2003 Series

Bivariate Normal Mixture Spread Option Valuation

Abstract: This paper explores the properties of a European spread option valuation method for correlated assets when the marginal distribution each asset return is assumed to be a mixture of normal distributions. In this ?bivariate normal mixture? (BNM) approach no-arbitrage option values are just weighted sums of different 2GBM values based on two correlated lognormal diffusions, and likewise for theirContinue reading

Intra-day Patterns in the Returns, Bid-ask Spreads, and Trading Volume of Stocks Traded on the New York Stock Exchange

Abstract: Much research has demonstrated the existence of patterns in high-frequency equity returns, return volatility, bid-ask spreads and trading volume. In this paper, we employ a new test for detecting periodicities based on a signal coherence function. The technique is applied to the returns, bid-ask spreads, and trading volume of thirty stocks traded on the NYSE. We are able toContinue reading

On the Aggregation of Market and Credit Risks

Abstract: This paper presents a new approach to aggregating market and credit risks in large complex financial firms, banks in particular. By identifying risk factors that are common to many business activities, dependencies between different risk types across various lines of business can be properly accounted for in the aggregate risk estimate. The risk factor aggregation model is illustrated usingContinue reading

The Present, Future and Imperfect of Financial Risk Management

Abstract: Current research on financial risk management applications of econometrics centres on the accurate assessment of individual market and credit risks with relatively little theoretical or applied econometric research on other types of risk, aggregation risk, data incompleteness and optimal risk control. We argue that consideration of the model risk arising from crude aggregation rules and inadequate data could leadContinue reading

Application-Based Financial Risk Aggregation Methods

Abstract: Financial risks are usually analysed by type and by activity using different assumptions and methodologies as may seem appropriate in each case. This approach makes it very difficult to ascertain the degree of diversification between various activities and to obtain a proper estimate of global risk. We show that different risk aggregation methodologies should be used depending on theContinue reading

Long-term Information, Short-lived Securities

Abstract: We explore strategic trade in short-lived securities by agents who possess long-term information. Trading short-lived securities is profitable only if enough of the private information becomes public prior to contract expiration; otherwise the security will worthlessly expire. We highlight how this results in trading behavior fundamentally different from that observed in standard models of informed trading in equity. Specifically,Continue reading

Symmetric Normal Mixture GARCH

Abstract: Normal mixture (NM) GARCH models are better able to account for leptokurtosis in financial data and offer a more intuitive and tractable framework for risk analysis and option pricing than student’s t-GARCH models. We present a general, symmetric parameterisation for NM-GARCH(1,1) models, derive the analytic derivatives for the maximum likelihood estimation of the model parameters and their standard errorsContinue reading

Sources of Over-Performance in Equity Markets: Mean Reversion, Common Trends and Herding

Abstract: In the field of optimisation models for passive investments, we propose a general portfolio construction model based on principal component analysis. The portfolio is designed to replicate the first principal component of a group of stocks, instead of a traditional benchmark, thus capturing only the common trend in the stock returns. The main advantage of this approach is thatContinue reading

Multivariate GARCH Models: Software Choice and Estimation Issues

Abstract: A large number of important practical tasks can be accomplished using a multivariate GARCH model. This paper examines the relatively small number of software packages that are currently available for estimating such models, in spite of their widespread use. The review focuses upon estimation issues and differences in available options for controlling the optimisation, and the review then considersContinue reading

Modelling Short and Long Term Smile Effects: Extending the Normal Mixture Diffusion Local Volatility Model

Abstract: This paper extends the normal mixture diffusion (NMD) local volatility model of Brigo and Mercurio (2000, 2001a,b, 2002) so that it explains both short-term and long-term smile effects. Short-term smile effects are captured by a local volatility model where excess kurtosis in the price density decreases with maturity. This follows from the central limit theorem and concords with theContinue reading

What Drives Swap Spreads, Credit or Liquidity

Abstract: This paper investigates the determinants of swap spreads. Compared with previous work done in this area, such as the seminal paper by Duffie and Singleton (1997), the paper includes daily credit spreads data in the time series framework. The issue is whether ‘liquidity’ or ‘credit’ (or both) is the main determinant of swap spreads dynamics. Our results agree withContinue reading

An Empirical Study of Credit Default Swaps

Abstract: We examine the pricing of Asian and non-Asian credit default swaps that traded during the 1997 to 1999 time period. We employ two credit risk models, Duffie and Singleton (1999) and Jarrow and Turnbull (1995). We argue that credit default swaps should have a positive economic value since credit spreads reflect differences in liquidity as well as credit risk.Continue reading

Statistical Properties of Forward Libor Rates

Abstract: If historical forward rates are used to calibrate the lognormal forward rate model – as advocated by Hull and White (1999, 2000), Longstaff, Santa Clara and Schwartz (1999), Rebonato (1999a,b,c), Rebonato and Joshi (2001) and many others – a Libor yield curve needs to be fit to the available data on spot libor rates, forward rate agreements (FRAs) or futures,Continue reading

Equity Indexing, Cointegration and Stock Price Dispersion: A Regime Switching Approach to Market Efficiency

Abstract: This paper examines the performance of a general dynamic equity indexing strategy based on cointegration, from a market efficiency perspective. A consistent return in excess of the benchmark is demonstrated over different time horizons and in different, real world and simulated stock markets. A measure of stock price dispersion is shown to be a leading indicator for the excessContinue reading

The At Issue Maturity Of Corporate Bonds: The Influence Of Credit Rating, Security Level, Duration And Macroeconomic Conditions

Abstract: We examine the determinants of the at issue time to maturity of corporate bonds. We find evidence that corporations partly determine the at issue maturity of bonds by responding to economic conditions. They also appear to immunize by matching the maturity of assets with the at issue maturity of bonds regardless of credit quality. Finally, we find evidence thatContinue reading