The economic significance of CDS price discovery

© 2015 Springer Science+Business Media New York Between 2005 and 2009, we document evident time-varying credit risk price discovery between the equity and credit default swap (CDS) markets for 174 US non-financial investment-grade firms. We test the economic significance of a simple portfolio strategy that utilizes fluctuation in CDS spreads as a trading signal to set stock positions, conditional on the CDS price discovery status of the reference entities. We show that a conditional portfolio strategy which updates the list of CDS-influenced firms over time, yields a substantively larger realized return net of transaction cost over the unconditional strategy. Furthermore, the conditional strategy’s Sharpe ratio outperforms a series of benchmark portfolios over the same trading period, including buy-and-hold, momentum and dividend yield strategies.

Dynamically opted protection envelope (DOPE) - A cost-effective strategy of insuring an investment portfolio

Popular ways of hedging downside risk of a stock portfolio is by means of a constant proportion portfolio insurance (CPPI) strategy or by means of an options-based portfolio insurance strategy (OBPI). However both have drawbacks in terms of practical applicability given transaction costs. Moreover they are not useful in times of very low liquidity e.g. in a market crash. Here we shall first review the common portfolio insurance techniques and then posit an alternative approach using a zero-coupon bond to extract downside coverage to the extent desired by an investor. While the posited strategy will not guarantee full downside protection for the entire investment horizon, it is unaffected by transaction costs resulting from need to periodically reallocate funds and is a lot easier to implement practically compared to options-based strategies. Unlike CPPI and OBPI, it will work in a crash situation too.

A synthetic protective put strategy for phased investment in projects without an outright deferral

This paper proposes and computationally demonstrates a synthetic protective put strategy for real options. Specifically, it deals with the problem of deferral option when an outright deferral is not permissible owing to competitive pressures. It is demonstrated that, in such a situation, an appropriate strategy would be to invest in the new project in phases rather than doing it all at once. The replicating portfolio for a protective put on the project is obtained by setting the owner’s equity in the project equal to the price of a call option on the value of the project. This is a logical extension of the financial protective put to the real options scenario and is relatively simple and practicable for businesses to adopt and apply.