2009 Series
Time Varying Volatility and the Cross-Section of Equity Returns
Chris Brooks, Xiafei Li and Joelle Miffre
2009-01
Abstract: A vast literature has documented the value premium and the small firm effect as pervasive stylized facts in empirical asset pricing and yet research has been largely unable to provide entirely convincing explanations of why these phenomena exist. This paper demonstrates that the cross-sectional variation in returns between portfolios sorted by size and book-to-market value is significantly and positively related to the conditional volatility of those portfolios. We show that the explanatory power of the portfolios' sensitivities to conditional volatility for the cross-section of returns is in addition to that embodied in the sensitivities to market risk, macroeconomic, book-to-market and market capitalization factors.
Size and Scale Economies in Japanese Cooperative Banking
Tara Deelchand and Carol Padgett
2009-02
Abstract: The Japanese banking industry, including the cooperative sector has been restructured following the crisis of the 1990s. Here we examine the relationship between size and scale economies of cooperative banks in Japan (namely Shinkin and credit cooperatives). We use the translog cost-function methodology and intermediation approach coupled with a large set of both cross-sectional and panel data over the period 2003 to 2006. We find significant diseconomies of scale for both the full sample and sub-samples of small and large cooperative banks. It is of interest to note that larger cooperative banks were at cost disadvantage as compared to small ones throughout most of the period. Thus, bigger is not always better. Shinkin and credit cooperative banks need to make further efforts to assess the business environment and strengthen profitability by, for example, expanding the range of financial services they offer in their regional areas and making further progress in risk management.
Forecasting Yield Curves Using Analyst's Views
Leonardo Nogueira
2009-03
Abstract: Fixed income analysts are accustomed to monitoring a few benchmark yields on a continuous basis and to providing point estimates for these yields, or for a combination of them. Yet, the optimisation of fixed income portfolios requires an accurate forecast of not only a few benchmark yields, but of complete yield curves. This paper derives a forecast of one or more yield curves that is consistent with an analyst's views. The model is based on a novel application of principal component analysis (PCA). It can be extended to other markets and has no restrictions on the number of forecast variables, or the number of analyst's views. We consider examples of forecasting the government bond yield curves of the United States, the Eurozone and the United Kingdom, simultaneously or not. Our results have direct implications for portfolio management.
Transaction Costs, Trading Volume and Momentum Strategies
Xiafei Li, Chris Brooks, Joelle Miffre
2009-04
Abstract: This study considers the relationship between trading volumes, transactions costs, and the profitability of momentum strategies using data from the UK. We demonstrate that round-trip transactions costs for selling loser firms are around double those of buying winners, and in particular, the costs of selling low volume losers is more than twice as high as the cost of selling low volume winners. By contrast, there are only modest differences between the costs of buying winners and losers, irrespective of their volume levels. Yet we observe that, even in net terms, momentum strategies based on low volume stocks are more profitable than those using high volume stocks. We also note important differences between transactions costs measured using quoted versus effective spreads. Altogether, our findings should sound a word of caution for any study attempting to evaluate the impact of transactions costs on momentum profitability that such costs are very heterogeneous across firms and trade types, implying that they require careful calculation.
Analytic Approximations for Multi-Asset Option Pricing
Carol Alexander and Aanand Venkatramanan
2009-05
Abstract: We derive general analytic approximations for pricing European basket and rainbow options on N assets. The key idea is to express the option’s price as a sum of prices of various compound exchange options, each with different pairs of sub-ordinate multi- or single-asset options. For some multi-asset options a strong condition holds, whereby each compound exchange option is equivalent to a standard single-asset option under a modified measure, and in such cases an almost exact analytic price exists for the multi-asset option. The underlying asset prices are assumed to follow lognormal processes, although the strong condition can be extended to certain other price processes for the underlying. More generally, approximate analytic prices for multi-asset options are derived using a weak lognormality condition, where the approximation stems from making constant volatility assumptions on the price processes that drive the prices of the sub-ordinate basket options. The analytic formulae for multi-asset option prices, and their Greeks, are defined in a recursive framework. For instance, the option delta is defined in terms of the delta relative to sub-ordinate multi-asset options, and the deltas of these sub-ordinate options with respect to the underlying assets. Simulations test the accuracy of our approximations, given some assumed values for the asset volatilities and correlations, and we demonstrate how to calibrate these parameters to market data so that multi-asset option prices are consistent with the implied volatility and correlation skews of the assets.
Analytic Approximations for Spread Options
Carol Alexander and Aanand Venkatramanan
2009-06
Abstract: This paper expresses the price of a spread option as the sum of the prices of two compound options. One compound option is to exchange vanilla call options on the two underlying assets and the other is to exchange the corresponding put options. This way we derive a new analytic approximation for the price of a European spread option, and a corresponding approximation for each of its price, volatilty and correlation hedge ratios. Our approach has many advantages over existing analytic approximations, which have limited validity and an indeterminacy that renders them of little practical use. The compound exchange option approximation for European spread options is then extended to American spread options on assets that pay dividends or incur carry costs. Simulations quantify the accuracy of our approach; we also present an empirical application, to the American crack spread options that are traded on NYMEX. For illustration, we compare our results with those obtained using the approximation attributed to Kirk (1996) which is commonly used by traders.
Meshfree Approximation for Multi-Asset Options
Emmanuel Hanert and Aanand Venkatramanan
2009-07
Abstract: We price multi-asset options by solving their price partial differential equations using a meshfree approach with radial basis functions under jump-diffusion and geometric Brownian motion frameworks. In the geometric Brownian motion framework, we propose an effective technique that breaks the multi-dimensional problem to multiple 3D problems. We solve the price PDEs or PIDEs with an implicit meshfree scheme using thin-plate radial basis functions. Meshfree approach is very accurate, has high order of convergence and is easily scalable and adaptable to higher dimensions and different payoff profiles. We also obtain closed form approximations for the option Greeks. We test the model on American crack spread options traded on NYMEX.
Over the Moon or Sick as a Parrot? The Effect's of Football Results on a Club's Share Price
Adrian Bell, Chris Brooks, David Matthews, Charles Sutcliffe
2009-08
Abstract: This paper considers the impact of match results on the stock returns of English football clubs. We propose that the magnitude of the response to a given result depends on the importance of the game, which is measured in two ways. First, we consider the extent to which the clubs are close rivals vying for similar league positions, as winning such games is particularly significant. Second, we argue that each individual game becomes more important for those clubs likely to be promoted or relegated as the season draws to a close, since a given match will have increasing information content concerning the final league position of the club. Using a fairly large panel comprising data for 19 clubs, we find that the unexpected parts of both the points and the number of goals ahead from the match do affect stock prices. There is also some limited support for the notion that stock prices are more affected by the results of important matches.
Exact Moment Simulation using Random Orthogonal Matrices
Carol Alexander, Walter Ledermann and Daniel Ledermann
2009-09
Abstract: This paper introduces a method for simulating multivariate samples that have exact means, covariances, skewness and kurtosis. A new class of rectangular orthogonal matrices is fundamental to the methodology, and these ``L-matrices'' can be deterministic, parametric or data specific in nature. The target moments determine an L-matrix, then infinitely many random samples with the same exact moments may be generated by multiplying the L-matrix by arbitrary random orthogonal matrices. The methodology is thus termed ``ROM simulation''. We discuss certain classes of random orthogonal matrices and show how each class produces samples with different characteristics. ROM simulation has applications to many problems that are resolved using standard Monte Carlo methods. But since no parametric assumptions are required there is no sampling error caused by the discrete approximation of a continuous distribution, which is a major source of error in standard Monte Carlo simulations. For illustration, we apply ROM simulation to determine the value-at-risk of a stock portfolio.
Commodity Derivatives Valuation with Autoregression and Moving Average in the Price Dynamics
Raphael Paschke and Marcel Prokopczuk
2009-10
Abstract: In this paper we develop a continuous time factor model of commodity prices that allows for higher order autoregression and moving average components. The need for these components is documented by analyzing the convenience yield's time series dynamics. Making use of the affine model structure, closed-form pricing formulas for futures and options are derived. Empirically, a parsimonious version of the general model is estimated for the crude oil market using futures data. We demonstrate the model's superior performance in pricing nearby futures contracts in- and out-of-sample. Most notably, the model improves the pricing of long horizon contracts with information from the short end of the futures curve substantially.
Testing for periodically collapsing rational speculative bubbles in US REITs
Keith Anderson, Chris Brooks and Sotiris Tsolacos
2009-11
Abstract: This paper is the first to utilize a direct test for periodic, partially collapsing speculative bubbles in US REIT prices. A long history of data is employed for the All, Mortgage and Equity REIT categories. This approach is more powerful than existing tests and is based on the formulation of a switching model that has a surviving regime where the bubble continues to grow and a collapsing regime where the bubble implodes. There is some evidence for the presence of speculative bubbles, most notably in the Mortgage REITs series. There is also visual evidence of a negative bubble in all three series in the early 1970s and of a positive bubble after 2000 which subsequently burst. We are able to compute the time-varying probabilities of being in the surviving and collapsing regimes, and through this to estimate a probability that the bubble will burst during the following period. We show how this information may be used in developing a signal to inform investors' decisions on timing an exit from the market, thereby shielding their portfolios from the effects of periodically bursting bubbles or indeed taking advantage of such bubbles.
The Relationship between Risk, Capital and Efficiency: Evidence from Japanese Cooperative Banks
Tara Deelchand and Carol Padgett
2009-12
Abstract: The risk-capital positions of Japanese banks have been under tension throughout the 1990s. However, existing theory on the determinants of bank risk-taking still remains limited and the evidence is conflicting. Most studies concentrate on US and European banks, while empirical evidence has remained scarce for Asian banks. Added to that, to our knowledge, there are almost no papers on this subject for cooperative banks in Japan. Thus, the main contribution of this study is to shed some light on the determinants of bank risk-taking and analyse its relationship with capital and efficiency in Japanese cooperative banking (namely shinkin and credit cooperatives banks). This paper focuses on Japanese cooperative banks as they constitute an important segment of the Japanese banking sector. We employ a simultaneous equation model in which the relationships between, risk, capital and cost inefficiency are modelled. Two stage least squares with fixed effects estimation procedure are applied to a panel data set of 263 Japanese cooperative banks over the period 2003 through 2006. The results confirm the belief that risk, capital and inefficiency are simultaneously determined. The empirical model shows a negative relationship between risk and the level of capital for Japanese cooperative banks. Inefficient Japanese cooperative banks appear to operate with larger capital and take on more risk. These arguments may reflect the moral hazard problem that exists in the banking system through exploitation of the benefits of deposit insurance. We also assess the size effects and find that larger cooperative banks holding less capital take on more risk and are less efficient.
Back to the Future: A Long Term Solution to the Occupational Pensions Crisis
Charles Sutcliffe
2009-13
Abstract: In the UK and elsewhere, defined benefit (DB) schemes are being replaced by defined contribution (DC) schemes. However DC schemes have some substantial weaknesses, and a continuation of current policies will probably lead to another pensions crisis in a few decades. There is an alternative which avoids the major defects of both DB and DC schemes. It is proposed that, if UK employers wish to replace their DB schemes, they should do so with something that looks like a career average revalued earnings (CARE) scheme to the members, but is funded by single premium deferred annuities (SPDAs). The members get what is effectively a DB pension scheme. However pension provision is outsourced to specialist providers (insurance companies), with all the risk (and the decisions that must be made by members of a DC scheme) borne by insurance companies, not by the employer or members.
