Studies, Goethe-University Frankfurt) |
| Abstract: | This paper contributes to the economics of financial institutions risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to expand its loan business, thereby affecting systematic risk. For a sample of European CDO issues, we find an increase of the banks’ betas, but no significant stock price effect around the announcement of a CDO issue. |
| Date: | 2005–08–18 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0504&r=cfn |
| By: | Jens Carsten Jackwerth (Department of Economics, University of Konstanz); George M. Constantinaides (University of Chicago and NBER); Stylianos Perrakis (Concordia University) |
| Keywords: | Derivative pricing, risk-neutral distribution, incomplete markets, stochastic dominance bounds, transaction costs, index options, volatility smile |
| Date: | 2005–09–16 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0506&r=cfn |
| By: | Günter Franke (Department of Economics, University of Konstanz); Richard C. Stapleton (University of Manchester and University of Melbourne); Marti G. Subrahmanyam (Stern School of Business, New York University) |
| Abstract: | We present a necessary and sufficient condition on an agent’s utility function for a simple mean preserving spread in an independent background risk to increase the agent’s risk aversion (incremental risk vulnerability). Gollier and Pratt (1996) have shown that declining and convex risk aversion as well as standard risk aversion are sufficient for risk vulnerability. We show that these conditions are also sufficient for incremental risk vulnerability. In addition, we present sufficient conditions for a restricted set of stochastic increases in an independent background risk to increase risk aversion. |
| Date: | 2005–09–23 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0508&r=cfn |
| By: | Truc Le (School of Finance and Economics, University of Technology, Sydney); Eckhard Platen (School of Finance and Economics, University of Technology, Sydney) |
| Abstract: | In this paper, the authors use the concept of the population ROC curve to build analytic models of ROC curves. Information about the population properties can be used to gain greater accuracy of estimation relative to the non-parametric methods currently in vogue. If used properly this is particularly helpful in some situations where the number of sick loans is rather small; a situation frequently met in periods of benign macro-economic background. |
| Keywords: | world stock index; growth optimal portfolio; diversification; mean-variance portfolio selection; enhanced index fund |
| JEL: | G10 G13 |
| Date: | 2006–08–01 |
| URL: | http://d.repec.org/n?u=RePEc:uts:rpaper:180&r=cfn |
| By: | Richard Deaves (McMaster University); Erik Lüders (Pinehill Capital and Laval University); Michael Schröder (Center for European Economic Research (ZEW)) |
| Abstract: | As a group, market forecasters are egregiously overconfident. In conformity to the dynamic model of overconfidence of Gervais and Odean (2001), successful forecasters become more overconfident. What’s more, more experienced forecasters have “learned to be overconfident,” and hence are more susceptible to this behavioral flaw than their less experienced peers. It is not just individuals who are affected. Markets also become more overconfident when market returns have been high. |
| Date: | 2005–10–07 |
| URL: | http://d.repec.org/n?u=RePEc:knz:cofedp:0510&r=cfn |
| By: | Ricardo Lagos; Guillaume Rocheteau |
| Abstract: | We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers’ entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient. |
| Keywords: | Assets (Accounting) - Prices ; Portfolio management |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedcwp:0607&r=cfn |
| By: | Rajnish Mehra |
| Abstract: | In this article we examine the Equity Premium in the Indian context and review the related literature. The equity premium is the returned earned by a well-diversified stock portfolio in excess of that earned by a risk free security such as a Treasury Bill. Consistent with U.S. experience we find that the Indian equity premium has been quite high in the post 1991 period, averaging 9.7% above the corresponding risk free security. It is difficult to justify such a premium based on theoretical considerations. The article is an entry prepared for the Oxford Companion to Economics in India edited by Kaushik Basu |
| JEL: | E21 G1 G12 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:12434&r=cfn |
| By: | Bong-Chan Kho; René M. Stulz; Francis E. Warnock |
| Abstract: | Despite the disappearance of formal barriers to international investment across countries, we find that the average home bias of U.S. investors towards the 46 countries with the largest equity markets did not fall from 1994 to 2004 when countries are equally weighted but fell when countries are weighted by market capitalization. This evidence is inconsistent with portfolio theory explanations of the home bias, but is consistent with what we call the optimal insider ownership theory of the home bias. Since foreign investors can only own shares not held by insiders, there will be a large home bias towards countries in which insiders own large stakes in corporations. Consequently, for the home bias to fall substantially, insider ownership has to fall in countries where it is high. Poor governance leads to concentrated insider ownership, so that governance improvements make it possible for corporate ownership to become more dispersed and for the home bias to fall. We find that the home bias of U.S. investors decreased the most towards countries in which the ownership by corporate insiders is low and countries in which ownership by corporate insiders fell. Using firm-level data for Korea, we find that portfolio equity investment by foreign investors in Korean firms is inversely related to insider ownership and that the firms that attract the most foreign portfolio equity investment are large firms with dispersed ownership. |
| JEL: | F36 F30 G32 G30 G11 G15 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:12389&r=cfn |