Macroeconomic Volatility and Sovereign Asset-Liability Management

For most developing countries, the predominant source of sovereign wealth is commodity related export income. However, over-reliance on commodity related income exposes countries to significant terms of trade shocks due to excessive price volatility. The spillovers are pro-cyclical fiscal policies and macroeconomic volatility problems that if not adequately managed, could have catastrophic economic consequences including sovereign bankruptcy. The aim of this study is to explore new ways of solving the problem in an asset-liability management framework for an exporting country like Ghana. Firstly, I develop an unconditional commodity investment strategy in the tactical mean-variance setting for deterministic returns. Secondly, in continuous time, shocks to return moments induce additional hedging demands warranting an extension of the analysis to a dynamic stochastic setting whereby, the optimal commodity investment and fiscal consumption policies are conditioned on the stochastic realisations of commodity prices. Thirdly, I incorporate jumps and stochastic volatility in an incomplete market extension of the conditional model. Finally, I account for partial autocorrelation, significant heteroskedastic disturbances, cointegration and non-linear dependence in the sample data by adopting GARCH-Error Correction and dynamic Copula-GARCH models to enhance the forecasting accuracy of the optimal hedge ratios used for the state-contingent dynamic overlay hedging strategies that guarantee Pareto efficient allocation. The unconditional model increases the Sharpe ratio by a significant margin and noticeably improves the portfolio value-at-risk and maximum drawdown. Meanwhile, the optimal commodities investment decisions are superior in in-sample performance and robust to extreme interest rate changes by up to 10 times the current rate. In the dynamic setting, I show that momentum strategies are outperformed by contrarian policies, fiscal consumption must account for less than 40% of sovereign wealth, while risky investments must not exceed 50% of the residual wealth. Moreover, hedging costs are reduced by as much as 55% while numerically generating state-dependent dynamic futures hedging policies that reveal a predominant portfolio strategy analogous to the unconditional model. The results suggest buying commodity futures contracts when the country’s current exposure in a particular asset is less than the model implied optimal quantity and selling futures contracts when the actual quantity exported exceeds the benchmark.Open Acces

Optimal portfolio strategies of cointegrated assets

Statistical arbitrage, as a quantitative method of speculation, has been increasingly prevalent along with the evolution of computational nance. One of the most popular statistical arbitrage strategies is called pairs trading, which is widely used by hedge funds and investment banks since the mid-1980s. Pairs trading strategy exploits price spread between paired assets by taking long-short positions. If price spread is temporary according to past price information, a trading opportunity arises and pro ts can be made from price correction process. To capture these opportunities, we focus on assets sharing cointegration relations. This long-term relationship implies that paired assets are exposed to common fundamentals, and hence it guarantees price convergence to the equilibrium level. Therefore, this thesis applies cointegration technique to capture short-term market anomalies and exploits these inefficiencies using pairs trading in order to build optimal portfolio strategies. The thesis consists of three chapters. The first chapter presents an equilibrium framework based on equity commonality explicitly adapted to describe the dynamics of pairs trading. Our methodology, built on the price discovery model of Figuerola-Ferretti and Gonzalo (Journal of Econometrics 2010) exploits price leadership for portfolio replication purposes and shows how pairs trading profitability is linked to the speed of equilibrium reversion. A persistence-dependent trading trigger is introduced to impose higher thresholds on pairs with slower mean reversion. Our model demonstrates that equilibrium price convergence guarantees positive abnormal pro tability. Applied to STOXX Europe 600 traded equities our strategy delivers Sharpe ratios that outperform benchmark rules used in the literature. Portfolio performance is enhanced after firm fundamental factor restrictions are imposed. The second chapter proposes a VECM representation for cointegrated assets in the continuous time framework. This model implies a simple method to check for cointegration based on the speed of equilibrium reversion. A pair of cointegrated assets is then identified to derive a dynamically optimal pairs trading portfolio with a risk-free bond. This involves maximizing the portfolio value at terminal time without the requirement of a functional form for investor´s preferences. To this end, we connect the derived optimal portfolio with European-type spread options and in consequence the optimal investment policies can be modeled using the spread option's resulting delta hedging strategies. Our framework is tested empirically using pairs identi ed from the Dow Jones Industrial Average. This analysis requires maximum likelihood estimates on continuous VECM parameters, compared to the benchmark Johansen methodology. We nd that the proposed optimal strategy delivers consistent profitability in terms of Sharpe ratio and cumulative returns. This supports the usefulness of introducing spread option's deltas as the optimal investment policies for pairs portfolio construction. In addition, our model-implied selection algorithm outperforms the Johansen (1991) methodology commonly applied in the previous literature. Finally, the third chapter examines the performance of pair trading portfolios when sorted by the level of cointegration of their constituents. The supercointegrated portfolio, that is formed by pairs at 1% confidence level of cointegration tests, exhibits a superior out-ofsample performance than simple buy-and-hold and passive investments in terms of Sharpe ratio. We find that the degree of performance of pairs strategy is positively related to the level of cointegration among pairs. These evidence are also documented in an international context, from the analysis on the European stock market. The time-varying risk of the pairs strategy is linked to aggregate market volatility. A positive risk-return relationship of the strategy is also found.Programa Oficial de Doctorado en Empresa y Finanzas / Business and FinancePresidente: Federico Zapatero; Secretario: Ángel León; Vocal: Genaro Sucarra

Essays on pension funding and long-term investing

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Optimal currency shares in international reserves: the impact of the euro and the prospects for the dollar

Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important. JEL Classification: F02, F30, G11, G15Currency optimizer, euro, Foreign reserves, international currencies

A theory based stochastic investment model for actuarial use

Includes bibliographical references (leaves 73-79).This thesis reviews the origins, development and uses of asset-liability modelling, as well as existing largely stochastic investment models, notably those of the Maturity Guarantees Working Party (1980), Wilkie (1986,1995) and Thomson (1996). A stochastic investment model is developed which describes returns from equities, bonds and cash, as well as inflation and economic growth. The model is consistent with economic theory, adequately fits past data, and is relatively parsimonious compared with other models. A series of assumptions about the causal relationships between inflation, economic growth and interest rates are made based on standard economic theory. It is noted that consensus does not exist on some of the economic theory. Similarly a series of assumptions on the pricing of assets are made based on financial economic theory on market efficiency, expectations and asset pricing. Notably, it is assumed that financial markets are efficient. An economic model is described for inflation, economic growth and interest rates based on the set of assumptions. Each variable is modelled such that its value in one period is a function of its value in the previous period, the value of the other economic variables in the current and previous period, and a normally distributed residual. The model is a mixture of a random walk and autoregressive process that has two special cases of a (non-mean-reverting) pure random walk, and a (mean-reverting) pure autoregressive process. A financial market model is described for bond and equity returns based on the set of assumptions. Expected returns are derived from the expected real interest rate plus a risk premium, where the risk premium is linearly related to the standard deviation of real return. Bond yields are modelled as the sum of expected future short term real interest rates, expected future inflation, and a risk premium. Share prices are modelled as the present value of expected future distributable earnings, discounted at a rate equal to the sum of expected future short term real interest rates, expected future inflation, and a risk premium. The growth in earnings per share is modelled as the sum of inflation, real economic growth and a normal residual, and is also linked to real interest rates. Dividends are modelled as a smoothed function of earnings, with unit-gain from earnings to dividends. Annual data for a 15 year period is used to parameterise the model for the United States, Britain and South Africa respectively. The modelled volatilities of financial market returns, together with the economic data, are used to fit the economic model. The procedure is similar to the method of moments for statistical estimation. Parameters in the economic model that are not statistically significant or are not consistent with the assumptions are excluded. It was found that neither the random walk nor the autoregressive special case models could adequately explain observed volatility in financial markets, so the general case (mixture model) was adopted for economic variables. The parameterised models for the three countries studied exhibited a ""cascade structure"" where all variables are a function of one or two ""driving variables"", without any circularity/""feedback"". The models for the United States and Britain all have inflation as the driving variable, whereas the South African model has both inflation and economic growth as driving variables. The model achieves the objectives of consistency with economic theory as well as parsimony (when compared to Wilkie (1995)). With regards to the criterion of producing reasonable output, the model has advantages over existing models. These include that financial market returns simulated by the model are non-normal and exhibit significant leptokursis (fat-tails) with higher probabilities of severe down-market returns than are predicted by normal or log-normal distributions. Simulated returns also exhibit the weak and slow mean reversion that is observed in markets, and the simulated yield curve exhibits non-parallel shifts and inversions. However, simulated interest rates (particularly nominal interest rates), and even bond yields can become negative, although the probability of negative nominal interest rates is small in the model, and that of negative bond yields is negligible. Two areas where a good fit was not achieved were in the models of risk premiums and dividends. It is recommended that alternative approaches for estimating risk premiums be used. The poor fit to dividend data is not regarded as a significant weakness because modelled equity returns are not dependent on dividends

Corporate environmental performance and its impact on financial performance and financial risk: Evidence from Australia

This thesis consists of four essays on Corporate Environmental Performance (CEP) and its impact on Corporate Financial Performance (CFP). The first essay is entitled “Emission Indices for Hazardous Substances: An Alternative Measure of Corporate Environmental Performance”. This essay reviewed significant interdisciplinary research and concluded that firm chemical release/emission can be used as a proxy for a firm measure of environmental performance. It also proposed that due to the variety of chemicals and different levels of toxicity, a risk factor should be calculated for all chemicals on the basis of human health risk, environment risk and risk of exposure. Once a single risk factor is calculated for each chemical, then it should be multiplied by the level of each company chemical release that is reported to National Pollutant Inventory in order to calculate the weighted average risk factor for each company. Thus, the weighted average risk is a robust measure having the combined effect of level of toxicity and volume of chemical emissions. Once the environmental performance index is formulated, the second essay investigated the nature of the relationship between environmental performance and financial performance of publicly listed companies in Australia. The second essay provided evidence that the nature of the relationship between environmental performance and financial performance is positive. Further, this study divided the sample into a period of economic growth (2001-2007) and a period of economic contraction (2008-2010). The multivariate regression estimation shows a positive relation between CEP and CFP in the period of economic growth but during the extra ordinary circumstances like the financial crisis this relationship is insignificant. This research is of great relevance for managers, academics and society at large. The third essay investigates the relationship between Corporate Environmental Performance (CEP) and financial risk for Australian listed companies from 2001-2010. Three financial risk measures including firm market risk, systematic risk and downside risk were used. The analytical procedure based on fixed effects estimation provides strong evidence that environmental performance is negatively and statistically associated with market volatility and to different measures of downside risk. The third essay results show that downside risk is a better measure of firm risk especially when investors are not showing linear sensitivity to changes in prices. Therefore, this study concludes that environmental performance (reduction in toxic emissions) provides a wealth protection effect. The results are robust after controlling for several moderating effects including financial, institutional and environmental management. The fourth essay analyses the causal relationship between firm financial performance and environmental performance. The results provide convincing support for the idea that there is a bi-directional relationship between CEP and CFP in both the short and long run. These results support the Hart and Ahuja (1996) hunch that a ‘virtuous circle’ exists with regard to the relationship between pollution prevention and CFP, that is, firms can realize cost savings and plough these savings back into further emission reduction projects for a number of years before the benefits balance turns negative

ESSAYS IN CROSS-COUNTRY CONSUMPTION RISK SHARING

This dissertation concerns cross-country consumption risk sharing in a long-run perspective. Financial integration, empirically measured by cross-country holdings of assets and liabilities, has increased dramatically in the past two decades. But what can explain the lack of cross-country risk sharing documented in the literature? Chapters 2 and 3 of this dissertation address this question. In Chapter 2, we set up a model to illustrate the mechanical difference between a bond economy and an insurance economy. We show that a bond economy can intertemporally smooth consumption in face of transitory output shocks, but not for permanent output shocks; an insurance economy is essential for risk sharing on permanent shocks. We therefore show that when both transitory and permanent output shocks exist, transitory shocks only create "noise" if the focus of interest is on identifying risk sharing in the long run. In Chapter 3, we specify an empirical nonstationary panel regression model to test long-run consumption risk sharing across a sample of OECD and emerging market countries. This is in contrast to tests in the literature which are mainly about risks at business cycle frequency. We argue that these existing tests neglected the permanent elements of risks that are of interest and that their model specifications were not rich enough to accommodate heterogeneous short-run dynamics. Since our methodology focuses on identifying cointegrating relationships while allowing for arbitrary short-run dynamics, we can obtain a consistent estimate of long-run risk sharing while disregarding any short-run nuisance factors. Our results show that, for the period of 1950-2008, the level of long-run risk sharing in OECD countries is similar to that in emerging market countries. However, during the financial integration episode of the past two decades, long-run risk sharing in OECD countries increased more than in emerging market countries. Furthermore, we investigate the relationship between various measures of financial integration and cross-country risk sharing, but only find weak evidence of such linkages

UK market efficiency and the Myners review: a univariate analysis of strategic asset allocation by industrial sectors.

The Treasury's report "Institutional Investment in the United Kingdom: A Review" (the Myners Review) suggested in 2001 that various sectors of the UK equity market may be suitable for active investment management, tacitly assuming that some sectors are efficient whilst others are not. The validity of this assumption is tested against 29 industrial sector indices within the FTSE All Share index. Sector efficiency is, taken to be that index values reflect information correctly (strong efficient) or to the point where benefits do not exceed costs (weakly efficient). Existence of a sector index following a random walk is used to identify strong efficiency with the subsequent conclusion that passive management would be appropriate. Where the time series is not random, forecasting gains less than the management costs of active trading indicate weak efficiency with the corollary that passive management is still applicable. Industrial sectors where the index can be forecast with gains in excess of costs are not efficient and are appropriate for active management. The indices are tested for stationarity: none are stationary in levels but all reject the Dickey Fuller null hypothesis of a unit root in their first difference, the logarithmic return. Tests for randomness are based on pure random walks and random walks with drift and/or trend. Non-random time series are examined for maintained regressions based on AR, MA and ARMA. Where appropriate, ARCH is applied to the variance, utilising GARCH, Threshold GARCH, GARCH-in mean, Exponential GARCH and Component GARCH. Additionally there is a test for cointegration. All potential data generating processes' residuals are tested for independent identical distributions using the BDS test. If the maintained regression produces residuals that are III) then that series is assumed to be explained. The results show that four indices are strong efficient and five are weak; giving nine sectors that should be managed passively. Only one sector is found where there is scope for active management to make an abnormal gain in excess of costs. Nineteen of the indices had GARCH, which indicated a possible lack of efficiency but no decision on management style. One index was unexplained. Thus the Myners review's suggestion of active management where appropriate was valid, but limited solely to the Personal Care & Household Products sector

Essays on Pension Scheme Design and Risk Management.

This dissertation deals with the optimal design of funded pension schemes and its welfare implications for participants. The first article illustrates the welfare gain of well organized intergenerational risk sharing within collective pension funds over the optimal individual benchmark. The second article demonstrates the significant welfare improvements by adapting age-dependent contribution rule as default for individual DC pension schemes. The final article examines the implication of longevity in terms of pricing for pension fund risk management.

Strategic asset allocation considerations for German pension insurance funds: theoretical analysis and empirical evidence : applying stochastic time-series simulations and dynamic, multiperiod investment strategies to determine optimal portfolio structures

Our research project analyses the suitability of social responsible investments (SRI) and alternative asset classes (in particular commodities, hedge fund investments, high-yield bonds) for the portfolio management of German Pension Insurance Funds (Pensionskassen), the largest external occupational pension scheme in Germany. The research objective is to determine optimal portfolio allocations for varying asset classes and investment strategies. The empirical methodology applied in our analysis will consist of stochastic time series simulations in combination with dynamic, multi-period asset allocation strategies. To our knowledge, our research proposal is to date the first of its kind and will provide valuable results to the academic research community as well as represent a useful reference for finance practitioners