Risk Aversion, Intertemporal Substitution, and Option Pricing

This paper develops a general stochastic framework and an equilibrium asset pricing model that make clear how attitudes towards intertemporal substitution and risk matter for option pricing. In particular, we show under which statistical conditions option pricing formulas are not preference-free, in other words, when preferences are not hidden in the stock and bond prices as they are in the standard Black and Scholes (BS) or Hull and White (HW) pricing formulas. The dependence of option prices on preference parameters comes from several instantaneous causality effects such as the so-called leverage effect. We also emphasize that the most standard asset pricing models (CAPM for the stock and BS or HW preference-free option pricing) are valid under the same stochastic setting (typically the absence of leverage effect), regardless of preference parameter values. Even though we propose a general non-preference-free option pricing formula, we always keep in mind that the BS formula is dominant both as a theoretical reference model and as a tool for practitioners. Another contribution of the paper is to characterize why the BS formula is such a benchmark. We show that, as soon as we are ready to accept a basic property of option prices, namely their homogeneity of degree one with respect to the pair formed by the underlying stock price and the strike price, the necessary statistical hypotheses for homogeneity provide BS-shaped option prices in equilibrium. This BS-shaped option-pricing formula allows us to derive interesting characterizations of the volatility smile, that is, the pattern of BS implicit volatilities as a function of the option moneyness. First, the asymmetry of the smile is shown to be equivalent to a particular form of asymmetry of the equivalent martingale measure. Second, this asymmetry appears precisely when there is either a premium on an instantaneous interest rate risk or on a generalized leverage effect or both, in other words, whenever the option pricing formula is not preference-free. Therefore, the main conclusion of our analysis for practitioners should be that an asymmetric smile is indicative of the relevance of preference parameters to price options.

Arbitrage-Based Pricing when Volatility is Stochastic.

The paper investigates the pricing of derivative securities with calendar-time maturities.

Arbitrage Pricing Theory and Return Generating Process: A Macroeconomic Approach to Indian Stock Market

A study focusing on the identification of return generating factors and to the extent of their influence on share prices the outcome will be a tool for investment analysis in the hands of investors portfolio managers and mutual funds who are mostly concerned with changing share prices. Since the study takes into account the influence of macroeconomic variables on variations in share returns by using the outcome the government can frame out suitable policies on long term basis and that will help in nurturing a healthy economy and resultant stock market. As every company management tries to maximize the wealth of the share holders a clear idea about the return generating variables and their influence will help the management to frame various policies to maximize the wealth of the shareholders.

A Nonparametric Approach to Pricing and Hedging Derivative Securities via Learning Networks

We propose a nonparametric method for estimating derivative financial asset pricing formulae using learning networks. To demonstrate feasibility, we first simulate Black-Scholes option prices and show that learning networks can recover the Black-Scholes formula from a two-year training set of daily options prices, and that the resulting network formula can be used successfully to both price and delta-hedge options out-of-sample. For comparison, we estimate models using four popular methods: ordinary least squares, radial basis functions, multilayer perceptrons, and projection pursuit. To illustrate practical relevance, we also apply our approach to S&P 500 futures options data from 1987 to 1991.

Impact of the Level of Disclosure of Financial Information on the Pricing of Shares in the Context of Adverse Selection: an experimental research

Managers know more about the performance of the organization than investors, which makes the disclosure of information a possible strategy for competitive differentiation, minimizing adverse selection. This paper's main goal is to analyze whether or not an entity's level of diclosure may affect the risk perception of individuals and the process of evaluating their shares. The survey was carried out in an experimental study with 456 subjects. In a stock market simulation, we investigated the pricing of the stocks of two companies with different levels of information disclosure at four separate stages. The results showed that, when other variables are constant, the level of disclosure of an entity can affect the expectations of individuals and the process of evaluating their shares. A higher level of disclosure by an entity affected the value of its share and the other company's.

Scenari finanziari e portafogli ottimi: modelli di previsione e strategie per l'asset allocation tattica

Le scelte di asset allocation costituiscono un problema ricorrente per ogni investitore. Quest’ultimo è continuamente impegnato a combinare diverse asset class per giungere ad un investimento coerente con le proprie preferenze. L’esigenza di supportare gli asset manager nello svolgimento delle proprie mansioni ha alimentato nel tempo una vasta letteratura che ha proposto numerose strategie e modelli di portfolio construction. Questa tesi tenta di fornire una rassegna di alcuni modelli innovativi di previsione e di alcune strategie nell’ambito dell’asset allocation tattica, per poi valutarne i risvolti pratici. In primis verificheremo la sussistenza di eventuali relazioni tra la dinamica di alcune variabili macroeconomiche ed i mercati finanziari. Lo scopo è quello di individuare un modello econometrico capace di orientare le strategie dei gestori nella costruzione dei propri portafogli di investimento. L’analisi prende in considerazione il mercato americano, durante un periodo caratterizzato da rapide trasformazioni economiche e da un’elevata volatilità dei prezzi azionari. In secondo luogo verrà esaminata la validità delle strategie di trading momentum e contrarian nei mercati futures, in particolare quelli dell’Eurozona, che ben si prestano all’implementazione delle stesse, grazie all’assenza di vincoli sulle operazioni di shorting ed ai ridotti costi di transazione. Dall’indagine emerge che entrambe le anomalie si presentano con carattere di stabilità. I rendimenti anomali permangono anche qualora vengano utilizzati i tradizionali modelli di asset pricing, quali il CAPM, il modello di Fama e French e quello di Carhart. Infine, utilizzando l’approccio EGARCH-M, verranno formulate previsioni sulla volatilità dei rendimenti dei titoli appartenenti al Dow Jones. Quest’ultime saranno poi utilizzate come input per determinare le views da inserire nel modello di Black e Litterman. I risultati ottenuti, evidenziano, per diversi valori dello scalare tau, extra rendimenti medi del new combined vector superiori al vettore degli extra rendimenti di equilibrio di mercato, seppur con livelli più elevati di rischio.

Equity pricing in the mining sector: evidence from NYSE and LSE

The study examines the Capital Asset Pricing Model (CAPM) for the mining sector using weekly stock returns from 27 companies traded on the New York Stock Exchange (NYSE) or on the London Stock Exchange (LSE) for the period of December 2008 to December 2010. The results support the use of the CAPM for the allocation of risk to companies. Most companies involved in precious metals (particularly gold), which have a beta value less than unity (Table 1), have been actuated as shelter values during the financial crisis. Values of R2 do not shown very explanatory power of fitted models (R2 < 70 %). Estimated coefficients beta are not sufficient to determine the expected returns on securities but the results of the tests conducted on sample data for the period analysed do not appear to clearly reject the CAPM

Essays in asset price bubbles

This thesis studies the field of asset price bubbles. It is comprised of three independent chapters. Each of these chapters either directly or indirectly analyse the existence or implications of asset price bubbles. The type of bubbles assumed in each of these chapters is consistent with rational expectations. Thus, the kind of price bubbles investigated here are known as rational bubbles in the literature. The following describes the three chapters. Chapter 1: This chapter attempts to explain the recent US housing price bubble by developing a heterogeneous agent endowment economy asset pricing model with risky housing, endogenous collateral and defaults. Investment in housing is subject to an idiosyncratic risk and some mortgages are defaulted in equilibrium. We analytically derive the leverage or the endogenous loan to value ratio. This variable comes from a limited participation constraint in a one period mortgage contract with monitoring costs. Our results show that low values of housing investment risk produces a credit easing effect encouraging excess leverage and generates credit driven rational price bubbles in the housing good. Conversely, high values of housing investment risk produces a credit crunch characterized by tight borrowing constraints, low leverage and low house prices. Furthermore, the leverage ratio was found to be procyclical and the rate of defaults countercyclical consistent with empirical evidence. Chapter 2: It is widely believed that financial assets have considerable persistence and are susceptible to bubbles. However, identification of this persistence and potential bubbles is not straightforward. This chapter tests for price bubbles in the United States housing market accounting for long memory and structural breaks. The intuition is that the presence of long memory negates price bubbles while the presence of breaks could artificially induce bubble behaviour. Hence, we use procedures namely semi-parametric Whittle and parametric ARFIMA procedures that are consistent for a variety of residual biases to estimate the value of the long memory parameter, d, of the log rent-price ratio. We find that the semi-parametric estimation procedures robust to non-normality and heteroskedasticity errors found far more bubble regions than parametric ones. A structural break was identified in the mean and trend of all the series which when accounted for removed bubble behaviour in a number of regions. Importantly, the United States housing market showed evidence for rational bubbles at both the aggregate and regional levels. In the third and final chapter, we attempt to answer the following question: To what extend should individuals participate in the stock market and hold risky assets over their lifecycle? We answer this question by employing a lifecycle consumption-portfolio choice model with housing, labour income and time varying predictable returns where the agents are constrained in the level of their borrowing. We first analytically characterize and then numerically solve for the optimal asset allocation on the risky asset comparing the return predictability case with that of IID returns. We successfully resolve the puzzles and find equity holding and participation rates close to the data. We also find that return predictability substantially alter both the level of risky portfolio allocation and the rate of stock market participation. High factor (dividend-price ratio) realization and high persistence of factor process indicative of stock market bubbles raise the amount of wealth invested in risky assets and the level of stock market participation, respectively. Conversely, rare disasters were found to bring down these rates, the change being severe for investors in the later years of the life-cycle. Furthermore, investors following time varying returns (return predictability) hedged background risks significantly better than the IID ones.

Can book-to-market and size be risk factors that predict economic growth in Asia's emerging economies?

We investigate whether the two 2 zero cost portfolios, SMB and HML, have the ability to predict economic growth for markets investigated in this paper. Our findings show that there are only a limited number of cases when the coefficients are positive and significance is achieved in an even more limited number of cases. Our results are in stark contrast to Liew and Vassalou (2000) who find coefficients to be generally positive and of a similar magnitude. We go a step further and also employ the methodology of Lakonishok, Shleifer and Vishny (1994) and once again fail to support the risk-based hypothesis of Liew and Vassalou (2000). In sum, we argue that search for a robust economic explanation for firm size and book-to-market equity effects needs sustained effort as these two zero cost portfolios do not represent economically relevant risk.

Implicit discount rates and fisheries management : is there a relationship?

Fishers are faced with multiple risks, including unpredictability of future catch rates, prices and costs. While the latter are largely beyond the control of fisheries managers, effective fisheries management should reduce uncertainty about future catches. Different management instruments are likely to have different impacts on the risk perception of fishers, and this should manifest itself in their implicit discount rate. Assuming licence and quota values represent the net present value of the flow of expected future profits, then a proxy for the implicit discount rate of vessels in a fishery can be derived by the ratio of the average level of profits to the average licence/quota value. From this, an indication of the risk perception can be derived, assuming higher discount rates reflect higher levels of systematic risk. In this paper, we apply the capital asset pricing model (CAPM) to determine the risk premium implicit in the discount rates for a range of Australian fisheries, and compare this with the set of management instruments in place. We test the assumption that rights based management instruments lower perceptions of risk in fisheries. We find little evidence to support this assumption. although the analysis was based on only limited data.

Principles of investments

"Emphasises asset allocation while presenting the practical applications of investment theory. The authors concentrate on the intuition and insights that will be useful to students throughout their careers as new ideas and challenges emerge from the financial marketplace. It provides a good foundation to understand the basic types of securities and financial markets as well as how trading in those markets is conducted. The Portfolio Management section is discussed towards the end of the course and supported by a web-based portfolio simulation with a hypothetical $100,000 brokerage account to buy and sell stocks and mutual funds. Students get a chance to use real data found in the Wall Street Survivor simulation in conjunction with the chapters on investments. This site is powered by StockTrak, the leading provider of investment simulation services to the academic community. Principles of Investments includes increased attention to changes in market structure and trading technology. The theory is supported by a wide range of exercises, worksheets and problems."--publisher website Contents: Investments: background and issues -- Asset classes and financial markets -- Securities markets -- Managed funds and investment management -- Risk and return: past and prologue -- Efficient diversification -- Capital asset pricing and arbitrage pricing theory -- The efficient market hypothesis -- Bond prices and yields -- Managing bond portfolios -- Equity valuation -- Macroeconomic and industry analysis -- Financial statement analysis -- Investors and the investment process -- Hedge funds -- Portfolio performance evaluation.

Essays on momentum investing strategies

The momentum investment strategy, which buys recent winner stocks and sells recent loser stocks, earns returns that are simply too good to be explained by traditional finance theories. This thesis extends our understanding of the sources of momentum profits. The research shows that part of the seemingly anomalous returns can be explained by the market's reaction to public news, is affected by how delisting returns are calculated, and is biased by ignoring the time-varying risk of the trading strategy.