The Endowment Challenge

The financial crisis of 2008 is nearly five years behind us, yet its impact on nonprofit organizations persists. The bull market that began in the early 1980s delivered historically strong returns for most long-term investment portfolios through 2008, but the factors that contributed to that performance may have run their course. Equity returns weakened over the past decade, and despite better results from bonds, overall portfolio returns have declined. Looking ahead, inflation is likely to remain low, but investment returns are also expected to be lower for the next few market cycles within more volatile markets. This will make it difficult for nonprofits to rebound from portfolio losses suffered in the 2008 downturn. Nonprofits face a "New Reality" of lower returns, higher volatility and increased scrutiny from boards and regulators. This paper discusses the challenges and opportunities nonprofit organizations face in a changing market environment

A Benchmark Framework for Risk Management

The paper describes a general framework for contingent claim valuation for finance, insurance and general risk management. It considers security prices and portfolios with finite expected returns, where the growth optimal portfolio is taken as numeraire or benchmark. Benchmarked nonnegative wealth processes are shown to be supermartingales. Fair benchmarked values are conditional expectations of future benchmarked prices under the real world probability measure. Standard risk neutral and actuarial pricing formulas are obtained as special cases of fair pricing. The proposed benchmark framework covers the infinite time horizon and does not require the existence of an equivalent risk neutral pricing measure.benchmark model; growth optimal portfolio; fair pricing; risk neutral pricing; actuarial pricing

Optimal Portfolio Management for Individual Pension Plans

We explore the various arguments for and against the recommendation that younger households should invest a larger share of their pension wealth in risky assets. The ability of young agents to compensate their financial losses by saving more during their career provides the strongest argument in favour of younger people investing more aggressively in the stock market. Meanreversion in stock returns yields another argument. However, the uninsurability of the risky human capital goes in the opposite direction, together with the imperfect knowledge that young investors have about the distribution of asset returns.dynamic portfolio choice, pension plan, retirement, time horizon

Implied rates of return, the discount rate effect, and market risk premia

We show analytically under quite general conditions that implied rates of return based on analysts' earnings forecasts are only a downward biased estimator for future expected one-period returns and therefore not suited for computing market risk premia. The extent of this bias is substantial as verified by a bootstrap approach. We present an alternative estimation equation for future expected one-period returns based on current and past implied rates of return that is superior to simple estimators based on historical returns. The reason for this superiority is a lower variance of estimation results and not the circumvention of the discount rate effect typically stated as a major problem of estimators based on historical return realizations. The superiority of this new approach for portfolio selection purposes is verified numerically for our bootstrap environment and empirically for real capital market data. --analysts' earnings forecasts,discount rate effect,equity premium puzzle,implied rate of return

Precautionary saving and portfolio allocation: DP by GMM

There is much research on consumption-savings problems with risky labor income and a constant interest rate and also on portfolio allocation with risky returns but nonstochastic labor income. Less is known quantitatively about the interaction between the two forms of risk. Under CRRA utility, undiversifiable income risk should be reflected in both savings rates and portfolio allocations. To quantify these effects in a model of consumption and portfolio choice, we adopt a semi-parametric projection method for solving dynamic programmes, based on generalized method of moments estimation of the parameters of approximate decision rules. We find that background income risk does affect optimal portfolios but that this effect may be difficult to detect empirically.portfolio theory, precautionary saving

Export diversification and resource-based industrialization: the case of natural gas

For resource-rich economies, primary commodity specialization has often been considered to be detrimental to growth. Accordingly, export diversification policies centered on resource-based industries have long been advocated as effective ways to moderate the large variability of export revenues. This paper discusses the applicability of a mean-variance portfolio approach to design these strategies and proposes some modifications aimed at capturing the key features of resource processing industries (presence of scale economies and investment lumpiness). These modifications help make the approach more plausible for use in resource-rich countries. An application to the case of natural gas is then discussed using data obtained from Monte Carlo simulations of a calibrated empirical model. Lastly, the proposed framework is put to work to evaluate the performances of the diversification strategies implemented in a set of nine gas-rich economies. These results are then used to formulate some policy recommendations

Optimal bank portfolio choice under fixed-rate deposit insurance

An analysis of the investment decisions of a bank whose deposits are fully insured under fixed-rate insurance, showing how banks dynamically adjust their investment portfolios in response to market information and how this flexibility affects both investment decisions and the fair cost of deposit insurance.Deposit insurance ; Bank investments

Conservation Payments under Risk: A Stochastic Dominance Approach

Conservation payments can be used to preserve forest and agroforest systems. To explain landowners’ land-use decisions and determine appropriate conservation payments, it is necessary to focus on revenue risk. Marginal conditional stochastic dominance rules are used to derive conditions for determining the conservation payments required to guarantee that the environmentally-preferred land use dominates. An empirical application to shaded-coffee protection in the biologically important Chocó region of West-Ecuador shows that conservation payments required for preserving shaded-coffee areas are much higher than those calculated under risk-neutral assumptions. Further, the extant distribution of land has strong impacts on the required payments.agroforest systems, conservation payments, land allocation, portfolio diversification, risk, stochastic dominance

Explaining the Magnitude of Liquidity Premia: The Roles of Return Predictability, Wealth Shocks and State-Dependent Transaction Costs

The seminal work of Constantinides (1986) documents how, when the risky return is calibrated to the U.S. market return, the impact of transaction costs on per-annum liquidity premia is an order of magnitude smaller than the cost rate itself. A number of recent papers have formed portfolios sorted on liquidity measures and found a spread in expected per-annum return that is definitely not an order of magnitude smaller than the transaction cost spread: the expected per-annum return spread is found to be around 6-7% per annum. Our paper bridges the gap between Constantinides' theoretical result and the empirical magnitude of the liquidity premium by examining dynamic portfolio choice with transaction costs in a variety of more elaborate settings that move the problem closer to the one solved by real-world investors. In particular, we allow returns to be predictable and transaction costs to be stochastic, and we introduce wealth shocks, both stationary multiplicative and labor income. With predictable returns, we also allow the wealth shocks and transaction costs to be state dependent. We find that adding these real world complications to the canonical problem can cause transactions costs to produce per-annum liquidity premia that are no longer an order of magnitude smaller than the rate, but are instead the same order of magnitude. For example, predictable returns and i.i.d. labor income growth causes the liquidity premium for an agent with a wealth to monthly labor income ratio of 0 or 10 to be 1.68\% and 1.20\% respectively; these are 21-fold and 15-fold increases, respectively, relative to that in the standard i.i.d. return case. We conclude that the effect of proportional transaction costs on the standard consumption and portfolio allocation problem with i.i.d. returns can be materially altered by reasonable perturbations that bring the problem closer to the one investors are actually solving.

Capital Asset Pricing for Markets with Intensity Based Jumps

This paper proposes a unified framework for portfolio optimization, derivative pricing, modeling and risk measurement in financial markets with security price processes that exhibit intensity based jumps. It is based on the natural assumption that investors prefer more for less, in the sense that for two given portfolios with the same variance of its increments, the one with the higher expected increment is preferred. If one additionally assumes that the market together with its monetary authority acts to maximize the long term growth of the market portfolio, then this portfolio exhibits a very particular dynamics. In a market without jumps the resulting dynamics equals that of the growth optimal portfolio (GOP). Conditions are formulated under which the well-known capital asset pricing model is generalized for markets with intensity based jumps. Furthermore, the Markowitz efficient frontier and the Sharpe ratio are recovered in this continuous time setting. In this paper the numeraire for derivative pricing is chosen to be the GOP. Primary security account prices, when expressed in units of the GOP, turn out to be supermartingales. In the proposed framework an equivalent risk neutral martingale measure need not exist. Fair derivative prices are obtained as conditional expectations of future payoff structures under the real world probability measure. The concept of fair pricing is shown to generalize the classical risk neutral and the actuarial net present value pricing methodologies.benchmark model; jump diffusions; growth optimal portfolio; market portfolio; effiient frontier; Sharpe ratio; fair pricing; actuarial pricing