Optimal portfolio selection with stochastic maximum downside risk and uncertain implicit transaction costs

Published ArticleA multi-stage stochastic optimal portfolio policy that minimizes downside risk in the presence of uncertain implicit transaction costs is proposed. As asset returns in economic recessions and booms are characterised by extreme movements, some individual stocks show an extreme reaction while others exhibit a milder reaction. The study therefore considers a risk-averse and conservative investor who is highly concerned about the performance of his portfolio in an economic recession environment. Maximum negative deviation is taken as the downside risk and stochastic programming is applied with stochastic data given in the form of a scenario tree. A set of discrete scenarios of asset returns is considered, taking the deviation around each return scenario. Thus uncertainties of asset returns and implicit transaction costs are represented by discrete approximations of a multi-variate continuous distribution. The portfolio is rebalanced at discrete time intervals as new information on returns get realised. First-stage optimal-portfolio results show that implicit transaction costs vary from 7.1% to 16.7% of returns on investment

A Different Perspective On Volatility? An Empirical Analysis of the Effects of Volatility-Management in a Norwegian Conte.at

To raise awareness of volatility-management - that is, improving portfolio performance by adjusting exposure according to volatility information, this thesis aims to provide empirical evidence on the effects of volatility-management in a Norwegian context. We find that volatility-managed multifactor portfolios that are rebalanced monthly outperform its nonmanaged counterparts. Specifically, our strategy generates an annualized alpha of up to 5.56% and an appraisal ratio of 0.72 before transaction costs. In economic terms, this implies that an investor who manages volatility increases the Sharpe ratio by 0.72 annually compared to an investor who ignores volatility timing. We also find that the benefits are not limited to short-term investors, but remain modest at a rebalancing frequency of up to 12 months. These results may originate from some investors reacting slowly to changes in market volatility, which leads to an unfavorable risk-return trade-off. Our results suggest that participants investing in the Norwegian market may capitalize on prior volatility information, which challenges the weak form of the efficient market hypothesis. This provides an incentive to pay attention to volatility fluctuations.nhhma

When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification

By exploiting basic common practice accounting and risk-management rules, we propose a simple analytical dynamical model to investigate the effects of microprudential changes on macroprudential outcomes. Specifically, we study the consequence of the introduction of a financial innovation that allows reducing the cost of portfolio diversification in a financial system populated by financial institutions having capital requirements in the form of Value at Risk (VaR) constraint and following standard mark-to-market and risk-management rules. We provide a full analytical quantification of the multivariate feedback effects between investment prices and bank behavior induced by portfolio rebalancing in presence of asset illiquidity and show how changes in the constraints of the bank portfolio optimization endogenously drive the dynamics of the balance sheet aggregate of financial institutions and, thereby, the availability of bank liquidity to the economic system and systemic risk. The model shows that when financial innovation reduces the cost of diversification below a given threshold, the strength (because of higher leverage) and coordination (because of similarity of bank portfolios) of feedback effects increase, triggering a transition from a stationary dynamics of price returns to a nonstationary one characterized by steep growths (bubbles) and plunges (bursts) of market prices

The risk-related behaviour of financial intermediaries

The following thesis contains four empirical chapters focusing on the contagion, interest rate, foreign exchange rate, and investment risk exposures of financial institutions, respectively. Chapter 1 provides an overarching view of the four empirical chapters and the main objective of the thesis. Chapter 2 examines the return and volatility spillovers among the financial sector portfolios across the global financial markets from an US investor’s perspective. The potential influence of the recent financial crisis on the return and risk interdependence among these sector portfolios has also been evaluated. Financial institutions with different characteristic and size have been examined separately as well as jointly. Chapter 3 and 4 investigate the interest rate and foreign exchange rate risk exposures of financial institutions, respectively. In chapter 3, we evaluate the impact of changes in term structure on the equity value of financial intermediaries across major economies. In chapter 4, the influences of both domestic and foreign currency fluctuations on the equity value of financial intermediaries are explored. Furthermore, we split the sample period into pre- and post-crisis period to investigate the potential impact of recent financial crisis on the interest rate and foreign exchange rate risk exposure of these financial intermediaries under examination. Chapter 5 focuses on the investment risk faced by financial institutions (mainly non-banking financial service firms, e.g. mutual funds, pension funds and hedge funds). We shed light on the economic value of correlation timing for dynamic asset allocation strategies. In order to further evaluate the influence of the rebalancing frequency on the economic value of the correlation timing, we assess the performance of the dynamic asset allocation strategy on both daily and monthly basis. Finally, chapter 6 provides the concluding remarks that summarize the thesis

Hedging Interest-Rate Options Using Principal Components Analysis

It is often a goal of the risk management of a portfolio of interest rate sensitive instruments to minimize the impact of movements in market rates on the value of the portfolio. This can be done by considering the sensitivity of the portfolio to each of the market rates that are used to bootstrap a yield curve. However, this is likely to lead to an excessive amount of trading due to an investment in a large number of hedging securities. As an alternative, we consider using principal components analysis (PCA) to condense most of the variability in the market rates into a much smaller number of risk factors, called the principal components. One can then construct a hedging portfolio so as to make the portfolio immune to shocks in these principal components, and hence to the most common movements in the yield curve. We compare the effectiveness of these two hedging strategies for hedging a portfolio of interest-rate options, both in the absence and presence of transaction costs. We also consider the additional feature of being able to update each hedging methodology on a daily basis and rebalance the hedge portfolios accordingly

Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses

This paper surveys the empirical analyses that examine the effects of the Bank of Japan's (BOJ's) quantitative easing policy (QEP), which was implemented from March 2001 through March 2006. The survey confirms a clear effect whereby the commitment to maintain the QEP fostered the expectations that the zero interest rate would continue into the future, thereby lowering the yield curve centering on the short- to medium-term range. There were also phases in which an increase in the current account balances held by financial institutions at the BOJ bolstered this expectation. While the results were mixed as to whether expansion of the monetary base and altering the composition of the BOJ's balance sheet led to portfolio rebalancing, generally this effect, if any, was smaller than that stemming from the commitment. When viewing the QEP's impact on Japan's economy through various transmission channels, many of the analyses suggest that the QEP created an accommodative environment in terms of corporate financing. In particular, the QEP contained financial institutions' funding costs from the market and staved off financial institutions' funding uncertainties. The QEP's effect on raising aggregate demand and prices was often limited, due largely to the then progressing corporate balance-sheet adjustment, as well as the zero bound constraint on interest rates.Zero interest rate policy; Quantitative easing policy; Commitment; Zero bound constraint on interest rates; Deflation

Financial advisors: a case of babysitters?

We merge administrative information from a large German discount brokerage firm with regional data to examine if financial advisors improve portfolio performance. Our data track accounts of 32,751 randomly selected individual customers over 66 months and allow direct comparison of performance across self-managed accounts and accounts run by, or in consultation with, independent financial advisors. In contrast to the picture painted by simple descriptive statistics, econometric analysis that corrects for the endogeneity of the choice of having a financial advisor suggests that advisors are associated with lower total and excess account returns, higher portfolio risk and probabilities of losses, and higher trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own. Regression analysis of who uses an IFA suggests that IFAs are matched with richer, older investors rather than with poorer, younger ones

Essays in financial economics

In the first paper of my dissertation I study the size and source of exchange-traded funds’ (ETFs) price impact in the most ETF-dominated asset classes: volatility (VIX) and commodities. I show that the introduction of ETFs increased futures prices. To identify ETF-induced price distortions, I propose a model-independent approach to replicate the value of a VIX futures contract. This allows me to isolate a nonfundamental component in VIX futures prices, of 18.5% per year, that is strongly related to the rebalancing of ETFs. To understand the source of that component, I decompose trading demand from ETFs into three main parts: leverage rebalancing, calendar rebalancing, and flow rebalancing. Leverage rebalancing has the largest effects. It amplifies price changes and introduces unhedgeable risks for ETF counterparties. Surprisingly, providing liquidity to leveraged ETFs turns out to be a bet on variance, even in a market with a zero net share of ETFs. Trading against leverage rebalancing delivers large abnormal returns and Sharpe ratios above two across markets. The second paper analyses the impact of the ECB’s Corporate Sector Purchase Programme (CSPP) announcement on prices, liquidity and debt issuance in the European corporate bond market. I find that the quantitative easing (QE) programme increased prices and liquidity of bonds eligible to be purchased substantially. Bond yields dropped on average by 30 bps (8%) after the CSPP announcement. Tri-party repo turnover rose by 8.15 million USD (29%), and bilateral turnover went up by 7.05 million USD (72%). Bid-ask spreads also showed significant liquidity improvement in eligible bonds. QE was successful in boosting corporate debt issuance. Firms issued 2.19 billion EUR (25%) more in QE-eligible debt after the CSPP announcement, compared to other types of debt. Surprisingly, corporates used the attracted funds mostly to increase dividends. These effects were more pronounced for longer-maturity, lower-rated bonds, and for more credit-constrained, lower-rated firms. The third paper (co-authored with Christian Julliard, Zijun Liu, Seyed E. Seyedan and Kathy Yuan) studies the determinants of repo haircuts in the UK market. We find that transaction maturity and collateral quality have first order importance. We also document that counterparties matter in determining haircuts. Hedge funds, as borrowers, receive significantly higher haircuts. Larger borrowers with higher ratings receive lower haircuts, but we find that these effects can be overshadowed by collateral quality. Repeated bilateral relationships also matter and generate lower haircuts. We find evidence supporting an adverse selection explanation of haircuts, but limited evidence in favor of lenders’ liquidity position or default probabilities affecting haircuts