This special issue of The Journal of Investing presents a set of articles that addresses some fac... more This special issue of The Journal of Investing presents a set of articles that addresses some facets of the complex issues around liability-driven investment (LDI). Given the complexity of LDI, the authors recognize that many issues have been left unaddressed in this special issue. However, the researchers in this special issue have considerable experience in managing fixed-income portfolios and in designing custom solutions for client needs in the LDI arena. The articles address important issues, such as the role of risk factors in LDI solutions, distinguishing between liability-hedging and risk-seeking assets in designing LDI programs, the importance of diversification for LDI, and, importantly, the role of glide paths in dynamic de-risking.
... 35, No. 1 (Fall 2008), pp. 40-51.Abstract; DeMiguel, V., Garlappi, L., and Uppal, R. Optimal... more ... 35, No. 1 (Fall 2008), pp. 40-51.Abstract; DeMiguel, V., Garlappi, L., and Uppal, R. Optimal versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy? Review of Financial Studies, Vol. 22, No. 5 (2009), pp. ... White, Amanda. ...
In this paper we develop an improvement on one of the more popular methods for Value-at-Risk meas... more In this paper we develop an improvement on one of the more popular methods for Value-at-Risk measurement, the historical simulation approach. The procedure we employ is the following: First, the density of the return on a portfolio is estimated using a non-parametric method, called a Gaussian kernel. Second, we derive an expression for the density of any order statistic of the return distribution. Finally, because the density is not analytic, we employ Gauss-Legendre integration to obtain the moments of the density of the order statistic, the mean being our Value-at-Risk estimate, and the standard deviation providing us with the ability to construct a confidence interval around the estimate. We apply this method to trading portfolios provided by a financial institution.
ABSTRACT In this article I examine whether suitability rules should be applied to OTC derivatives... more ABSTRACT In this article I examine whether suitability rules should be applied to OTC derivatives transactions. Suitability refers to an obligation owed by the dealer to the counterparty to enter into a transaction only if the dealer has reason to believe that the transaction is "suitable" for a counterparty, given its policies, goals, and circumstances. First, I detail the current status of suitability requirements imposed by the various regulators with an interest in OTC derivatives markets. Then I discuss an economic framework for evaluating the need for suitability requirements.The views expressed in the paper represent those of the author and not necessarily those of the Office of the Comptroller of the Currency or the Comptroller.
ABSTRACT In this paper we examine the effect of bias in option price estimates on the estimated r... more ABSTRACT In this paper we examine the effect of bias in option price estimates on the estimated returns from hedging options against stocks. The source of bias examined here is the estimation bias introduced from inserting an estimate of asset volatility into an option-pricing formula. This source of bias has been documented in a number of theoretical studies. To empirically evaluate the effect of estimation bias in option price estimates we use the unbiased option price estimator of Butler and Schachter (1986) and an unbiased estimator of the option hedge ratio. We identify four mutually exclusive and exhaustive cases for the effect of estimation bias on calculated option hedge returns. We find the returns on portfolios of mispriced options are very similar whether we use biased or unbiased estimates of option prices and option hedge ratios, indicating that the effects of estimation biases are, for the most part, smaller than other sources of "noise" in the data.
Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et... more Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et al.). Derivatives in U.S. banking: Theory, practice, and empirical evidence (J.F. Sinkey, Jr., D. Carter). Derivatives dealers and credit risk (T. Azarchs). The valuation of off-balance-sheet financial instrument disclosures in the banking industry (S.M. Riffe). Sources of bank foreign exchange trading profits: Taking positions or making markets? (J. Ammer, A.D. Brunner). Bank positions and forecasts of exchange rate movements (M.P. Leahy). Indexed certificates of deposit (E.H. Cantor, B. Schachter). A strategic analysis of stock index-linked CDS (J.P. Ogden). Over-the-counter derivatives and systemic risk to the global financial system (M.R. Darby). Derivatives regulation (J. Board et al.). Financial innovation, money banking and financial fragility in the UK (A. Mullineux). Value-at-risk analysis and the proposed Basle accord amendment (P. Jackson et al.). Recent developments in bank capital regulation of market risks (P.H. Kupiec, J.M. O'Brien). Netting agreements and potential credit exposure (D. Hendricks). A proposed framework for studying the domino effect (L. Schneck).
The stochastic properties of discretely rebalanced option hedges have been studied extensively be... more The stochastic properties of discretely rebalanced option hedges have been studied extensively beginning with Black and Scholes (1973). In each analysis hedges were “delta-neutral” after rebalancing. We argue that the distributional properties of discretely rebalanced hedges are such that delta-based hedging is not the variance minimizing strategy. This paper obtains analytical expressions for the variance minimizing option hedge ratios. We also evaluate the hedge variance to assess the magnitude of the variance reduction over delta-based hedges. For representative parameter values, we show that systematic departures from delta-based hedges can yield significant reductions in hedge variance even for one day rebalancing intervals.
The Financial Crisis has engendered much criticism of the dominant paradigm of neo-classical econ... more The Financial Crisis has engendered much criticism of the dominant paradigm of neo-classical economics and of market-based capitalism. Many negative reappraisals have been published, and hedge fund icon George Soros has even established an Institute for New Economic Thinking. I came to Taylor’s book in a round-about way as a result of my own introspections on the alleged crisisrelated failures of financial risk management. In my mind, market price dynamics and trading behavior during the crisis argued for the conclusion that the risk measurement and management paradigm had conceptual flaws. Improving risk management in a fundamental way isn’t going to result from collecting more or better data or from devising ways for increasing the theoretical precision of risk measures. I focused my thinking on models of complexity, evolutionary and behavioral economics, and social networks. As I read on these topics, it became apparent to me that there were strong parallels between some of these ideas and ideas I had read in F.W. Hayek’s books. That thought was not unique to me. W. Brian Arthur has stated, ‘Right after we published our first findings, we started getting letters from all over the country saying, ‘‘You know, all you guys have done is rediscover Austrian economics’’’.y Ideas from Austrian economics appeal because they seem to offer up the possibility of a better understanding of both macroeconomic dynamics and markets as we have experienced them. Then, by extension, this alternative view may help suggest how to approach re-thinking risk measurement and management. This is also important for 2012, Ludwig von Mises Institute
Mean-Variance optimisation has come under great criticism recently, based on the poor performance... more Mean-Variance optimisation has come under great criticism recently, based on the poor performance experienced by asset managers during the global financial crisis. In response, an alternative approach, called Risk Parity, which proceeds by equalising risk contributions, has garnered much interest. In this paper we summarise the work of a group of leading researchers on Risk Parity. We also survey more generally what is known about this approach. While Risk Parity has intuitive appeal and has performed well over some historical time periods, it is premature to claim the superiority of Risk Parity over other asset allocation approaches. We raise several conceptual and practical questions about Risk Parity, which we think are worthy of additional research. We would like to thank Brian Bruce for encouraging us to write this paper. We have greatly benefited from discussions on this topic with Andrew Ang & Ravi Jagannathan. The views expressed herein are solely those of the authors and do...
In this paper we examine the effect of bias in option price estimates on the estimated returns fr... more In this paper we examine the effect of bias in option price estimates on the estimated returns from hedging options against stocks. The source of bias examined here is the estimation bias introduced from inserting an estimate of asset volatility into an option-pricing formula. This source of bias has been documented in a number of theoretical studies. To empirically evaluate the effect of estimation bias in option price estimates we use the unbiased option price estimator of Butler and Schachter (1986) and an unbiased estimator of the option hedge ratio. We identify four mutually exclusive and exhaustive cases for the effect of estimation bias on calculated option hedge returns. We find the returns on portfolios of mispriced options are very similar whether we use biased or unbiased estimates of option prices and option hedge ratios, indicating that the effects of estimation biases are, for the most part, smaller than other sources of "noise" in the data.
Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et... more Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et al.). Derivatives in U.S. banking: Theory, practice, and empirical evidence (J.F. Sinkey, Jr., D. Carter). Derivatives dealers and credit risk (T. Azarchs). The valuation of off-balance-sheet financial instrument disclosures in the banking industry (S.M. Riffe). Sources of bank foreign exchange trading profits: Taking positions or making markets? (J. Ammer, A.D. Brunner). Bank positions and forecasts of exchange rate movements (M.P. Leahy). Indexed certificates of deposit (E.H. Cantor, B. Schachter). A strategic analysis of stock index-linked CDS (J.P. Ogden). Over-the-counter derivatives and systemic risk to the global financial system (M.R. Darby). Derivatives regulation (J. Board et al.). Financial innovation, money banking and financial fragility in the UK (A. Mullineux). Value-at-risk analysis and the proposed Basle accord amendment (P. Jackson et al.). Recent developments in bank capital regulation of market risks (P.H. Kupiec, J.M. O'Brien). Netting agreements and potential credit exposure (D. Hendricks). A proposed framework for studying the domino effect (L. Schneck).
this paper we propose an alternative way to implement the historical simulation approach to Value... more this paper we propose an alternative way to implement the historical simulation approach to Value-atRisk
This special issue of The Journal of Investing presents a set of articles that addresses some fac... more This special issue of The Journal of Investing presents a set of articles that addresses some facets of the complex issues around liability-driven investment (LDI). Given the complexity of LDI, the authors recognize that many issues have been left unaddressed in this special issue. However, the researchers in this special issue have considerable experience in managing fixed-income portfolios and in designing custom solutions for client needs in the LDI arena. The articles address important issues, such as the role of risk factors in LDI solutions, distinguishing between liability-hedging and risk-seeking assets in designing LDI programs, the importance of diversification for LDI, and, importantly, the role of glide paths in dynamic de-risking.
... 35, No. 1 (Fall 2008), pp. 40-51.Abstract; DeMiguel, V., Garlappi, L., and Uppal, R. Optimal... more ... 35, No. 1 (Fall 2008), pp. 40-51.Abstract; DeMiguel, V., Garlappi, L., and Uppal, R. Optimal versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy? Review of Financial Studies, Vol. 22, No. 5 (2009), pp. ... White, Amanda. ...
In this paper we develop an improvement on one of the more popular methods for Value-at-Risk meas... more In this paper we develop an improvement on one of the more popular methods for Value-at-Risk measurement, the historical simulation approach. The procedure we employ is the following: First, the density of the return on a portfolio is estimated using a non-parametric method, called a Gaussian kernel. Second, we derive an expression for the density of any order statistic of the return distribution. Finally, because the density is not analytic, we employ Gauss-Legendre integration to obtain the moments of the density of the order statistic, the mean being our Value-at-Risk estimate, and the standard deviation providing us with the ability to construct a confidence interval around the estimate. We apply this method to trading portfolios provided by a financial institution.
ABSTRACT In this article I examine whether suitability rules should be applied to OTC derivatives... more ABSTRACT In this article I examine whether suitability rules should be applied to OTC derivatives transactions. Suitability refers to an obligation owed by the dealer to the counterparty to enter into a transaction only if the dealer has reason to believe that the transaction is "suitable" for a counterparty, given its policies, goals, and circumstances. First, I detail the current status of suitability requirements imposed by the various regulators with an interest in OTC derivatives markets. Then I discuss an economic framework for evaluating the need for suitability requirements.The views expressed in the paper represent those of the author and not necessarily those of the Office of the Comptroller of the Currency or the Comptroller.
ABSTRACT In this paper we examine the effect of bias in option price estimates on the estimated r... more ABSTRACT In this paper we examine the effect of bias in option price estimates on the estimated returns from hedging options against stocks. The source of bias examined here is the estimation bias introduced from inserting an estimate of asset volatility into an option-pricing formula. This source of bias has been documented in a number of theoretical studies. To empirically evaluate the effect of estimation bias in option price estimates we use the unbiased option price estimator of Butler and Schachter (1986) and an unbiased estimator of the option hedge ratio. We identify four mutually exclusive and exhaustive cases for the effect of estimation bias on calculated option hedge returns. We find the returns on portfolios of mispriced options are very similar whether we use biased or unbiased estimates of option prices and option hedge ratios, indicating that the effects of estimation biases are, for the most part, smaller than other sources of "noise" in the data.
Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et... more Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et al.). Derivatives in U.S. banking: Theory, practice, and empirical evidence (J.F. Sinkey, Jr., D. Carter). Derivatives dealers and credit risk (T. Azarchs). The valuation of off-balance-sheet financial instrument disclosures in the banking industry (S.M. Riffe). Sources of bank foreign exchange trading profits: Taking positions or making markets? (J. Ammer, A.D. Brunner). Bank positions and forecasts of exchange rate movements (M.P. Leahy). Indexed certificates of deposit (E.H. Cantor, B. Schachter). A strategic analysis of stock index-linked CDS (J.P. Ogden). Over-the-counter derivatives and systemic risk to the global financial system (M.R. Darby). Derivatives regulation (J. Board et al.). Financial innovation, money banking and financial fragility in the UK (A. Mullineux). Value-at-risk analysis and the proposed Basle accord amendment (P. Jackson et al.). Recent developments in bank capital regulation of market risks (P.H. Kupiec, J.M. O'Brien). Netting agreements and potential credit exposure (D. Hendricks). A proposed framework for studying the domino effect (L. Schneck).
The stochastic properties of discretely rebalanced option hedges have been studied extensively be... more The stochastic properties of discretely rebalanced option hedges have been studied extensively beginning with Black and Scholes (1973). In each analysis hedges were “delta-neutral” after rebalancing. We argue that the distributional properties of discretely rebalanced hedges are such that delta-based hedging is not the variance minimizing strategy. This paper obtains analytical expressions for the variance minimizing option hedge ratios. We also evaluate the hedge variance to assess the magnitude of the variance reduction over delta-based hedges. For representative parameter values, we show that systematic departures from delta-based hedges can yield significant reductions in hedge variance even for one day rebalancing intervals.
The Financial Crisis has engendered much criticism of the dominant paradigm of neo-classical econ... more The Financial Crisis has engendered much criticism of the dominant paradigm of neo-classical economics and of market-based capitalism. Many negative reappraisals have been published, and hedge fund icon George Soros has even established an Institute for New Economic Thinking. I came to Taylor’s book in a round-about way as a result of my own introspections on the alleged crisisrelated failures of financial risk management. In my mind, market price dynamics and trading behavior during the crisis argued for the conclusion that the risk measurement and management paradigm had conceptual flaws. Improving risk management in a fundamental way isn’t going to result from collecting more or better data or from devising ways for increasing the theoretical precision of risk measures. I focused my thinking on models of complexity, evolutionary and behavioral economics, and social networks. As I read on these topics, it became apparent to me that there were strong parallels between some of these ideas and ideas I had read in F.W. Hayek’s books. That thought was not unique to me. W. Brian Arthur has stated, ‘Right after we published our first findings, we started getting letters from all over the country saying, ‘‘You know, all you guys have done is rediscover Austrian economics’’’.y Ideas from Austrian economics appeal because they seem to offer up the possibility of a better understanding of both macroeconomic dynamics and markets as we have experienced them. Then, by extension, this alternative view may help suggest how to approach re-thinking risk measurement and management. This is also important for 2012, Ludwig von Mises Institute
Mean-Variance optimisation has come under great criticism recently, based on the poor performance... more Mean-Variance optimisation has come under great criticism recently, based on the poor performance experienced by asset managers during the global financial crisis. In response, an alternative approach, called Risk Parity, which proceeds by equalising risk contributions, has garnered much interest. In this paper we summarise the work of a group of leading researchers on Risk Parity. We also survey more generally what is known about this approach. While Risk Parity has intuitive appeal and has performed well over some historical time periods, it is premature to claim the superiority of Risk Parity over other asset allocation approaches. We raise several conceptual and practical questions about Risk Parity, which we think are worthy of additional research. We would like to thank Brian Bruce for encouraging us to write this paper. We have greatly benefited from discussions on this topic with Andrew Ang & Ravi Jagannathan. The views expressed herein are solely those of the authors and do...
In this paper we examine the effect of bias in option price estimates on the estimated returns fr... more In this paper we examine the effect of bias in option price estimates on the estimated returns from hedging options against stocks. The source of bias examined here is the estimation bias introduced from inserting an estimate of asset volatility into an option-pricing formula. This source of bias has been documented in a number of theoretical studies. To empirically evaluate the effect of estimation bias in option price estimates we use the unbiased option price estimator of Butler and Schachter (1986) and an unbiased estimator of the option hedge ratio. We identify four mutually exclusive and exhaustive cases for the effect of estimation bias on calculated option hedge returns. We find the returns on portfolios of mispriced options are very similar whether we use biased or unbiased estimates of option prices and option hedge ratios, indicating that the effects of estimation biases are, for the most part, smaller than other sources of "noise" in the data.
Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et... more Introduction. Financial innovations and the growth of bank derivatives activities (J. Jagtiani et al.). Derivatives in U.S. banking: Theory, practice, and empirical evidence (J.F. Sinkey, Jr., D. Carter). Derivatives dealers and credit risk (T. Azarchs). The valuation of off-balance-sheet financial instrument disclosures in the banking industry (S.M. Riffe). Sources of bank foreign exchange trading profits: Taking positions or making markets? (J. Ammer, A.D. Brunner). Bank positions and forecasts of exchange rate movements (M.P. Leahy). Indexed certificates of deposit (E.H. Cantor, B. Schachter). A strategic analysis of stock index-linked CDS (J.P. Ogden). Over-the-counter derivatives and systemic risk to the global financial system (M.R. Darby). Derivatives regulation (J. Board et al.). Financial innovation, money banking and financial fragility in the UK (A. Mullineux). Value-at-risk analysis and the proposed Basle accord amendment (P. Jackson et al.). Recent developments in bank capital regulation of market risks (P.H. Kupiec, J.M. O'Brien). Netting agreements and potential credit exposure (D. Hendricks). A proposed framework for studying the domino effect (L. Schneck).
this paper we propose an alternative way to implement the historical simulation approach to Value... more this paper we propose an alternative way to implement the historical simulation approach to Value-atRisk
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