2007 Series
Valuing Medieval Annuities: Were Corrodies Underpriced?
Adrian Bell and Charles Sutcliffe
2007-15
Abstract: Medieval bishops condemned and restricted the sale of corrodies (a type of annuity), partly on the grounds of their perceived unprofitability. The available data on the profitability of corrodies is limited and little analysed, and the episcopal condemnation of corrodies has been adopted by modern researchers. After recognising the difficulties, this paper applies an annuity pricing model to study corrody pricing. Given various assumptions, contrary to the established view, it is argued that the sale of corrodies was financially profitable for institutions. Finally, some reasons are considered for the negative attitude of contemporary and historical opinion towards the sale of corrodies.
An exact formula for default swaptions’ pricing in the SSRJD stochastic intensity model
Damiano Brigo and Naoufel El-Bachir
2007-14
Abstract: We develop and test a fast and accurate semi-analytical formula for single-name default swaptions in the context of the shifted square root jump diffusion (SSRJD) default intensity model. The formula consists of a decomposition of an option on a summation of survival probabilities in a summation of options on the underlying survival probabilities, where the strike for each option is adjusted.
Low-Cost Momentum Strategies
Xiafei Li, Chris Brooks and Joëlle Miffre
2007-12
Abstract:The article analyses the impact of trading costs on the profitability of momentum strategies in the UK and concludes that losers are more expensive to trade than winners. The observed asymmetry in the costs of trading winners and losers crucially relates to the high cost of selling loser stocks with small size and low trading volume. Since transaction costs severely impact net momentum profits, the paper defines a new low-cost relative-strength strategy by shortlisting from all winner and loser stocks those with the lowest total transaction costs. While the study severely questions the profitability of standard momentum strategies, it concludes that there is still room for momentum-based return enhancement, should asset managers decide to adopt low-cost relative-strength strategies.
Analytic Approximations for Spread Options
Carol Alexander and Aanand Venkatrammanan
2007-11
Abstract: Even in the simple case that two price processes follow correlated geometric Brownian motions with constant volatility no analytic formula for the price of a standard European spread option has been derived, except when the strike is zero in which case the option becomes an exchange option. This paper expresses the price of a spread option as the price of a compound exchange option and hence derives a new analytic approximation for its price and hedge ratios. This approximation has several advantages over existing analytic approximations, which have limited validity and an indeterminacy that renders them of little practical use. Simulations quantify the accuracy of our approach and demonstrate the indeterminacy and inaccuracy of other analytic approximations. The American spread option price is identical to the European option price when the two price processes have identical drifts, and otherwise we derive an expression for the early exercise premium. A practical illustration of the model calibration uses market data on American crack spread options.
Short-Term Returns of UK Share Buyback Activity
Carol Padgett and Zhiqi Wang
2007-10
Abstract: This paper examines the short-term signalling power of UK open market share repurchases between 1999 and 2004. The 5-day and 11-day abnormal returns centred on the announcement date are statistically significant at 1.13% and 1.21% respectively. However, there is no evidence to support any relationship between the 5-day announcement abnormal returns and characteristics of UK share repurchases, such as the percentage of shares to be repurchased, pre-announcement return, size and lag time. These results are largely in line with results reported by Rees (1996). It seems that UK share repurchases are not primarily motivated by share undervaluation. That is why the signalling hypothesis fails to explain the announcement abnormal returns of the UK open market share repurchases.
Tests on the Accuracy of Basel II
Simone Varotto
2007-09
Abstract: Basel II rules allow qualified banks to assess the risk in their portfolio of credit exposures with a methodology based on the informational content of credit ratings and two crucial assumptions: (1) the credit risk of individual exposures is driven by one systematic risk factor only and (2) the portfolio is fully diversified. We test the accuracy of the credit risk measures obtained with the new rules by comparing them with benchmark measures derived with a popular ratings-based credit risk model which accounts for multiple risk factors and portfolio concentration. We find that the Basel II assumptions may have a substantial impact on risk assessments and produce deviations from the benchmark that may be economically significant.
Admissions of International Graduate Students: Art or Science? A Business School Experience
Samantha Heslop and Simone Varotto
2007-08
Abstract: International students are often well represented in graduate programmes in North America and Europe. Information on foreign countries' education systems and grading schemes is available but cross-country comparisons are often challenging and highly subjective. Therefore, universities have a clear need for calibrating admissions of international students to ensure a fair and cost effective selection process. By comparing the performance of international students in their host institution with their entry qualifications we devise a simple approach to detecting systematic biases in the perceived quality of the applicants and propose corrective actions. We find that by using public information on cross-country comparisons of academic qualifications, country selection biases can occur and produce a substantial impact on international students' performance and failure rates. Our model is based on admission data that are routinely collected by universities which should ensure its broad applicability.
Global Portfolio Optimization Revisited: A Least Discrimination Alternative to Black-Litterman
Jacques Pézier
2007-07
Abstract: Global portfolio optimization models rank among the proudest achievements of modern finance theory, but practitioners are still struggling to put them to work. In 1992, Black and Litterman recognized the difficulties portfolio managers have in expanding their personal views about some expected asset returns into full probabilistic forecasts about all asset returns and developed a method to facilitate this task. We propose a more general method based on a least discrimination (LD) principle. It produces a probabilistic forecast that is true to personal views but is otherwise as close as possible to a chosen reference forecast. For this purpose we expand the concept of optimal portfolio to include non-linear pay-offs and derive an economic measure of distance - a generalized relative entropy distance - between probabilistic forecasts. The LD method produces optimal portfolios matching any views, including views on volatility and correlation as well as expected returns, and containing option-like pay-offs, if allowed. It also justifies a simple linear interpolation between reference and personal forecasts, should a compromise need be reached.
Should Defined Benefit Pension Schemes be Career Average or Final Salary?
Charles Sutcliffe
2007-06
Abstract: There is widespread dissatisfaction amongst employers with defined benefit pension schemes, and many are switching to defined contribution schemes. Career average is a form of defined benefit scheme that has some important advantages over final salary schemes. The comparison of career average and final salary schemes is a neglected area, and this paper offers one of the first in-depth analyses of this topic. It considers the advantages and disadvantages of a cost neutral switch to a career average re-valued earnings (CARE) scheme.
Konstanina Kappou, Chris Brooks and Chales Ward
2007-05
Abstract: The advent of index tracking early in the 1970s and the continuous growth of assets tied to the S&P 500 index have enforced perceptions of the importance of becoming an index-member, due to increased demand by index fund participants for the stocks involved in index composition changes. This study focuses on S&P 500 inclusions and examines the impact of potential overnight price adjustment after the announcement of an S&P 500 index change. We find evidence of a significant overnight price change that diminishes the profits available to speculators although there are still profits available from the first day after announcement until a few days after the actual event. More importantly observing the tick-by-tick stock price performance of the key days of the event window for the first time, we find evidence of consistent trading patterns during trading hours over inclusion event. A separate analysis of two different sub-periods as well as of NASDAQ and NYSE listed stocks allows for a detailed examination of the price and volume effect in continuous time.Better Cross Hedges with Composite Hedging? Hedging Equity Portfoloios Using Financial and Commodity Futures
Fei Chen and Charles Sutcliffe
2007-04
Abstract: Unless a direct hedge is available, cross hedging must be used. In such circumstances portfolio theory implies that a composite hedge (the use of two or more hedging instruments to hedge a single spot position) will be beneficial. Surprisingly, the study and use of composite hedging has been neglected; possibly because it requires the estimation of two or more hedge ratios. This paper demonstrates a statistically significant increase in out-of-sample effectiveness from the composite hedging of the Amex Oil Index using S&P500 and Nymex crude oil futures. This conclusion is robust to the technique used to estimate the hedge ratios, and to allowance for transactions costs, dividends and the maturity of the futures contracts.
The Value premium and Time-Varying Unsystematic Risk
Xiafei Li, Chris Brooks and Joelle Miffre
2007-03
Abstract: Recent research has discussed the possible role of unsystematic risk in explaining equity returns. Simultaneously, but somehow independently, numerous other studies have documented the failure of the static and conditional capital asset pricing models to explain the differences in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. In accordance with existing studies, we find that the static CAPM has no explanatory power for the value premium, and that firm size has only a limited role to play. Our results show that the conditional variance specification incorporating time-varying idiosyncratic risk can fully capture the post-1963 value premium and that the value premium is a compensation for exposure to time-varying risk. This conclusion is robust to different characteristics of value and growth stocks and to the country under review (US and UK).
Model-Based Stress Tests:
Linking Stress Tests to VaR for Market Risk
Carol Alexander and Elizabeth Sheedy
2007-02 (revised, 29/05/2007)
Abstract: Under the new capital accord stress tests are to be included in market risk regulatory capital calculations. This development necessitates a coherent and objective framework for stress testing portfolios exposed to market risk. Following recent criticism of stress testing methods our tests are conducted in the context of risk models, building on the VaR literature. First, to identify the most suitable risk models for stress testing, we apply an extensive back testing procedure that focuses on extreme market movements. We consider eight possible risk models including both conditional and unconditional models and four possible return distributions (normal, Student’s t, empirical and normal mixture) applied to three heavily traded currency pairs using a sample of daily data spanning more than 20 years. Finding that risk models accommodating both volatility clustering and heavy tails are the most accurate predictors of extreme returns, we develop a corresponding model-based stress testing methodology. Our results are compared with traditional stress tests and we assess the implications for capital adequacy. On the basis of our results we conclude that the new recommendations for market risk regulatory capital calculation will have little impact on current levels of foreign exchange regulatory capital.
Hedging and Cross-hedging ETFs
Carol Alexander and Andreza Barbosa
2007-01
Forthcoming in Journal of Banking and Finance
Abstract: This paper presents an empirical study of hedging the four largest US index exchange traded funds (ETFs). When hedging each ETF position with its own index futures we find that it is difficult to improve on the naïve 1:1 futures hedge, that hedging is less effective around the time of dividend payments, and that hedged portfolio returns tend to have very large negative skewness and highly significant excess kurtosis. We also investigate the extent to which a long position on one ETF can be offset by a short position on another correlated ETF and consider how best to hedge portfolios of ETFs with one index futures. In these situations minimum variance hedging is clearly preferable to naïve hedging, although it seems to matter little which econometric hedge ratio is used, and the cross-hedged portfolio returns are closer to normality than the futures hedged portfolios. The evaluation focuses on a very large out of sample hedging performance analysis that includes aversion to negative skewness and excess kurtosis as well as effective reduction in variance. Our results should be of interest to hedge funds employing tax arbitrage or leveraged long-short equity strategies. They will also be of interest to ETF market makers since hedging is the most cost effective way of reducing the market risk of inventories, thus hedging enables market makers to reduce bid-ask spreads in a competitive environment.
