Capital requirements: Are they the best solution?

General risk functions are becoming very important in finance and insurance. Many risk functions are interpreted as initial capital requirements that a manager must add and invest in a risk-free security in order to protect his clients wealth. Nevertheless, until now it has not been proved that an alternative investment will be outperformed by the riskless asset. This paper deals with a complete arbitrage free market and a general expectation bounded risk measure and analyzes whether the investment in the riskless asset of the capital requirements is optimal. It is shown that it is not optimal in many important cases. For instance, if the risk measure is the CVaR and we consider the assumptions of the CAPM or the Black and Scholes model. Furthermore, the Black and Scholes model the explicit expression of the optimal strategy is provided, and it is composed of several put options. If the confidence level of the CVaR is close to 100% then the optimal strategy becomes a classical portfolio insurance strategy. This may be a surprising and important finding for both researchers and practitioners. In particular, managers can discover how to reduce the level of initial capital requirements by trading options

Stochastic Dominance Portfolio Analysis of Forestry Assets

We consider the forestry decision-making and harvesting problem from the perspective of financial portfolio management, where harvestable forest stands constitute one of the liquid assets of the portfolio. Using real data from Finnish mixed borealis forests and from the Helsinki stock exchange, we investigate the effect of trading the timber stock together with the forest land, or without the land (i.e., harvesting), on the portfolio efficiency. As our research methodology, we utilize the general Stochastic Dominance (SD) criteria, focusing on the recent theoretical advances in analyzing portfolio diversification within the SD framework. Our findings shed some further light on the question of how to model the forestry planning problem, and provide some comparative evidence of the applicability of the alternative SD test approaches.Forest Management, Portfolio Optimization, Stochastic Dominance, Diversification

Portfolio choice and estimation risk : a comparison of Bayesian approaches to resampled efficiency

Estimation risk is known to have a huge impact on mean/variance (MV) optimized portfolios, which is one of the primary reasons to make standard Markowitz optimization unfeasible in practice. Several approaches to incorporate estimation risk into portfolio selection are suggested in the earlier literature. These papers regularly discuss heuristic approaches (e.g., placing restrictions on portfolio weights) and Bayesian estimators. Among the Bayesian class of estimators, we will focus in this paper on the Bayes/Stein estimator developed by Jorion (1985, 1986), which is probably the most popular estimator. We will show that optimal portfolios based on the Bayes/Stein estimator correspond to portfolios on the original mean-variance efficient frontier with a higher risk aversion. We quantify this increase in risk aversion. Furthermore, we review a relatively new approach introduced by Michaud (1998), resampling efficiency. Michaud argues that the limitations of MV efficiency in practice generally derive from a lack of statistical understanding of MV optimization. He advocates a statistical view of MV optimization that leads to new procedures that can reduce estimation risk. Resampling efficiency has been contrasted to standard Markowitz portfolios until now, but not to other approaches which explicitly incorporate estimation risk. This paper attempts to fill this gap. Optimal portfolios based on the Bayes/Stein estimator and resampling efficiency are compared in an empirical out-of-sample study in terms of their Sharpe ratio and in terms of stochastic dominance

International diversification benefits with foreign exchange investment styles

This paper provides a comprehensive analysis of portfolio choice with popular foreign exchange (FX) investment styles such as carry trades and strategies commonly known as FX momentum, and FX value. We investigate if diversification benefits can be achieved by style investing in FX markets relative to a benchmark allocation consisting of U.S. bonds, U.S. stocks, and international stocks. Overall, our results suggest that there are significant improvements in international portfolio diversification due to style-based investing in FX markets (both in the statistical, and most importantly, in the economic sense). These results prevail for the most important investment styles after accounting for transaction costs due to re-balancing of currency positions, and also hold in out-of-sample tests. Moreover, these gains do not only apply to a mean-variance investor but we also show that international portfolios augmented by FX investment styles are superior in terms of second and third order stochastic dominance. Thus, even an investor who dislikes negatively skewed return distributions would prefer a portfolio augmented by FX investment styles compared to the benchmark. --International Diversification,Foreign Exchange Speculation and Hedging,Carry Trades,Stochastic Dominance,Investment Styles

Market imperfections, discount factors and stochastic dominance: an empirical analysis with oil-linked derivatives

Oil-linked derivatives are becoming very important in Modern Investment Theory. Accordingly, the analysis of Pricing Techniques and Portfolio Choice Problems involving these securities is a major topic for both managers and researchers. We focus on both the No-Arbitrage Approach and Stochastic Discount Factor (SDF) based methods in order to study oil-linked derivatives available at The New York Mercantile Exchange, Inc, one of the world's largest markets in energy and precious metals. First, we generalize some theoretical properties of the SDF in order to capture the effects induced by the bid-ask spread when analyzing dominated/efficient portfolios. Secondly, we apply our findings and empirically analyze the existence of dominated assets and portfolios in the oil derivatives market. Our results reveal the systematic presence of dominated prices, which should be taken into account by traders when composing their portfolios. Additionally, the test yields pricing and portfolio choice methods as well as new strategies that may allow brokers to outperform their service for their clients. It is worth to point out that the conclusions of the test have two important characteristics: On the one hand, they are very precise since we draw on perfectly synchronized bid/ask prices, as provided by Reuters. On the other hand, they are robust in the sense that they do not depend on any assumption about the underlying asset price dynamics. Finally, despite the empirical test focuses on oil derivatives, the methodology is general enough to apply to a broad range of markets

MARKET IMPERFECTIONS, DISCOUNT FACTORS AND STOCHASTIC DOMINANCE: AN EMPIRICAL ANALYSIS WITH OIL-LINKED DERIVATIVES

Oil-linked derivatives are becoming very important in Modern Investment Theory. Accordingly, the analysis of Pricing Techniques and Portfolio Choice Problems involving these securities is a major topic for both managers and researchers. We focus on both the No-Arbitrage Approach and Stochastic Discount Factor (SDF) based methods in order to study oil-linked derivatives available at The New York Mercantile Exchange, Inc, one of the world's largest markets in energy and precious metals. First, we generalize some theoretical properties of the SDF in order to capture the effects induced by the bid-ask spread when analyzing dominated/efficient portfolios. Secondly, we apply our findings and empirically analyze the existence of dominated assets and portfolios in the oil derivatives market. Our results reveal the systematic presence of dominated prices, which should be taken into account by traders when composing their portfolios. Additionally, the test yields pricing and portfolio choice methods as well as new strategies that may allow brokers to outperform their service for their clients. It is worth to point out that the conclusions of the test have two important characteristics: On the one hand, they are very precise since we draw on perfectly synchronized bid/ask prices, as provided by Reuters. On the other hand, they are robust in the sense that they do not depend on any assumption about the underlying asset price dynamics. Finally, despite the empirical test focuses on oil derivatives, the methodology is general enough to apply to a broad range of markets.

A General Equilibrium Financial Asset Economy with Transaction Costs and Trading Constraints

This paper presents a unified framework for examining the general equilibrium effects of transactions costs and trading constraints on security market trades and prices. The model uses a discrete time/state framework and Kuhn-Tucker theory to characterize the optimal decisions of consumers and financial intermediaries. Transaction costs and constraints give rise to regions of no trade and to bid-ask spreads: their existence frustrate the derivation of standard results in arbitrage-based pricing. Nevertheless, we are able to obtain as dual characterizations of our primal problems, one-sided arbitrage pricing results and a personalized martingale representation of asset pricing. These pricing results are identical to those derived by Jouini and Kallal (1995) using arbitrage arguments. The paper's framework incorporates a number of specialized existing models and results, proves new results and discusses new directions for research. In particular, we include characterizations of intermediaries who hold optimal portfolios; brokers who do not hold portfolios, and consumer-specific transactions costs and trading constraints. Furthermore we show that in the special case of equiproportional transaction costs and a sufficient number of assets, there is an analogue of the arbitrage pricing result for European derivatives where prices are interpreted as mid-prices between the bid-ask spread. We discuss the effects of non-convex transaction technologies on prices and trades.Financial Markets, Transaction Costs, Trading Constraints, Asset Pricing, General Equilibrium, Incomplete Markets

Stochastic simulation framework for the Limit Order Book using liquidity motivated agents

In this paper we develop a new form of agent-based model for limit order books based on heterogeneous trading agents, whose motivations are liquidity driven. These agents are abstractions of real market participants, expressed in a stochastic model framework. We develop an efficient way to perform statistical calibration of the model parameters on Level 2 limit order book data from Chi-X, based on a combination of indirect inference and multi-objective optimisation. We then demonstrate how such an agent-based modelling framework can be of use in testing exchange regulations, as well as informing brokerage decisions and other trading based scenarios