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on Risk Management |
| By: | Long Chen; Hui Guo; Lu Zhang |
| Abstract: | This paper revisits the time-series relation between the conditional risk premium and variance of the equity market portfolio. The main innovation is that we construct a measure of the ex ante equity market risk premium using corporate bond yield spread data. This measure is forward-looking and does not rely critically on either realized equity returns or instrumental variables. We find strong support for a positive risk-return tradeoff, and this result is not sensitive to a number of robustness checks, including alternative proxies of the conditional stock variance and controls for hedging demands. |
| Keywords: | Stock exchanges ; Securities |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2006-007&r=rmg |
| By: | Hui Guo; Christopher J. Neely |
| Abstract: | We revisit the risk-return relation using the component GARCH model and international daily MSCI stock market data. In contrast with the previous evidence obtained from weekly and monthly data, daily data show that the relation is positive in almost all markets and often statistically significant. Likelihood ratio tests reject the standard GARCH model in favor of the component GARCH model, which strengthens the evidence for a positive risk-return tradeoff. Consistent with U.S. evidence, the long-run component of volatility is a more important determinant of the conditional equity premium than the short-run component for most international markets. |
| Keywords: | Stock exchanges ; Securities |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2006-006&r=rmg |
| By: | Jonathan Treussard (Department of Economics, Boston University); |
| Abstract: | Over the past decade, risk measurement has received a much needed amount of attention from the .nancial community. Risk measures based on .xed quantiles un- der the actual probability distribution, especially Value-at-Risk and its re.nement the Conditional Tail Expectation, were instrumental in capturing the attention of .nancial decision-makers. However, these were developed in a way that is inconsistent with eco- nomic theory. Consequently, these instruments possess characteristics that make them invalid risk measures for the purposes they intend to serve, be it informing life-cycle investors or guaranteeing the .rm.s capital adequacy through regulation. In particular, in addition to failing to guarantee the intregity of .nancial .rms when used for capital adequacy, these measures can eventually decrease with the investment horizon. Risk-neutral .xed-quantile measures are valid for framing life-cycle decisions because of their economic content. When endowed with a dynamic replication technology, Q- measure .xed-quantile risk measures become least-cost insurance contracts that may be used for capital adequacy considerations. However, no single quantile of the risk-neutral distribution can be used for the procurement of risk capital at all horizons. A risk-neutral varying-quantile instrument is needed. This unique instrument is a put option proposed by Merton-Perold (1993) and Bodie (1995). The Bodie-Merton-Perold Put is universally valid for both risk disclosure to investors and for the regulatory provision of risk capital at all horizons. It is a natural candidate for an industry standard in risk measurement. |
| Date: | 2005–08 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-028&r=rmg |
| By: | Massimo Guidolin (Federal Reserve Bank of St. Louis); Giovanna Nicodano (Department of Economics, University of Turin and Center for Research on Pensions and Welfare Policies, Turin) |
| Abstract: | Small capitalization stocks are known to have asymmetric risk across bull and bear markets. This paper investigates how variance risk affects international equity diversification by examining the portfolio choice of a power utility investor confronted with an asset menu that includes (but is not limited to) European and North American small equity portfolios. Stock returns are generated by a multivariate regime switching process that is able to account for both non-normality and predictability of stock returns. Non-normality matters for portfolio choice because the investor has a power utility function, implying a preference for positively skewed returns and aversion to kurtosis. We find that small cap portfolios command large optimal weights only when regime switching (and hence variance risk) is ignored. Otherwise a rational investor ought to hold a well-diversified portfolio. However, the availability of small caps substantially increases expected utility, in the order of riskless annualized gains of 3 percent and higher. These findings are robust to a number of modifications concerning the coefficient of relative risk aversion, the investment horizon, short-sale possibilities, and the exact structure of the asset menu. |
| Keywords: | strategic asset allocation, markov-switching, size effects, liquidity (variance) risk |
| Date: | 2005–02 |
| URL: | http://d.repec.org/n?u=RePEc:crp:wpaper:41&r=rmg |
| By: | Carolina Fugazza (Center for Research on Pensions and Welfare Policies); Massimo Guidolin (Federal Reserve Bank of St. Louis); Giovanna Nicodano (Department of Economics, University of Turin and Center for Research on Pensions and Welfare Policies, Turin) |
| Abstract: | We calculate optimal portfolio choices for a long-horizon, risk-averse European investor who diversifies among stocks, bonds, real estate, and cash, when excess asset returns are predictable. Simulations are performed for scenarios involving different risk aversion levels, horizons, and statistical models capturing predictability in risk premia. Importantly, under one of the scenarios, the investor takes into account the parameter uncertainty implied by the use of estimated coefficients to characterize predictability. We find that real estate ought to play a significant role in optimal portfolio choices, with weights between 10 and 30% in most cases. Under plausible assumptions, the welfare costs of either ignoring predictability or restricting portfolio choices to financial assets only are found to be in the order of at least 100 basis points per year. These results are robust to changes in the benchmarks and in the statistical framework. |
| Keywords: | Optimal asset allocation, real estate, predictability, parameter uncertainty |
| JEL: | G11 L85 |
| Date: | 2005–03 |
| URL: | http://d.repec.org/n?u=RePEc:crp:wpaper:40&r=rmg |
| By: | Kazuhiko NISHINA (Graduate School of Economics, Osaka University); Tatsuro Nabil MAGHREBI (Faculty of Economics, Wakayama University); Moo-Sung KIM (College of Business Administration, Pusan National University) |
| Abstract: | This study develops a new model-free benchmark of implied volatility for the Japanese stock market similar in construction to the new VIX based on the S&P 500 index. It also examines the stochastic dynamics of the implied volatility index and its relationship with realized volatility in both markets. There is evidence that implied volatility is governed by a long-memory process. Despite its upward bias, implied volatility is more reflective of changes in realized volatility than alternative GARCH models, which account for volatility persistence and the asymmetric impact of news. The implied volatility index is also found to be inclusive of some but not all information on future volatility contained in historical returns. However, its higher out-of sample performance provides further support to the rationale behind drawing inference about future stock market volatility based on the incremental information contained in options prices. |
| Keywords: | Licensing; Implied volatility index, Out-of-sample forecasting, GARCH modelling |
| JEL: | C52 C53 G14 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:osk:wpaper:0609&r=rmg |