Measuring and Explaining Pension System Risk

We discuss pension system risk in the United States by focusing on the investment policy and the methodology for the valuation of the liabilities of the Pension Benefit Guaranty Corporation (PBGC). We offer suggestions as to how the PBGC should consider modifying the Pension Insurance Modeling System. The issues of investment policy and liability valuation are not two distinct topics. As emphasized here, the proper valuation of liabilities provides a benchmark for the PBGC to use as a starting point for the establishment of its investment policy and then for assessing investment performance

A profit model for spread trading with an application to energy futures

This paper proposes a profit model for spread trading by focusing on the stochastic movement of the price spread and its first hitting time probability density. The model is general in that it can be used for any financial instrument. The advantage of the model is that the profit from the trades can be easily calculated if the first hitting time probability density of the stochastic process is given. We then modify the profit model for a particular market, the energy futures market. It is shown that energy futures spreads are modeled by using a meanreverting process. Since the first hitting time probability density of a mean-reverting process is approximately known, the profit model for energy futures price spreads is given in a computable way by using the parameters of the process. Finally, we provide empirical evidence for spread trades of energy futures by employing historical prices of energy futures (WTI crude oil, heating oil, and natural gas futures) traded on the New York Mercantile Exchange. The results suggest that natural gas futures trading may be more profitable than WTI crude oil and heating oil due to its high volatility in addition to its long-term mean reversion, which offers supportive evidence of the model prediction. --futures spread trading,energy futures markets,mean-reverting process,first hitting,time probability density,profit model,WTI crude oil,heating oil,natural gas

CVaR sensitivity with respect to tail thickness

We consider the sensitivity of conditional value-at-risk (CVaR) with respect to the tail index assuming regularly varying tails and exponential and faster-than-exponential tail decay for the return distribution. We compare it to the CVaR sensitivity with respect to the scale parameter for stable Paretian, the Student's t, and generalized Gaussian laws and discuss implications for the modeling of daily returns and marginal rebalancing decisions. Finally, we explore empirically the impact on the asymptotic variability of the CVaR estimator with daily returns which is a standard choice for the return frequency for risk estimation. --fat-tailed distributions,regularly varying tails,conditional value-at-risk,marginal rebalancing,asymptotic variability

Bayesian inference for hedge funds with stable distribution of returns

Recently, a body of academic literature has focused on the area of stable distributions and their application potential for improving our understanding of the risk of hedge funds. At the same time, research has sprung up that applies standard Bayesian methods to hedge fund evaluation. Little or no academic attention has been paid to the combination of these two topics. In this paper, we consider Bayesian inference for alpha-stable distributions with particular regard to hedge fund performance and risk assessment. After constructing Bayesian estimators for alpha-stable distributions in the context of an ARMA-GARCH time series model with stable innovations, we compare our risk evaluation and prediction results to the predictions of several competing conditional and unconditional models that are estimated in both the frequentist and Bayesian setting. We find that the conditional Bayesian model with stable innovations has superior risk prediction capabilities compared with other approaches and, in particular, produced better risk forecasts of the abnormally large losses that some hedge funds sustained in the months of September and October 2008. --

Analysis of the intraday effects of economic releases on the currency market

Using four years of second-by-second executed trade data, we study the intraday effects of a representative group of scheduled economic releases on three exchange rates: EUR/$, JPY/$ and GBP/$. Using wavelets to analyze volatility behavior, we empirically show that intraday volatility clusters increase as we approach the time of the releases, and decay exponentially after the releases. Moreover, we compare our results with the results of a poll that we conducted of economists and traders. Finally, we propose a wavelet volatility estimator which is not only more efficient than a range estimator that is commonly used in empirical studies, but also captures the market dynamics as accurately as a range estimator. Our approach has practical value in high-frequency algorithmic trading, as well as electronic market making. --Foreign exchange,volatility estimation,economic release,wavelet,high frequency