Axel Adam-Müller, University of Konstanz, Germany
Risk management in incomplete financial markets has to rely on cross hedging which creates basis risk. This paper focuses on cross hedging price risk with futures contracts in an expected utility model. So far, basis risk has been additively related to either the spot price or the futures price. This paper takes an alternative view by assuming a multiplicative relation where the spot price is the product of the futures price and basis risk. The paper also analyses the reverse relation where the futures price is the product of the spot price and basis risk. In both cases, basis risk is proportional to the price level. It is shown that the decision maker's prudence is of central importance for the optimal futures position in an unbiased futures market: For the first relation, positive prudence is a necessary and sufficient condition for underhedging. For the second, non-negative prudence is a sufficient condition for underhedging. Numerical examples show that the optimal futures position can deviate significantly from the variance-minimizing position.
Axel Adam-Müller, K.P. Wong, University of Konstanz, Germany
Multiple delivery specifications exist on nearly all commodity futures contracts. Sellers are typically allowed to choose among several grades of the underlying commodity. On the delivery day, the futures price converges to the spot price of the cheapest-to-deliver grade rather than to that of the par-delivery grade of the commodity. This imposes an additional delivery risk on hedgers. This paper derives the optimal production and futures hedging strategy for a risk-averse competitive firm in the presence of delivery risk. We show that, depending on its relative valuation, the delivery option may induce the firm to produce more than in the absence of delivery risk. If delivery risk is additively related to commodity price risk, the firm will under-hedge its exposure to commodity price risk. If delivery risk is multiplicatively related to commodity price risk, the firm will under- or over-hedge this exposure. For constant relative risk aversion, this is illustrated by a numerical example.
Renee Adams, J.A.C. Santos, Federal Reserve Bank of New York, USA
In this paper we examine the effects of fiduciaries holding stock in themselves in a fiduciary capacity. These shares provide no direct incentives to the fiduciary manager, since the beneficiary has the claim to all cash-flows from the stock. In his capacity as fiduciary manager, however, the manager may be able to vote these shares and thus increase his voting control over his own corporation. Using a unique sample of data on 210 of the 300 largest banks in 1966, we document that the amount of voting rights banks may control in themselves through their trust departments may be significant. We use this fact to investigate the effect of managerial voting control on firm value, as proxied by Tobin’s Q. In our sample firm value does not decrease as banks (and hence managers) obtain more shares that have some voting control when voting stakes are not too large. In certain specifications we find an inverse U-shaped relation between firm value and voting control. State laws differ in the extent to which they restrict the voting of shares held in trust. Given the nature of our data we are able to exploit this variation to address the potential endogeneity of voting control in our regressions in an instrumental variable framework. Our results are robust to various specifications and to using return on assets as an alternate performance measure, and are generally consistent with theory.
THE CAPITAL
ASSET PRICING MODEL AND THE THREE FACTOR MODEL OF FAMA AND FRENCH REVISITED
IN THE CASE OF FRANCE
Souad Ajili, CEREG-University of Paris Dauphine, France
Size and book to market ratio are both highly correlated with the
average returns of common stocks. Fama and French (1993) argue that these
effects are proxies for factors of risk. In this study, we try to test the
three factor model of Fama and French and the Capital Asset Pricing Model on
French Stock Market. We use returns on the Fama and French six portfolios
sorted by size and book to market ratio. The sample is from July 1976 to June
2001. Our results show that the three factor model explains better the common
variation in stock returns than the capital asset pricing model. Moreover, both
the CAPM and the three factor model do a good job in explaining the cross
section of stock returns. We test the three factor model with a set of market
portfolios and we show that all market portfolios capture the common variation
in stock returns. However, only the value-weight market portfolio can explain
the cross-section in the stock returns. Finally, we test the January effect in
the French case and we show that there is no January effect for both the
dependent variable (stock portfolios) and the explanatory variables (the
market, HML and SMB).
Since the turn of the year 2001/2002 the International Accounting Standards Board (IASB) has been publishing the Draft Statement of Principles (DSOP) on insurance accounting in the internet chapter by chapter. The completion of the International Financial Reporting Standard (IFRS) Insurance Contracts is scheduled for 2003. This paper aims at critically analysing the main issues of the DSOP without requiring specific knowledge of insurance. The intention is to discuss fundamental problems not only of international accounting, but of accounting in general: How to determine a fair value in the absence of markets? When to realize business results? In accounting terms, what is an asset and what is a liability? The DSOP attempts to give different answers to essential questions than the preparatory Issues Paper. The new evaluation concept, the “entity-specific value”, turns out to be as problematic for insurance contracts as the fair value. The suggestion to realize the result from an insurance contract immediately at the conclusion of the contract is contrary to current practice (almost) worldwide. Above all the proposal has to be criticized for being self-contradictory. The most important inconsistencies will be pointed out systematically. Finally the consequences for insurance companies and other enterprises will be discussed, if the IASB, despite all opposition, insists on the planned revolutionary changes in accounting concerning insurance contracts. Insurance accounting takes the lead in a fundamental reform of accounting bringing parts of the value of the firm (the so-called embedded value) into the financial statements.
A reverse merger (RM) is a
technique in which a private company is acquired by a shell or defunct public
company via stock swap. As a result, the private company becomes public. The
main difference between an IPO and a RM is that an IPO allows going public and
also allows raising capital while the RM only allows going public. This paper
addresses the following question: Why do some companies prefer a RM to an IPO?
We construct a three-period model in which a company has uncertainty about the
availability of a project and need to issue equity to finance it. The model
predicts that under suitable conditions, a separating equilibrium exists in
which a high-type firm will prefer IPO and a low-type firm will prefer RM. The
empirical evidence supports these predictions. In addition, looking at the cost
of RMs between 1990 and 2000 in the NYSE and NASDAQ and adding the cost of an
additional SEO, we find evidence to support the idea that an IPO and a RM are
equally costly.
Playing
Hardball: Relationship Banking in the Age of Credit Derivatives
Stefan Arping, University of Lausanne, Switzerland
This paper develops a contracting framework in order to explore the
effects of credit derivatives on banks’ incentives to monitor loans, their incentives to intervene, and, ultimately, borrowers’ incentives to perform. We show that (i) credit
derivatives with short term maturity strengthen
incentives to intervene, incentives to monitor, and managerial incentives
to perform; (ii) while credit derivatives with long term maturity weaken
incentives to intervene, intervention incentives can be maintained by sourcing
more short term credit insurance; (iii) long term credit insurance nevertheless
weakens managerial incentives through a dilution effect. These findings suggest
that properly designed credit derivatives strengthen monitoring incentives and
result in efficiency gains, rather than impeding economic efficiency.
Wolfgang
Aussenegg, Pegaret Pichler, Alex Stomper, Vienna University
of Technology, Austria
This paper examines the IPO pricing processes of two different markets,
each of which employs bookbuilding methods for marketing the IPO shares. For
each market we investigate two questions: Does bookbuilding serve mainly as a
method for distributing shares, or also as a means for gathering information?
And, to what extent do underwriters respond in IPO pricing to any information
that they obtain through bookbuilding? We find that a direct comparison of
these two markets sheds light on the bookbuilding process in each. For Nasdaq
IPOs we find evidence consistent with informational rents being earned by
investors for providing information during bookbuilding. On the Neuer Markt
there is no such evidence. Instead, we find evidence consistent with rents
being paid for information that helps underwriters to set indicative price
ranges prior to bookbuilding. The two
markets differ further in how underwriters respond to information in pricing
IPOs. For the Neuer Markt, this response is severely constrained since
underwriters do not set prices above the price ranges. We estimate the total
cost of this “restriction” to be approximately one billion Euros for our sample
of IPOs. While there are no such apparent restrictions for Nasdaq, we show that
also on this market IPO prices are “sticky” in that underwriters respond less to
information received later in the pricing process.
ASSESSING
PORTFOLIO PERFORMANCE USING ASSET PRICING KERNELS
Mohamed A. Ayadi, Lawrence Kryzanowski, Brock University, St. Catharines, Canada
The Stochastic Discount Factor (SDF) representation or asset pricing
kernel approach provides a general and
convenient framework to
price various financial assets. We use
this general asset pricing
framework to derive a
conditional asset pricing kernel that
accounts efficiently for time variation in expected returns and risk. Our model
is suitable to perform unconditional
evaluations of fixed-weight
strategies and (un)conditional evaluations of dynamic strategies. We develop
the appropriate empirical framework for
the estimation of the performance measures and their associated tests using the
GMM of Hansen (1982). We examine the performance of Canadian equity mutual
funds over the period, November 1989 through December 1999. The results
indicate that there is evidence of abnormal unconditional performance and that
performance deteriorates and becomes negative using the conditional asset
pricing kernel model. Moreover, the performance statistics are weakly sensitive
to changes in the level of relative risk aversion of the uninformed investor.
Sanjay Banerji, P. Bose, McGill University, Montreal, Canada
In this paper, we build up a signaling model that links management
pay-off in corporate restructuring (widely known as absolute priority
violations) and optimal composition of a firm’s debt. We show that in the event
of corporate reorganization and the renegotiation of debt claims, the
management receives a pay-off that consists of two elements. (a) A signaling component
that sends a message to outside financiers about the quality of the reorganized
firm. (b) Incentive components that induce the management to exert a higher
level of effort resulting in a larger firm value. The signaling component of
management compensation reduces the interest issued on fresh loans needed for refinancing old obligations. Faced with a liquidity crisis, the lending bank
will prefer to reveal the quality of profitable projects to “arms- length”
financiers in order to reduce the costs of refinancing of outstanding junior
debt. We show that a renegotiated contract (one in which the manager’s payoff
is appropriately high and increasing in the firm value) can serve as a credible
signal of project quality of a firm. As for the impact of ex-post
renegotiations on the ex-ante choice financial structure, we show that the
signaling component is fully priced (ex-ante) in the financing costs of the
entrepreneur and does not affect the optimal composition of debt. On the other
hand, the incentive component enhances the value of the firm and thus prompts
the entrepreneur either to issue public debt (along with a senior private debt)
or to resort to multiple lenders —a large bank coupled with smaller banks.
Hence, it is not only the level but also the composition of debt that exert
impact on firm value. Our result holds true when even we allow the bank to
issue protective covenants that restrict the amount of the junior debt that a
firm can issue. Finally, despite renegotiations, we show that the choice of
optimal financial structure results in inefficient liquidation of assets due to
endogenous debt-overhang effects.
Weltweit setzt sich der elektronische Handel an Börsen immer schneller
durch. Im vorliegenden Beitrag wird argumentiert, daß durch die Automatisierung
des Börsenhandels die Leistungsfähigkeit von Börsen vor allem hinsichtlich
zweier Merkmale gesteigert werden kann. Erstens erhöht sich ihre Reichweite und
zweitens sinken die Kosten der Marktorganisation. Am Beispiel der Verlagerung
der Umsätze im DM-Bund Future von der LIFFE zur Eurex werden diese
Wettbewerbsvorteile einer Computerbörse empirisch dokumentiert.
In 2001, securities
industry revenues dipped dramatically the largest decline in 20 years and
spurred a similar drop in profit margins. In the near term, securities firms
have tried to prop up margins by reducing capacity. However, long-term competitiveness
depends on altering a company's cost structure permanently. The IBM Institute
for Business value looked at three strategic initiatives that promise the
type of far-reaching change that is required to rein in costs today and position
firms favorably for the next market upturn. The goal of the IBV study was
to lay out cost cutting alternatives available to management of securities
firms, distinguishing between short term reductions in capacity and longer
term process improvements. Through primary research, understand which alternatives
are currently being pursued by management and their expected savings. The
Study delved deeply into four technologically intensive cost reduction initiatives
- STP, industry processing utilities, infrastructure consolidation, and IT
outsourcing. It quantified expected benefits and identified potential hurdles
to successful implementation, but also focused on areas where some investment
will be needed; hence differentiation between "cost-cutting" and "cost-optimization".
The Value Realization Study gives an overview of current cost cutting initiatives
underway in the industry. It also examines the benefits and considerations
of pursuing four promising cost cutting measures - laying out a roadmap for
change for each.
We look at
moral hazard by an insider investor in the context of venture financing The
inside investor has experienced the entrepreneur’s quality in a previous stage.
An outside investor cannot assess the quality. Thus, generally, an outside
investor offers financial terms reflecting the average entrepreneurial quality.
If the entrepreneur is a good one the inside investor may have an incentive to
appropriate rents due to his information monopoly by demanding a higher share
on the venture’s return before financing the next stage. If it is more costly
for the entrepreneur to switch to an outside investor, she sticks to the inside
investor, though. However, she may not choose the efficient level of effort or
specific investments, rather she underinvests. This problem of expropriation
depends on the information structure and may be mitigated when the parties ex
ante fix the financial terms of future capital infusions conditionally on the
performance of previous stages. These provisions are quite common. So far, the
literature considered them as a device to mitigate moral hazard by
entrepreneurs. But they can also mitigate the inside investor’s incentive to
negotiate opportunistically. The syndication of venture capital investments may
mitigate the moral hazard problem, too, since co-investors are likely to be
better informed than outside investors. Debt financing or mixed financing may
be more favorable than equity financing since legal boundaries on interest
rates limit the extent to which an inside investor could hold up an
entrepreneur.
Martin T. Bohl, Stefan Reitz, European University Viadrina, Frankfurt (Oder), Germany
In this paper we provide empirical findings on the significance of
positive feedback trading for the return behavior in the German stock market.
Relying on the Shiller- Sentana-Wadhwani model, we use the link between index
return auto-correlation and volatility to obtain a better understanding into
the return characteristics generated by traders adhering to positive feedback
trading strategies. Our empirical evidence shows that in the German stock
market a significant proportion of investors are positive feedback traders and
that this positive feedback trading seems to be responsible for the observed
negative return autocorrelation during periods of high volatility.
Bank
Efficiency: The Role of Local Market Conditions
Jaap Bos, C. Kool, De Nederlandsche Bank, Netherlands
We question whether bank X-efficiency is indeed managerial efficiency
and measure to what extent it depends on local market conditions. We do so by
estimating stochastic profit and cost frontiers for a balanced panel of 401
Dutch cooperative local banks in 1998 and 1999. We explain the resulting
efficiency measures with both bank- and market-specific variables. Results show
that market factors explain roughly 10-20% of the variation in bank efficiency.
Only focusing on cost efficiency results in opening too many main offices and
putting too much emphasis on non-traditional services. Investing in (wholesale)
relationship banking and market penetration pays off through increases in
profit efficiency.
This paper analyses two implied methods
to determine the pricing function for derivatives when the market is incomplete.
First, we consider the choice of the equivalent martingale measure exhibiting
minimal cross-entropy with respect to a given benchmark measure. We show that
the choice of the numeraire has an impact on the resulting pricing function,
but that there is no sound economic answer to the question with numeraire to
choose. The ad-hoc choice of the numeraire introduces an element of
arbitrariness into the pricing function, thus contradicting the motivation of
this method as being the least-prejudiced way to choose the pricing operator.
Second, we propose two new methods to select a pricing function: the choice of
the stochastic discount factor (SDF) having minimal extended cross-entropy with
respect to a given benchmark SDF, and the choice of the Arrow-Debreu (AD)
prices having minimal extended cross-entropy with respect to some set of
benchmark AD prices. We show that these two methods are equivalent. They avoid
the dependence on the numeraire and replace it by the dependence on the
benchmark pricing function. This benchmark pricing function, however, can be
chosen based on economic considerations.
There is empirical evidence that the implied
volatility smile for index options is significantly steeper than the smile for
individual options. We propose a simple model setup that is able to explain
this difference. When modelling the index, an aggregation restriction has to be
taken into account. The index level is a weighted sum of individual stock
prices, so that the distribution of the index is completely determined by the
joint distribution of the component stocks. The difference between the index
smile and the smiles for individual stocks is then determined entirely by the
dependence structure among the stocks. Changing only this dependence structure
changes the implied volatility curve for the index, whereas individual smiles
would remain unchanged. We illustrate our basic idea in the context of a jump-diffusion
model. The dependence among stocks is captured by decomposing both the jump and
the diffusion terms into common and idiosyncratic parts. Special attention is
paid to the dependence during a crash. In this situation stocks are supposed to
move together more than during normal market periods, which causes implied
volatilities for OTM index puts to go up by much more than for individual stock
options. Although the smile is explained exclusively by the risk-neutral
distribution the relation between this distribution and the data-generating
process is of interest. It is an important feature of our model that large
downward movements are caused by jumps, which behave quite differently from
diffusions under a change of measure. While for purely diffusion-based models
second moments are preserved under the new measure this is not necessarily true
for models featuring jump components. Thus a change of measure will also alter
the dependence structure of the stocks in a jump-diffusion model.
Interpretating probability density functions (PDFs)
extracted from currency options data is ambiguous because PDFs combine risk
neutral market views regarding the likelihood of particular exchange rate
outcomes with investors' preferences towards risk. In order to disentangle
the two effects, market expectations derived for option prices need to be
adjusted for the time-varying volatility risk premium that compensates risk
averse option writers. Assuming rational expectations this risk premium can
be extracted ex-post. The implied volatility bid-ask spread and volatility
of implied volatility are considered here as proxies for the risk premium
to enable the ex-ante adjustment of risk-neutral exchange rate expectations
for risk preferences. The method is applied to demonstrate the impact of this
adjustment on exchange rate expectations around Hong Kong SAR’s equity market
intervention in 1998. The risk premium explains part of the bias found in
existing empirical studies of the predictability of future realized volatility
by implied volatility.
Banks' Capital Adequacy: Computing the 'Fair' Capital Charge for Loan Commitment Credit Risk
Jean-Pierre Chateau, J. Wu, ESC-Rouen, France
This research makes two contributions. The first one is to price extendible or
rollover commitments, and the second to compute the "fair" capital charge for commitment
"true" credit risk. The commitment valuation model comprises two steps. The commitment
put option implicit in extendible credit line commitments is first valued analytically and is
next combined with an exercise-cum-takedown proportion to determine the bank's net
exposure to commitment credit risk. The following patterns are emerging from the model
simulations: (i) the extension privilege constitutes a substantial premium with regard to the
one-year straight commitment, and (ii) the bank's exposure to commitment credit risk gives
rise to a net notional premium or discount. At this stage, we do away with the BIS
accounting-based credit-equivalent conversion factor, principal-risk factor, and commitment
maturity dichotomy and replace them by the exercise-cum-takedown proportion and the
extendible-commitment put value, respectively. These are then used to compute the
risk-weighted balance which links all commitments, irrespective of their initial term to
maturity, to the regulatory capital charge. Finally, the approach is developed one step
further to account for the borrowers' ratings by external credit agencies; this results in a
matrix of new standard risk weights that applies to all off-balance-sheet
commitments.
TRADE
CREDIT AND PRODUCT MARKET COMPETITION :THEORY AND EVIDENCE
Anne-France Delannay, Universite Robert Schuman, Strasbourg, France
Financial structure may affect output market competition. This paper
analyses the strategic role played by trade credit in the determination of
firms’ competitive position. In a market structure in which trade relations
between suppliers and retailers are governed by exclusive distribution, we show
that trade credit may reduce conflicts of interest between shareholders and
debt holders, and make firms compete less aggressively in the output market. We
verify the empirical relevance of this strategic explanation of trade credit
extension, with a sample of 40 000 couples of suppliers and clients.
Recently, the
Basel Committee asked for an appropriate treatment of exposures to small and
medium-sized enterprises (SMEs) in the new risk-weight formulas. Assets correlations
are a major determinant of the distribution
of losses in a portfolio credit risk model and a central element of these
formulas. This paper uses the same one factor model used by the Basel Committee
to compute the risk weights functions and provides estimates of correlations
in two large populations of SMEs containing around 450.000 French firms and
280.000 German firms. Results show that the correlations are on average in
the magnitude of 1 to 2%. So, the estimated correlations are much lower than
the 10% to 20% levels assumed by the Basel Committee. In addition results
do not show a negative relationship between correlations and PDs. Moreover,
the paper presents also a bootstrap-like simulation that permits to test the
robustness of the previous results. This test confirms the relatively low
level of assets correlations in SMEs portfolios. However, it shows that portfolios
of large businesses have a greater likelihood to exhibit high values of the
assets correlation.
How Fundamental are Fundamental Values? Valuation Methods and Their Impact on the Performance of
German Venture Capitalists
Ingolf Dittmann, Johannes Kemper, Ernst Maug, Humboldt-University, Berlin, Germany
In this paper we investigate how the use of alternative valuation methodologies affects
the investment performance of a sample of 53 German venture capitalists. We analyze the
methods they use for valuing portfolio companies. We then ask how these methods affect their
investment performance as measured by the amount of investments they need to write off. We
find that a significant number of investment managers use discounted cash flow (DCF) techniques,
but only a minority appears to use them correctly. However, only the correct use of DCF leads
to superior investment performance. Also, funds that invest with a longer horizon (4 years and
more) perform better. The use of multiples (comparables) does not predict improvements in
investment performance which we attribute to the fact that comparable companies (mostly
technology stocks) where also poorly valued by the stock market during the sample period.
Surprisingly, the size of funds under management cannot explain superior performance. We
conclude that investment managers who focus on fundamental values perform better.
Neil Doherty, J. Lamm Tennant, L. Starks, University of Pennsylvania, USA
The behavior of insurer stock prices after September 11th presents an interesting spectacle. Prior to 9/11, insurer stock prices had fallen short of market indices. Despite suffering from what has turned out to be by far the biggest loss ever to fall on the industry, insurer stock prices recovered quickly to exceed their pre 9/11 levels and, for a while, outperformed market indices. But this pattern is not without precedent. A similar pattern was seen following hurricane Andrew and the Northridge earthquake, the two previous costliest U.S. insured events.
The events of September 11th and their impact on the insurance industry offer an opportunity to test a number of related theories about how this industry will respond to, and recover from, a severe shock to its capital. The theoretical models do allow us to predict the temporal and cross sectional variation in stock prices and 9/11 present a grand natural experiment to test these models.
The main theories we will test are the capacity constraint model of Winter 1988 and Gron 1994 and the related implicit contract theory of Doherty and Posey 1996 which argue that insurers will experience sharp price spikes and capacity swings following capital shocks due to the high cost of accessing external capital markets. This, and the related models we describe below, allow us to predict the relative impact of 9/11 on different firms and the market opportunities different firms will face going forward. Brokers, with little exposure and revenue based fees, perform extremely well, commercial writers most hard hit by claims but still with attractive post-loss market opportunities, perform less well and personal lines underwriters are hardly affected. However, the main constraint facing many insurers will be shortage of capital and those least affected will benefit most. Thus, for example, we find that firms with smaller pre-loss leverage, smaller risk overhang, higher post-loss liquidity are the best performers.
While the events of 9/11 created many of the conditions predicted in these models, the magnitude of these events, and their economic and political ramifications, created considerable uncertainty and information asymmetry. Unlike, previous natural catastrophes, 9/11 closed the stock market, induced the Fed to reduce interest rates again, may well have nudged the developing recession and sparked a massive military response. Morever, the impact of 9/11 on insurers was less clear than that of the previous capital shocks which were mostly natural catastrophes. Those prior events caused much property damage with some modest loss of life, for which insured losses can be estimated quite quickly with moderate error. In contrast, 9/11 caused massive property loss, business interruption, workers compensation and potential open ended liability losses all of which are extremely difficult to estimate with any accuracy and which will probably take many years or even decades to finally be run off. Thus, loss estimates by insurers are given with very wide boundaries or are subject to enormous margins of error. Under these conditions, one might expect opportunistic behavior by insurers and an offsetting demand by investors (and a consequent reward for) transparency. Thus, we find that the opening of trading was accompanied by a rush of share repurchases despite the fact that many firms were short of capital. On the other hand, we also find the market tended to reward those firms that were early in reporting their net loss estimates. We also find the emergence of a "lemons" phenomenon whereby selective low risk firms sought to signal to investors their risk status by their early announcement of their gross claim exposures.
Value at Risk with
Informed Traders, Herding, and the Optimal Structure of Trading Divisions
Tanja Dresel, Hans-Peter Burghof, Ludwig-Maximilians-University, Munich, Germany
We scrutinize
the use of value at risk as traders’ limit in banks. Thereby, we compare a bank
with uninformed traders dealing on a perfect capital market, with a bank in
which traders receive a noisy signal about the future price of the stock they
are dealing in. Additionally, they are able to deduce some information about
the market trend from the observation of the behavior of other traders. In the
imperfect market setting, informed traders tend to herd in informational
cascades, which increases the probability of extreme results and value at risk.
Thus, banks should either avoid or optimize information flow between traders.
We discuss different optimization approaches to maximize a value at risk-based
RORAC through an efficient information policy. Likewise, we compare our results
with „neoclassical” value at risk both from an ex ante and ex post-perspective
and identify systemic risks from neoclassical negligence of informational
herding.
Conversion
Factors, Delivery Option and Hedge Efficiency of a Multi-Issuer Bond Future
Klaus Düllmann, Wolfgang Bühler, Deutsche Bundesbank, Germany
This paper makes three contributions to the literature on bond futures
contracts: Firstly, we analyse the value of the delivery option of a multi-issuer
contract. This contract differs from traditional contracts like the T-Bond
or the Bund Future in that bonds of different issuers can be delivered by
the seller of the future. The future and its delivery option are valued using
a two-factor affine model, which belongs to the intensity-based class of default-risk
models developed by Duffie and Singleton (1999). Secondly, we propose three
conversion-factor systems to reduce the danger of a short squeeze in the spot
market. The conversion factors simultaneously account for differences in coupon,
time to maturity, and the credit risk of deliverable bonds. Thirdly, in the
empirical part of the paper we analyse the impact of these conversion-factor
systems on the hedge efficiency of the corresponding futures contracts. Based
on the value of the delivery option and the results for the hedge efficiency,
an appropriate conversion-factor system is recommended, having a prospective
European sovereign bond future in mind.
Risk management
approaches that do not incorporate randomly changing volatility tend to under-
or overestimate the risk depending on current market conditions. We show how
some popular stochastic volatility models in combination with the hyperbolic
model introduced in Eberlein and Keller (1995) can be applied quite easily for
risk management purposes. Moreover, we compare their relative performance on
the basis of German stock index data.
THE TERM
STRUCTURE OF INTEREST RATES: BOUNDED OR FALLING?
David Feldman, Ben-Gurion University of the Negev, Israel
This short paper resolves an apparent contradiction between Feldman’s
(1989) and Riedel’s (2000) equilibrium models of the term
structure of interest
rates under incomplete information. Feldman
(1989) showed that
in an incomplete
information version of
Cox, Ingersoll, and Ross
(1985), where the stochastic productivity factors are
unobservable, equilibrium term structures are “interior” and bounded.
Interestingly, Riedel (2000) showed that
an incomplete information
version of Lucas (1978), with an
unobservable constant growth rate,
induces a “corner”
unbounded equilibrium term
structure: it decreases
to negative infinity. This paper defines constant and stochastic
asymptotic moments, clarifies the apparent
conflict between Feldman’s
and Riedel’s equilibria,
and discusses implications. Because productivity and growth rates
are not directly
observable in the
real world, the question we answer is of particular
relevance.
Do
Bank Loan Relationships Still Matter?
Donald Fraser,
T. Berry, S. Beyers, Texas A&M University, USA
We find
that bank loan announcement abnormal returns have diminished considerably since
1980. Indeed, bank loan announcements
produced no statistically significant abnormal returns over the 1996-2000
period. These results are consistent
with the argument that increasing competition in financial markets has reduced
the value of bank loan relationships.
We also find that loan announcement returns are more likely to be
positive for syndicated loans, and in periods of high credit risk spreads.
Financial Instruments Fair Value Accounting for (not against) the Banking Industry
Günther Gebhardt, Rolf Reichardt, Carsten Wittenbrink, J.W.-Goethe University, Frankfurt, Germany
Accounting for financial instruments is one of the most controversial areas
in current standardsetting. Recent standards (SFAS 133, IAS 39) introduce
fair value measurement for all derivative instruments but put restrictive
burdens on the application of hedge accounting. Representatives of the banking
industry argue that the current standards do not adequately portray the economics
of the banking business. They further strongly oppose fair value accounting
for all financial instruments as recommended by the Financial Investments
Joint Working Group of Standard Setters (JWG).
The objective of this paper is to carefully analyze and evaluate the arguments
of the critics from the banking industry. We develop a simulation model that
captures the essential characteristics of a modern universal bank with investment
banking and commercial banking activities that hedges its interest rate risks
in the banking book through internal contracts with the trading book. We run
simulations for our model bank following different banking strategies (fully
hedging risks or hedging only a part of their risk) using historical interest
rates from periods with rising interest rates and from periods with decreasing
interest rates.
Application of different sets of accounting rules - Old IAS before IAS 39
became effective, "Current IAS or US GAAP" with and without hedge
accounting, and the JWG Full Fair Value Model - to the activities of our model
bank in the different interest rate scenarios yields important insights. We
demonstrate that under Old IAS a fully hedged bank that under our model assumptions
has zero economic earnings is in the position to adequately portray this in
its financial statements. However, as Old IAS allow much discretion, a fully
hedged bank may as well present income that is either positive or negative,
for example, by not applying hedge accounting that is optional but not required
under Old IAS. We further show that under Current IAS or US GAAP banks can
not adequately portray their investment banking and commercial banking activities
because of the restrictive hedge accounting rules that do not allow best practice
asset liability management activities to be adequately reflected in the financial
statements.
We demonstrate that application of the mandatory Full Fair Value Model of
the JWG Draft Standard bank adequately reflects the economics of the banking
activities. The fully hedged bank has to present zero net income. If the bank
hedges only part of its risks this will result in non zero net income. The
model does not allow discretion in presenting the results of the banking operations.
This is the essential difference to the optional fair value model proposed
by the International Accounting Standards Board (IASB) in the IAS 32 and IAS
39 Improvement Exposure Draft issued in June 2002 that does allow banks to
adequately portray their business but does not require them to do so.
Our detailed analysis of the different sets of accounting rules, in addition,
identifies several critical issues of the different accounting models that
have not been covered in the literature.
Cookie-Cutter
versus Character: The Micro Structure
Lawrence Goldberg, R.A. Cole, L.J.White, University of Miami, USA
The informational opacity of small businesses makes them an interesting
area for the study of banks' lending practices and procedures. We use a survey
of small businesses conducted by the Federal Reserve to analyze the micro-level
differences between large banks and small banks in the loan approval process.
We provide evidence that large banks ($1 billion or more in assets) tend to
employ standard criteria obtained from financial statements in the loan
decision process, but that small banks (less than $1 billion in assets) deviate
from these criteria by relying to a larger extent on the character of the
borrower. Some of the results are inconsistent, however. These
"cookie-cutter" and "character" approaches are compatible
with the incentives and environments facing large and small banks.
The question we
solve is the optimal design of the minimum guarantee in a Defined Contribution
Pension Fund Scheme. We study the investment in the financial market by
assuming that the pension fund optimizes its retribution which is a part of the
surplus, that is the difference between the pension fund value and the
guarantee. Then we define the optimal guarantee as the solution of the
contributor's optimization program and find the solution explicitly. Finally,
we analyze the impact of the main parameters, and particularly the sharing rule
between the contributor and the pension fund. We find that favorable sharing
rules for the pension fund lead to conservative guarantees for the contributor:
the sharing rule is a way to create a continuum between two extreme pension
funding methods that are Defined Benefit and Defined Contribution Pension Schemes,
and the sharing rule allows partial risk transfer between the contributor and
the pension fund manager.
Helmut
Gründl, Hato Schmeiser, Humboldt-University, Berlin, Germany
In this article, we look at various approaches to pricing a new type of
contract that has emerged from the area of “Alternative Risk Transfer” – the
doubletrigger reinsurance contract. The potential coverage from a double-trigger
contract depends on both actuarial risk development and financial risk development.
In a traditional financial pricing environment, this type of contract will
make necessary large safety loadings on the expected loss payments. In the
presence of a reinsurer’s default risk, we determine the reinsurer’s reservation
price in the event the reinsurer wants to remain in the same risk class after
signing the contract. To maintain the desired risk situation, these contracts
must be backed with large amounts of equity capital, if equity capital is
the risk management measure to be taken. The amount of additional equity capital
induced by the double-trigger contract depends heavily on the correlations
between the double-trigger loss distribution and the reinsurer’s underwriting
and investment portfolio. We contrasted the financial insurance pricing models
with an actuarial insurance pricing model that determines the price of a contract
where the objective is that the contract should result neither in the reinsurance
company’s expected profits falling nor its ruin probability rising. We will
show, that actuarial pricing can lead the reinsurer into a trap that results
in failing to close insurance contracts that would have a positive net present
value for the reinsurer. Typical actuarial pricing dictates the type of risk
management measure that must be taken, namely, the insertion of additional
capital. What is more, it forces the reinsurance buyer to provide this safety
capital as a debtholder. Taking financial theory into consideration, the reinsurance
purchaser would be prepared to provide only a small portion of this capital
in the context of the insurance premium; for the largest portion the purchaser
would demand the status of an equity provider. Finally, we investigate conditions
leading to a market for double-trigger reinsurance contracts.
Price Discrimination
on Syndicated Loans and the Number of Lenders: Empirical
Evidence from the Sovereign Debt Syndication
Issam Hallak, Center for Financial Studies, J.W.-Goethe University, Frankfurt, Germany
Syndicated loans and the number of lending relationships have raised
growing attention. All other terms being equal (e.g. seniority), syndicated
loans provide larger payments (in basis points) to lenders funding larger
amounts. The paper explores empirically the motivation for such a price
discrimination on sovereign syndicated loans in the period 1990-1997. First
evidence suggests larger premia are associated with renegotiation prospects.
This is consistent with the hypothesis that price discrimination is aimed at
reducing the number of lenders and thus the expected renegotiation costs.
However, larger payment discrimination is also associated with additional
market segments and with larger loans, thus minimising borrowing costs and/or
attempting to widen the circle of lending relationships in order to raise
successfully the targeted amount.
Considerations to the Quantification of Operational Risks
Thomas Hartung, Ludwig-Maximilians-University, Munich, Germany
In the proposal for an New Basel Capital Accord suggestions are made,
how operational risk have to be underlied with equity. Up to now the management
of operational risk in a bank is restricted widely to the transfer to insurance companies.
So the objective of the paper is to show, which of the well known actuarial methods
from the field of insurance mathematics seem to be suitable for application in the
area of operational risks. A method is presented that can be used to calculate both
risks with high frequency and low severity in the same manner as risks with low
frequency and high severity. Accordingly within the scope of an actuarial based
analysis a possible prototoype will be presented. This bases on loss frequency
and loss severity distributions and their aggregation with the help of a monte carlo
simulation. This model is qualified for fulfilling the requirements of the Basel
Committee. Furthermore the question is discussed, how far the application of insurance
should be admitted as a more efficient substitute to individual capital requirements.
Ownership and Control in Joint Ventures: Theory and Evidence
Ulrich Hege, Robert Hauswald, HEC School of Management, France
Joint ventures, a particularly popular form of corporate cooperation, exhibit ownership patterns that are
clustered around equal shareholdings for a wide variety of parent firms. In this paper,
we investigate why 50-50 or "50 plus one share" equity allocations should be so prevalent.
In our model, parent firms trade off control benefits and costs with incentives for resource
contributions in the presence of asset complementarities. We show that strict resource
complementarity eliminates moral hazard in parent contributions so that ownership provides
sufficient incentives for optimal investments. However, the potential for extraction of residual
control benefits by the majority owner creates a discontinuity in contribution incentives at 50 equity
stakes that explains the optimal clustering of ownership around 50-50 shareholdings.
Using data from 1,248 US joint ventures announced between 1985 and 2000, we empirically
analyze the determinants of their ownership allocations and conduct tests of model predictions
that offer strong support for our theory.
INFERRING
INFORMATION FROM TRADING
Hans-Gerhard
Heidle, University of Notre Dame, USA
Most
theoretical as well as empirical models in market microstructure model
information flow and insider trading for one stock at a time. Information
consists of a market-wide, an industry-specific, and a firm-specific component.
An as yet unexplored implication is that information for one stock may have
consequences for other stocks as well. This suggests that market makers may be
able to infer information for a specific stock not only from observing the
order flow in that stock, but also from observing order flows in other stocks,
particularly other stocks within the same industry. This paper models
information arrival and the resulting order flows by developing a two-stock
sequential trade model based on the one-stock model in Easley, Kiefer, O’Hara,
and Paperman (1996). The paper uses a sample of NYSE listed S&P 500 stocks
and estimates the model for stock pairs in the same industry and for control
stock pairs in different industries. The control pairs consist of stocks in
different industries, which are matched on market capitalization and average
daily turnover. Using the information in trade data, the model determines the
frequency of information events relevant to one or both of the stocks. The
analysis shows that the probability of an information event relevant to both
stocks is significantly higher for stock pairs in the same industry than for
matched stock pairs in different industries. This suggests that market makers
may not only infer information from the order flow in their assigned stock, but
also from the order flow in other stocks within the same industry.
Analysten-Empfehlungen
und Ad hoc-Mitteilungen: Eine empirische Studie zum Neuen Markt
Jürgen Herf,
W. Bessler, Justus-Liebig University, Giessen, Germany
In der vorliegenden
Studie werden für Unternehmen am Neuen Markt die kurzfristigen Bewertungseffekte
von Ad hoc-Mitteilungen und Analysten-Empfehlungen sowie deren Interdependenzen
für das Jahr 1999 analysiert. Damit ist diese Untersuchung in der Literatur
zwischen Ereignisstudien zur Beurteilung der Leistung von Analysten und Studien
zur Verarbeitung von Ad hoc-Mitteilungen einzureihen. Die empirischen Ergebnisse
verdeutlichen die hohe Bedeutung von externen Einflüssen und überlappender
Ereignisse bei der Beurteilung von empirischen Studien. Dabei zeigt sich,
dass bei 65% aller Ad hoc-Mitteilungen Analysten-Empfehlungen in ihrem zeitlichen
Umfeld auftreten, die wiederum zu 75% aus Kauf-Empfehlungen bestehen. Dadurch
scheinen die Bewertungseffekte durchschnittlich positiv verzerrt zu sein.
Trotz der Berücksichtigung überlappender Ereignisse zeigen sich bei Empfehlungen
von Emissionsbanken und Börseninformationsdiensten auffällige Antizipationseffekte.
Capital
structure and the prediction of bankruptcy
Suzan Hol, Sjur Westgaard, Nico van der Wijst, Norwegian University
of Science and Technology, Trondheim, Norway
This paper addresses
the theoretical foundations of bankruptcy prediction, using the neo-classical
theory of capital structure as a starting point. The paper intends to
demonstrate the feasibility of such an approach in a simple setting, i.e. by
using a simple theoretical model and a limited empirical analysis. A model of
optimal capital structure is constructed and rewritten as a model of default
probability. Its empirical implications are derived and tested on a sample of
Norwegian data. It is concluded that this approach clearly has its limitations,
but also that it may be a valuable contribution compared to the multitude of
theory-less empirical studies and a useful alternative to the default theory
based on option pricing.
In diesem
Beitrag wird die Schätzung von Ausfallwahrscheinlichkeiten im Rahmen des
Internal Ratings-Based Approach des Basler Ausschußes für Bankenaufsicht
untersucht. Dazu wird zunächst der Zusammenhang zwischen Bonitäts- und
Ausfallkorrelation unter Annahme des dem IRB-Ansatz zugrunde liegenden
Schranken- oder Schwellenwert-Modells betrachtet. Unter Verwendung der
speziellen Abhängigkeitsstruktur des IRB-Ansatzes, die ein Gleichkorrelationsmodell
impliziert, wird gezeigt, daß das Gesetz der großen Zahlen für die Ausfallquote
nicht gilt. Das heißt, die Ausfallquote ist zwar der naheliegende Schätzer für
die Ausfallwahrscheinlichkeit, konvergiert aber im Ein-Perioden-Modell mit wachsender
Portfoliogröße nicht gegen die Ausfallwahrscheinlichkeit, sondern gegen eine
nichtdegenerierte Wahrscheinlichkeitsverteilung auf dem Einheitsintervall, die
in dieser Arbeit hergeleitet wird. Mit Hilfe dieser Verteilung können die
Ablehnungsbereiche für ein Backtestingverfahren und Konfidenzintervalle für die
Ausfallwahrscheinlichkeit angegeben werden. Die Breite der erhaltenen
Konfidenzintervalle zeigt, daß sich mit abhängigen Querschnittsdaten die
Ausfallwahrscheinlichkeiten nicht verläßlich schätzen lassen. Vielmehr muß sich
eine Schätzung der Ausfallwahrscheinlichkeit wesentlich auf Längsschnittsdaten
stützen, die – falls sie begründet als stochastisch unabhängig angenommen
werden können – eine hinreichende Schätzgenauigkeit ermöglichen.
Non-separation
between loan and deposit policy of German banks: some multi-step Granger-causality
results
In banking literature, typically a
strict separation between a bank’s credit and deposit policy is either assumed
or the result of a restrictive model structure. We want to know whether this
independence assumption, base for many a recommendation on a bank’s price
policy, is really valid. Therefore, we investigate this question empirically
for the interest rate policy of German universal banks. We use a recently
proposed one- and multi-step Granger-causality test that is designed for
possibly cointegrated time series. If information about the interest rate
policy of one side of the balance has predictive power for the other, the
separation property has to be rejected. As the variable for the refinance
conditions, we use the interbank call money rate in the information set. For
the estimation periods before and after the EMS-crises, we find clear evidence
for intertemporal dependence between different loan and deposit rates. In the
first period with increasing interest rates, credit rates are granger-causal
for deposit rates, possibly as a result of a positive correlation between
interest rate and credit risks. In the second period, the deposit side is
granger-causal for the credit side. In summary, the assumed or theoretically
proven separation of loan and deposit rate policy is empirically rejected. In
consequence, the often recommended creation of two independent profit centers
is likely to have suboptimal results.
Parsimonious
estimation of credit spreads
Rainer Jankowitsch, Stefan Pichler, Vienna University of Technology, Austria
The traditional method of credit spread estimation is based on
subtracting independently estimated risk-free and risky term structures of interest
rates which in many cases yields unrealistically shaped and often irregular
credit spread curves. A parsimonious joint estimation of the risk-free term
structure and the credit spread as proposed by Houweling et al. (2001) might
serve as a valuable alternative to overcome this drawback but it is hard to
decide whether a seemingly irregular shape of the credit spread curve is
economically caused by the data or is only an artefact of the functional form
of the estimation model. Results of an empirical examination of EMU government
bond data show that traditional estimation models with different functional
forms yield differing irregularities in the credit spread curves whereas joint
estimation procedures result in well-behaving and coinciding curves. Moreover,
the explanatory power of the more parsimonious joint estimation procedures is
virtually equal to the traditional methods. This is strong evidence for the
superiority of a joint estimation procedure of credit spread curves. Finally,
we conclude that a simple linear joint cubic splines specification performs
surprisingly well compared to a numerically more affording non-linear model.
Quantifizierung
des Risikos eines deutschen Lebensversicherers - Übertragung des S&P-Ansatzes
Reinhold Jaquemod, SV-Versicherungen, Stuttgart, Germany
Ziel ist die Neukonzeption der Versicherungsaufsicht durch einen stärker an
Risikosteuerungsmodellen orientierten Ansatz. Auf internationaler Ebene wird die
Diskussion um Reformbestrebungen bei der Finanzaufsicht durch Banken dominiert.
Es soll jedoch vermieden werden, dass das Muster der Banken unangepasst auf die
Versicherungswirtschaft übertragen wird, weil sich Versicherungsunternehmen und
Banken in Geschäftstätigkeit sowie Produkten und damit insbesondere auch in ihrer
Risikosituation deutlich unterscheiden. Das neue Modell soll in zwei Stufen ausgeführt
werden: (i) Die erste Stufe soll ein für alle Lebensversicherungsunternehmen (LVU)
einfach handhabbares System darstellen. (ii) Die zweite Stufe sollte als Alternative
stärker auf die speziellen Gegebenheiten in den einzelnen LVU abstellen. Hier sollen
interne Risikomodelle verwendet werden. Das bestehende Modell von
Standard & Poor's (S&P UK Life Model) soll so angepasst werden, dass es als
Aufsichtssystem für die erste Stufe dienen kann. Insbesondere sollen Problembereiche
bzw. Unschärfen des UK Life Models identifiziert und das Modell entsprechend modifiziert
werden. An der Grundstruktur des englischen Modells soll jedoch möglichst
festgehalten werden.
Using a large sample of cross-sectional data for 1998
of companies operating in the general insurance industry we attempt to shed some
light on the issue of competition in this industry. Companies offering products
and services in the general insurance market are believed to trade under very
competitive conditions. In order to test this widely-held claim we investigate
whether firms’ pricing policies reflect competitive or monopolistic market
features. Under competitive conditions companies are forced to pass on any
increase in costs in prices and thus their revenues will rise pari passu should wages, underwriting
costs or other expenses increase. By contrast, a firm operating under
monopolistic competition responds to an increase in marginal and average costs
by increasing price and reducing output, resulting in a less then complete
pass-through in revenue; profit falls. Our study is the first, to our
knowledge, to apply this research methodology to the general
(causality/liability) insurance industry. Firms in this industry generate
revenue through underwriting of insurance risks and from investing their
assets. As underwriting and capital markets are in general segmented
(catastrophe bonds apart), our empirical approach is based on the insurance and
portfolio behaviour of firms and not on an integrated view of both. Previous
investigations of this kind have focussed on the banking industry. Contrary to
widely held views we find that competition is less than perfect.
COMPETITION BETWEEN EXCHANGES: EURONEXT VERSUS XETRA
Maria
Kasch-Haroutounian, Erik Theissen, University
of Bonn, Germany
Exchanges in Europe face increasing competition. Smaller exchanges may come under pressure to cooperate with one of the larger exchanges and adopt its trading system. It is, therefore, important to evaluate the attractiveness of the two dominating continental European trading systems, Euronext and Xetra. Though both are anonymous electronic limit order books, there are important differences in the trading protocols. In this paper we use a matched-sample approach to compare execution costs in Euronext Paris and Xetra. We find that both the effective spreads and its components, the realized spread and the adverse selection component, are lower in Xetra. Differences in market organization - we consider differences in the number of liquidity provision agreements, and differences in the minimum tick size - do not explain the spread differences.
Karl-Ludwig
Keiber, WHU, Otto Beisheim Graduate School of
Management, Koblenz, Germany
In this paper we analyze how overconfidence affects the principal-agent relationship when both the principal and the agent are assumed to be overconfident with respect to the quality
of a common signal on the future state of nature. We study the impact of that psychological bias on both the compensation contract which the principal offers to the agent and the severity
of the moral hazard problem. Most notably, our analysis indicates that a more pronounced overconfidence bias generally reduces the agency costs but enhances the incentive component of the compensation contract as well as the agent's effort. Therefore we conclude that overconfidence plays a crucial role in the design of incentive compatible compensation contracts. Furthermore, we find that from the principal's perspective overconfidence is advantageous only if favorable information about the future state of nature is available. If poor signals are available the overconfidence bias is detrimental to the principal.
Olaf Korn
In
this paper we extend an analysis by Lo and Wang (1995), who showed that predictability
of asset returns affects derivatives prices through its impact on instantaneous
volatility. We investigate how the whole instantaneous variance-covariance
matrix of two assets returns is affected by typical lead-lag patterns. A close
link between the cross-autocorrelations of finite holding-period returns and
the instantaneous correlation is derived, which implies a strong impact of
lead-lag patterns on correlation dependent derivatives. We provide simple
adjustments for lead-lag effects and apply our results to the valuation of
stock option plans.
CLUSTERING
OF TRADING ACTIVITY IN THE DAX INDEX OPTIONS MARKET
Zdravetz Lazarov, Alexander
K. Koch,University of Bonn, Germany
Trades in DAX index options with identical maturities cluster around
particular classes of strike prices. For example, options with strikes ending
on 50 are less traded than options with strikes ending on 00. Clustering is
higher when options with close strike prices are good substitutes. The degree
of substitution between options with neighboring strikes depends on the strike
price grid and options’ characteristics. Using regression analysis we analyze
the relation between clustering, grid size, and the options’ characteristics.
To our knowledge this paper is the first to explore how the grid size of strike
prices affects options’ trading volume.
Markus Leippold
We offer a framework to analyze Value-at-Risk based regulation rules and their possible distortion effects on financial markets. Our model is formulated in a continuous-time economy where investors maximize expected utility subject to some regulatory Value-at-Risk constraint when asset price dynamics are not lognormal and exhibit stochastic volatility. To retain tractability of the optimization problem, we make use of perturbation theory. We show that in partial equilibrium, the effectiveness of VaR regulation is closely linked to the "leverage effect", the tendency of volatility to increase when prices decline. We extend our analysis to a pure exchange economy and explore the implications of VaR regulation on equilibrium quantities such as interest rates and volatilities. Analysis of the general equilibrium model with heterogenous investors indicates that, when economic growth is slow, VaR regulation tends to reduce the level of interest rates and, at the same time, increases volatilities in stock markets.
Dietmar Leisen, K.L. Judd, McGill University, Montreal, Canada
Open interest in a financial contract describes the total number that
are held long at the close of the exchange and is quoted at the end of each
trading day in addition to daily closing prices and volume. Our paper investigates the risk-sharing rationale for option demand and
the resulting shape of the open interest curve in calls across strikes in an
equilibrium setup. We argue that agent’s preferences over skewness drives
equilibrium demand in options and that the observed shape of the open interest
curve is the result of trade-offs between co-skewness and variance. We explain
that open interest curves are sensitive to the distributional assumptions made
for the underlying security; an analysis of open interest in addition to price
and volume could therefore enrich current empirical studies.
AVOIDING
THE RATING BOUNCE: WHY RATING AGENCIES ARE SLOW TO REACT TO NEW INFORMATION
Gunter Löffler, J.W.-Goethe University, Frankfurt, Germany
Rating agencies state that they take a rating action only when it is
unlikely to be reversed shortly afterwards. Based on a formal representation of
the rating process, I show that such a policy provides a good explanation for
the puzzling empirical evidence: Rating changes occur relatively seldom,
exhibit serial dependence, and lag changes in the issuers’ default risk. In
terms of informational losses, avoiding rating reversals can be more harmful
than monitoring credit quality only twice per year.
Why are Asset Returns Predictable?
Erik Lüders, University of Konstanz; ZEW, Mannheim, Germany
This paper shows that predictability of asset returns may be induced by a pricing kernel with
nonconstant elasticity. Starting from an information process governed by a geometric
Brownian motion we show that asset returns are predictable if the elasticity of the pricing
kernel is not constant. For example, under nonconstant elasticity of the pricing kernel price-earnings
ratios have predictive power for future expected returns. In addition, it is shown that asset prices
will be governed by a time-homogeneous stochastic differential equation only under the constant
elasticity pricing kernel. Hence, usually asset price processes do not satisfy the assumptions
needed for empirical estimation.
In recent years
different techniques to uncover the information on market expectations implicit
in option prices have been developed. This paper proposes an approach to
highlight statistically significant changes in risk-neutral probability density
functions by comparing the distributional characteristics of statistics derived
from risk-neutral densities to those of a benchmark sample. In an application
we extract risk-neutral probability density functions from LIFFE-Euribor
futures options and look for characteristic differences in market expectations
related to meetings of the Governing Council of the ECB.
A
natural solution to the problem of real-time monitoring and management of
structured counterparty exposure limits
Sean Matthews, Financial Markets, IBM, Germany
We describe a logic (based on Boolean algebra)—together with supporting
algorithms and domain specific optimisations—for monitoring and managing counterparty
risk, and in particular, for implementing high speed pre-deal limit checking
(our logic should also be applicable to any similar application where
transactions must be classified in real-time). Our design is general, fast, and
insensitive to scaling. We provide some analysis of complexity, which we relate
to empirical aspects of the problem. We also analyse the problem of how to
implement well behaved reservations. Finally we describe an application to
automatic limit management.
J. Felix Meschke, Arizona State University, USA
This paper examines price and volume reactions to CEO interviews
broadcast on CNBC between 1999 and 2001. Since interviews per se are nonevents,
an analysis of the market response can be viewed as a simple test of the
conjecture that enthusiastic public attention alone may move stock prices away
from fundamentals. I document a significant mean price increase of 1.65 percent
accompanied by higher trading volume on the day of the interview. Prices exhibit
strong mean reversion of minus 2.78 percent during the 10 trading days
following the interview. These price dynamics suggest that the financial news
media is able to generate transitory buying pressure by catching the attention
of enthusiastic investors.
Der Vertrieb
von Versicherungsprodukten erfolgt in Deutschland größtenteils durch
persönliche Akquisition. Die Schlüsselrolle spielt der Versicherungsvermittler,
der das Bindeglied zwischen Versicherungsunternehmen und Versicherungsnehmer
darstellt. Als Vergütungsmodell für Vertreter dominiert in Deutschland die
umsatzproportionale Abschlussprovision, die sich aufgrund der von ihr
ausgehenden Steuerungswirkung (im Bezug auf eine Umsatzmaximierung seitens des
Absatzorgans ohne Berücksichtigung der Qualität der akquirierten Risiken) als
problematisch erweist, da der Agent hier nicht im Sinne Versicherungsunternehmens
handelt, dessen Ziel eine langfristige Gewinnmaximierung ist. Ein reformiertes
Vergütungssystem, als zentrales Instrument des Versicherungsunternehmens, zur
Steuerung der Agenten, sollte direkt mit dem Unternehmensziel
„Gewinnmaximierung“ verknüpft sein. Da der Agent die „Qualität“ des Abschlusses
rudimentär einschätzen kann, muss es im Interesse des Versicherungsunternehmens
sein, dass er diese Information bei der Akquise adäquat berücksichtigt. Hieraus
folgt, dass der Agent am Geschäftsergebnis beteiligt werden sollte – auf Basis
der Erfahrungswerte der Vergangenheit. Für eine sekundäre
Prämiendifferenzierung haben sich seit langem Verfahren der Credibility-Theorie
bewährt, die eine Abstufung der Prämie nach dem individuellen und kollektiven
Schadendaten der Vergangenheit vornehmen. Die Übertragung dieses Ansatzes auf
die Vergütung des Außendienstes und deren Auswirkungen auf die
Einkommensentwicklung unterschiedlicher Agenten (in Abhängigkeit der
Akquisitionsqualität) und die Bestandszusammensetzung des
Versicherungsunternehmens (im Hinblick auf die Versicherungsnehmer) werden
modelliert und untersucht. Ferner werden Auswirkungen auf den
Versicherungsmarkt diskutiert.
Elisabeth Müller, London School of Economics, UK
This paper studies the influence of benefits of control on capital
structure and growth of private companies. It is argued that companies in which
existing owners would lose more control if they expanded, use more debt and
grow more slowly. The dataset covers 5601 private UK companies with limited
liability for up to 5 years. Loss of control is measured as the difference in
the probability of winning a vote for the largest owner before and after a
hypothetical equity increase. Consistent with benefits of control, we find that
companies with high potential loss of control do indeed use more debt, issue
less new equity and grow more slowly.
Alexander
Mürmann, University of Pennsylvania, USA
A market is
presented in which actuarial risk is traded through both insurance and
financial contracts. The coexistence of these contracts leads to a new price
selection criterion. Financial prices have to be actuarially consistent with
insurance premiums to exclude arbitrage opportunities in the market. Even
though this additional restriction on price dynamics does not imply unique
price determination, a representation of actuarially consistent prices is
deduced. In this representation, the underlying stochastic structure is
separated from the contract’s specifications and a link is established between
financial prices and insurance premiums. This connection is examined in more
detail for commonly used premium calculation principles.
Some real-world insurance products contain a minimum wealth or a income
stream guarantee, both of which have to be met irrespective of capital market
conditions. Therefore, the seller of such products will have to choose that
portfolio strategy that performs best in a reasonable worst case capital market
scenario, as the literature under model uncertainty (in particular
Anderson/Hansen/Sargent (2000)) suggests, if he wants to avoid additional cash
payments. This paper shows that this solution to the portfolio problem
crucially hinges on the assumption that model uncertainty is taken into account
by adding an explicit preference for models’ similarity to the objective function
of the decision problem, a so-called preference for robustness. If there are
strictly to meet minimum investment goals instead, as in the case of the
real-world insurance products cited above, the Anderson/Hansen/Sargent (2000)
solution will not exist in general. Then, only one trivial portfolio strategy
is able to defend minimum investment goals, namely invest in the riskless asset
the amount guaranteed discounted at the riskfree rate.
Andreas Oehler, Klaus Heilmann, Volker Läger, Michael Oberländer, University of Bamberg,
Germany
Prior research documents that many investors disproportionately hold on
losing stocks while selling stocks which have gained value. These systematic
behavior is labeled the “disposition
effect”. The phenomenon can be explained by prospect theory’s idea that
subjects value gains and losses relative to a reference point like the purchase
price, and that they are risk-seeking in the domain of possible losses and risk-averse
when a certain gain is obtainable. Our experiments were designed to test
whether individual-level disposition effects attenuate or survive in a dynamic
market setting. We analyze a series of 36 stock markets with 490 subjects. The
majority of our investors demonstrate a strong preference for realizing winners
(paper gains) rather than losers (paper losses). We adopt different reference
points and compare the behavioral patterns across three main trading
mechanisms, i.e. rules of price formation. The disposition effect is greatly
reduced only within high pressure mechanisms like a dealer market when the last
price is assumed as a reference point which is a more market driven (external)
benchmark. If disposition investors
use the purchase price as a reference point which is a more mental-accounting
driven (internal) benchmark they are dying hard in all market settings.
Distance, Lending Relationships, and Competition
Steven Ongena, Hans Degryse, Tilburg University, Netherlands
A recent string of theoretical papers highlights the importance of geographical
distance in explaining pricing and availability of loans to small firms. Lenders located in
the vicinity of small firms have significantly lower monitoring and transaction costs, and
hence considerable market power if competing financiers are located relatively far. We
directly study the effect on loan conditions of the geographical distance between firms,
the lending bank, and all other banks in the vicinity. For our study, we employ detailed
contract information from more than 15,000 bank loans to small firms and control for
relevant relationship, loan contract, bank branch, firm, and regional characteristics. We
report the first comprehensive evidence on the occurrence of spatial price discrimination
in bank lending. Loan rates decrease in the distance between the firm and the lending
bank and increase similarly in the distance between the firm and competing banks.
Both effects are statistically significant and economically relevant, are robust to changes
in model specifications and variable definitions, and are seemingly not driven by the
modest changes over time in lending technology we infer.
Heiko Opfer, Wolfgang Bessler, Justus-Liebig University, Giessen, Germany
In dieser Studie werden die Renditen von Bankaktien auf dem deutschen
Kapitalmarkt mit Mehrfaktorenmodellen untersucht. Dazu wird ein dynamischer
Ansatz verwendet, der geeignet ist, die zeitliche Entwicklung der Koeffizienten
des Modells zu erfassen. Zusätzlich wird eine Varianzzerlegung der Renditen
durchgeführt, um den Einfluss der einzelnen Faktoren auf die Renditen
differenziert darzustellen. Die Daten bestehen aus den monatlichen Renditen von
sieben marktwertgewichteten Branchenindices für den Zeitraum von 1975 bis 1997
sowie aus verschiedenen makroökonomischen Zeitreihen. Im Rahmen der
Untersuchung finden sich deutliche Hinweise auf eine Zeitvariabilität der
Betakoeffizienten des Mehrfaktorenmodells sowie auf eine erhöhte
Zinssensitivität des Bankindices im Vergleich mit den übrigen Indices.
Patrick
F. Panther, Gunther Löffler, Erik Theissen, J.W.-Goethe University,
Frankfurt, Germany
To resolve the IPO underpricing
puzzle it is essential to analyze who knows what when during the issuing
process. In Germany, broker-dealers make a market in IPOs during the
subscription period. We examine these pre-issue prices and find that they are
highly informative. They are closer to the first price that is subsequently
established on the exchange than either the midpoint of the bookbuilding range
or the offer price. We further document that pre-issue prices are unbiased
estimates of the subsequent first exchange price. They explain a large part of
the underpricing that cannot be explained by other variables. The results imply
that information asymmetries are much lower than the observed variance of
underpricing suggests, a finding that is relevant for judging the validity of
underpricing theories.
Are bank deposits
and bank-affiliated managed funds close substitutes?
Jerry T. Parwada, D.E. Allen, Securities Industry Research Centre of Asia Pacific, Sydney,
Australia
This study
tests the hypothesis that bank liabilities and managed funds are close
substitutes. Some literature associates the alleged decline in banking business
with the disintermediation of banks’ traditional deposit-taking business in
favour of investment management. A comparative assessment of managed fund and
bank deposit qualitative attributes fails to support substitutability. Using
data on Australian bankaffiliated funds and a nine-year record of bank
liability balances, this study finds that, empirically, managed funds do not
displace bank liabilities. Prudential capital adequacy requirements dissuade
banks from using in-house managed investments as indirect conduits for raising
funds in the same manner as deposit-taking.
Maria
F. Penas, H. Unal, Vrije Universiteit, Amsterdam, Netherlands
This paper presents evidence that
merging banks’ bond adjusted returns are positive and significant in premerger
and announcement months. Also, the acquiring banks’ credit spreads on new debt
issues are lower after the merger. Diversification and incremental size
attained in the merger are significant determinants of the bond returns and the
decline in credit spreads, after controlling for leverage and asset quality
changes. Size effects are only significant for medium-size banks.
Financial theory, both traditional and the most
recent, consider investments, almost exclusively, as single assets, whose value
depends only on their intrinsic characteristics. However, not rarely, these assets
are interrelated with the existent assets of the firm that evaluates and
(eventually) implements them which, in turn, means that the value of these
assets is also contingent on the established interrelationships. So, it is
important to consider these effects (usually denominated synergies) in the
valuation process. These same effects also exist in projects of parallel and
sequential development, independently of the interdependence relationships.
Since the traditional valuation methods (like the NPV), as it is well known and
documented, present several limitations and the Real Options (RO) models are,
in principle, more suitable to value, in particular, these types of investment
opportunities, in this paper we discuss and apply an appropriate RO model (the
Generic Valuation Model developed by Childs, Ott and Triantis (1998)) in the
evaluation of Portuguese firm Semapa, after Cimpor’s acquisition and try to
determine the shareholders’ wealth increment, given the Acquisition Public
Offer terms and the assumed interrelationships. From the results obtained, it seems that we can
conclude that the value of Semapa, after the acquisition, as well as the
shareholders’ wealth increment, are considerably superior to those obtained by
the traditional valuation methods. This seems to mean that the RO model used
would allow the managers of Semapa to perceive the real value of the investment
opportunity, which is very important for the success of the operation, since it
would condition the offer price.
Modern
frontier efficiency analysis has been widely utilized in bench marking banks,
insurers, and other financial services firms. Cost, revenue, and profit
efficiencies are estimated by measuring the performance of firms relative to
efficient frontiers consisting of the “best practice” firms in an industry.
Despite widespread interest in this type of research, nearly all extant
efficiency studies of the financial services industry are based on accounting
data, and there have been few attempts to measure the linkage between book
value efficiency and market value performance. The objective of this paper is
to determine whether book value efficiency translates into superior
market-value performance for publicly traded insurance companies. The topic is
important because book value efficiency analysis is often the best way to trace
the sources of inefficiency at a detailed level within the firm.
BANKING
REGULATION AND NETWORK-TOPOLOGY DEPENDENCE OF ITERATIVE RISK-TRADING GAMES
Stefan Pichler, Rudolf Hanel, Stefan Thurner, Vienna University of Technology, Austria
In the context
of understanding risk-regulatory behavior of financial institutions we propose
a general dynamical game between several agents who pick their trading
strategies depending on their individual risk-to-wealth ratio. The game is
studied numerically for different network topologies. Consequences of topology
are shown for the wealth time-series of agents, for the safety and efficiency
of various types of networks. The model yields realistic-looking time-series of
wealth and the cost of safety increases as a power-like function. The relevant
model parameters should be controllable in reality. This setup allows a
stringent analysis of the effects of different approaches of banking regulation
as currently suggested by the Basel Committee of Banking Supervision. We find
evidence that a tightening of the current regulatory framework does not
necessarily lead to an improvement of the safety of the banking system.
Moreover, the potential impact of catastrophic events like September 11, 2001,
on the financial system can be measured within this framework.
Stefan Pichler, Rainer Jankowitsch, H. Mösenbacher, Vienna University of Technology, Austria
It is the aim
of this paper to measure the impact of liquidity on European Monetary Union
(EMU) government bond prices. Although there is a growing theoretical and
empirical literature on liquidity effects in fixed income markets there is no
clear answer how to measure liquidity and whether liquidity is priced in the
market at all. Our empirical analysis is based on an unique data set containing
individual bond data from six major EMU government bond markets allowing us to
compare yield curves estimated for subportfolios which are formed with respect
to different potential liquidity measures. In a second procedure liquidity
measures are collected on the single bond level and estimated pricing errors
given some reference yield curve are regressed against these liquidity
variables. This enables us to conduct formal tests on the pricing impact of
liquidity measures. The results indicate that the benchmark property and the
number of contributors are the most promising liquidity proxies which have
significant results in most countries. The results do not support the
hypothesis that other liquidity measures under consideration like the
on-the-run property, the issue size, and bid-ask spread related measures have a
persistent price impact. A cross-country analysis on the subportfolio level
indicates that liquidity effects cannot explain the size of the yield spreads
between different issuers. This implies that other effects than liquidity like
credit risk are important driving factors of cross-country yield spreads.
PORTFOLIO
CONSTRUCTION BY VOLATILITY FORECASTS: DOES THE COVARIANCE STRUCTURE MATTER?
Momtchil
Pojarliev,Wolfgang Polasek, INVESCO Asset Management,
Frankfurt, Germany
This paper explores the performance of a global minimum variance (GMV) portfolio in dependence of the structure of the covariance matrix and the type of volatility model. Different information sets of time series are used to predict the future covariance matrix. We investigate diagonal portfolio strategies based on univariate and multivariate GARCH models for a portfolio consisting of the North America, Europe and the Pacific region. The evaluation is based on a daily out-of-sample comparison from 25th May 1998 until 3rd April 2000. We find that variance forecasts are more important than covariance forecasts and that multivariate volatility models yield better results than univariate volatility models.
Sachi
Purcal, University of New South Wales, Sydney, Australia
Using an optimising model in the tradition of Merton (1969, 1971), calibrated to stylised Japanese data, we explore the question of how individuals should determine their optimal consumption, portfolio selection, life insurance, and annuity choices, given uncertainly about investment returns and mortality. The model explicitly recognises the existence of social security in retirement, and of loadings on insurance premiums. It allows popular financial advice and to be quantitatively assessed. The model provides a vehicle for assessing the impact of social security in terms of its effect on private optimisation decisions. It sheds light on the reasons for the thinness of voluntary life annuity markets worldwide.
Following a decade of above-market
performance, retail banks are feeling the fallout from strategies that, while fueling growth, failed to leverage the
rich potential of these institutions' customer-facing channels fertile ground for growing and sustaining profitable,
long-term relationships. By shifting their focus back to the customer, banks can set of a new wave of value
creation.
CREDIT
PORTFOLIO MODELLING, MARGINAL RISK CONTRIBUTIONS, AND GRANULARITY ADJUSTMENT
Hans
Rau-Bredow, University of Würzburg, Germany
This paper first provides a simple but very general framework for credit portfolio modelling which is based on the distinction between systematic and unsystematic risk. Unsystematic or borrower-specific risk vanishes through diversification in a very large, infinitely fine-grained portfolio. The framework contains typical models like CreditRisk+ and CreditMetrics as special cases. An analysis of marginal risk contributions is then done which also includes a theoretical formula for the granularity adjustment in a "lumpy" credit portfolio.
EVALUATING
RISK MODELS WITH LIKELIHOOD RATIO TESTS: USE WITH CARE!
Burkhard Raunig,Gabriela de Raaij, Central Bank of Austria, Austria
Most modern approaches to measure and control the risks of financial portfolios are either directly or indirectly based on density forecasts. Tools to evaluate the quality of such forecasts are therefore essential. In this paper we examine a recently proposed methodology to evaluate density forecasts from risk models that builds on likelihood ratio tests. We discuss three cases that are highly relevant in risk management where likelihood ratio tests fail to detect incorrect density forecasts. We illustrate this fact with Monte Carlo simulations and empirical examples. We also demonstrate that the likelihood ratio testing framework in conjunction with additional diagnostic tests is an attractive tool to evaluate risk models.
Catastrophe
Risk Management – Implications of Default Risk and Basis Risk
Andreas Richter, University of Hamburg, Germany
A major problem for insuring catastrophic risk is that, as a disaster
causes damages to many insureds at the same time, such insurance and in particular
reinsurance contracts are often subject to considerable default risk. On the
other hand, the securitization of insurance risk, for example via a catastrophe
bond, can be designed to completely avoid default risk. In many cases, however,
the payout from an insurance-linked security is tied to some stochastic
variable, an index, which is correlated, but not identical, with the insured’s
actual losses. Therefore, such an instrument will usually not provide a perfect
hedge. There will be some mismatch, the so-called basis risk. This paper
investigates how the trade off between default respectively credit risk and
basis risk affects optimal risk management solutions, when (re)insurance and
risk securitization are used simultaneously. In particular, the impact of
credit risk and risk securitization on the optimal reinsurance contract is
analysed.
THE
FAIR PREMIUM OF AN EQUITY LINKED LIFE AND PENSION INSURANCE
Klaus Sandmann,J. Aase Nielsen, Johannes-Gutenberg University, Mainz, Germany
An equity linked life and pension insurance consists of an non-linear combination of a life and pension insurance with an investment strategy. In addition to the guaranteed payments the insured receives a bonus depending on the value of an investment strategy. The additional payment is similar to an Asian typ option. Since the insurance contract combines mortality and financial risks in a non-linear way, the value or premium of the contract must reflect these uncertainties. The paper shows the existence of a fair periodic premium defined so that the expected discounted premium is equal to the expected discounted payments. For two different pension policies an approximation of the fair periodic premium is derived, which implies the approximation of long term Asian typ options.
VALUATION
OF BOND ILLIQUIDITY: AN OPTION-THEORETICAL APPROACH
Peter Sauerbier, Christian Koziol, University of Mannheim, Germany
In this paper, we present an easy-to-apply option-theoretical approach
to quantifying liquidity spreads of bonds. We model illiquidity in the spirit
of Longstaff (1995) who describes the value of liquidity as that of an exotic
option. We extend this model in two directions: First, we introduce interest
rate uncertainty of the extended Vasicek type to model the dynamics of zero
bonds. Second, we allow for an arbitrary distribution of trading dates rather
than one single non-trading period. This results in liquidity spreads arising
from the values of both continuously and discretely monitored lookback options
written on a zero bond. The liquidity spreads show several meaningful and
plausible properties; they are humped-shaped functions of the maturity and
increase with the interest rate volatility. Furthermore, the liquidity spreads
are not only influenced by the number of possible trading dates, but also
by their distribution over time. In contrast to the total value of illiquid
zero bonds, the theoretical liquidity spreads are independent of the short
rate level. When we regard German Jumbo Pfandbrief market data, we find several
parallels between the theoretical liquidity spreads and the empirically observed
ones. The main challenge for a practical implementation of our model is the
determination of the possible trading dates for illiquid bonds. Nevertheless,
we can provide some evidence for the empirical relevance of our model.
MULTIPLICATIVE
BACKGROUND RISK
Harris Schlesinger, Günter Franke, R.C. Stapleton, University of Alabama, USA
We consider random wealth of the multiplicative
form xy, where x and y are statistically
independent random variables. We assume that x is endogenous to the economic agent, but that y is an exogenous and uninsurable
background risk. Our main focus is on how the randomness of y affects risk-taking behavior for decisions on the choice of x. We characterize conditions on
preferences that lead to more cautious behavior. We also develop the concept of
the affiliated utility function, which we define as the composition of the
underlying utility function and the exponential function. This allows us to
adapt several results for additive background risk to the multiplicative case.
In this paper we present a new approach to incorporate dynamic default
dependency in intensity-based default risk models. The model uses an arbitrary
default dependency structure which is specified by the Copula of the times of
default, this is combined with individual intensity-based models for the
defaults of the obligors without loss of the calibration of the individual
default-intensity models. The dynamics of the survival probabilities and credit
spreads of individual obligors are derived and it is shown that in situations
with positive dependence, the default of one obligor causes the credit spreads
of the other obligors to jump upwards, as it is experienced empirically in
situations with credit contagion. For the Clayton copula these jumps are
proportional to the pre-default intensity. If information about other obligors is
excluded, the model reduces to a standard intensity model for a single obligor,
thus greatly facilitating its calibration. To illustrate the results they are
also presented for Archimedean copulae in general, and Gumbel and Clayton
copulae in particular. Furthermore it is shown how the default correlation can
be calibrated to a Gaussian dependency structure of CreditMetrics-type.
Globalisation and structural change have lead to an increasing importance of value based management in insurance groups. Value based management understands the competitive and efficient use of resources regarding risk and return. By knowing this, management has to consider equity as the bottleneck area. In insurance groups, equity holds a dual function: first, it serves as a quality measure for the group’s ability to fulfil its contractual obligations; second it is the major criterion for investor to assess the profitability of their investment. Starting point is the identification of risk adjusted equity capitalization over all divisions, subsidiaries and regions. The basic idea is that divisions with high risk exposures originate more equity requirements than divisions with less risk exposures. Due to diversification, the group’s equity requirement group should be smaller than the sum of equity required by isolated divisions or subsidiaries. In order to determine the capitalization of the entire group, several models can be applied. Traditional procedures from actuarial science compete with approaches of established rating agencies, such as Standard & Poor’s. But even models of insurance supervision will be observed, especially of the National Association of Insurance Commissioners (NAIC). Using the determined group-wide capital as a starting point, allocating capital to the group’s units serves as a tool for managing the whole corporation’s value. Equity has to be allocated to those divisions, which are expected to obtain the highest profit related to its risk exposure. However, equity allocation can rather be considered the result of a formal optimisation problem than the starting point. Implementation of capital allocation can be seen as a fairly dynamic process. Finally, capital allocation supports performance measurement in the group’s divisions or subsidiaries. The major obstacle in capital allocation is to transfer the non-linear diversification effect into individually adequate amounts of capital for each unit. In our project a model is shown, which uncovers highly different allocation results forced by popular approaches based on risk and game theory. That contradicts the requirement of unity of task, competence and responsibility of division leaders. Thus, the project closes with an alternative approach to manage the apparent contradiction of capital allocation and responsibility.
Andreas Schüler, University of Regensburg, Germany
In this paper the performance of a sample of German companies is
measured by comparing the initially invested capital adjusted for cost of
capital, dividends paid, share repurchases and equity raised with the market
value at the end of the holding period. All possible holding periods between
1987 and 2000 are covered. The sample is subdivided into companies listed in
the DAX-, MDAX- and SMAX-index. Performance is measured based upon the actual
capital structure (levered performance) and also after assuming the company is
financed by equity entirely (unlevered performance). It can be shown that tax
shields on debt and provisions contribute considerably to levered performance.
This applies especially to the subsample of DAX companies. These tax effects
turn value decreasing holding periods into value increasing holding periods for
a number of cases. If the tax disadvantage on bond income as in Miller (1977)
is considered, tax effects of debt financing are close to zero or are even
negative depending upon the level of tax free capital gains assumed. Tax
shields on provisions exceed tax shields on debt quite regularly.
IMPLICATIONS
OF A FIRM’S MARKET WEIGHT IN A CAPM FRAMEWORK
Steve Swidler, Martin Lally, Auburn Universitiy, USA
This paper derives the relationship between a stock's beta and its
weighting in the portfolio against which its beta is calculated. Contrary to
intuition the effect of this market weight is in general very substantial. We
then suggest an alternative to the conventional measure of abnormal return,
which requires an estimate of a firm’s beta when its market weight is zero. We
argue that the alternative measure is superior, and show that it can differ
substantially from the conventional measure when a firm has non-trivial market
weight. The difference in abnormal returns may be disaggregated into a “market
return effect” and a “beta effect”.
DIE
VIERTE DIMENSION – DER MARKET IMPACT ALS KONZEPT ZUR ERFASSUNG DER ERNEUERUNGSKRAFT
IM ELEKTRONISCHEN WERTPAPIERHANDEL
Erik
Theissen, Peter Gomber, Uwe Schweickert, University of
Bonn, Germany
Liquidität ist
das zentrale Kriterium zur Beurteilung der Marktqualität im elektronischen
Wertpapierhandel. Trotzdem existiert kein einheitliches Verständnis des
Liquiditätsbegriffes oder seiner operationalen Umsetzung in der empirischen
Analyse der Wertpapiermärkte. Vor diesem Hintergrund wurde das Xetra Liquiditätsmaß
eingeführt (Gomber/ Schweickert 2002). Es basiert auf dem Konzept des
implementation shortfall und integriert über die Messung des Market Impact die
Marktliquidität in einer Kennzahl. Das Xetra Liquiditätsmaß deckt unmittelbar
drei der vier Dimensionen des Liquiditätsbegriffes ab - Marktbreite, Markttiefe
und Sofortigkeit. Die Einbeziehung der Vierten Dimension der Liquidität, der
Erneuerungskraft des Marktes, bietet neue Erkenntnisse bezüglich dieser
Dimension - sowohl konzeptionell als auch in der empirischen Auswertung.
Bisherige Analyseansätze haben die vierte Dimension oft auf der Basis eines
Preisgleichgewichtes behandelt. Dabei stellt sich jedoch das Problem der
Separierung von temporären und permanenten Preiseffekten. Der hier vorgestellte
Ansatz nutzt den Market Impact als Konzept zur Erfassung der Erneuerungskraft.
Dazu wird das Liquidity Based Resiliency Measure eingeführt und angewendet. Die
"Vierte Dimension" der Liquidität wird auf der Basis einer
gleichgewichtigen Liquiditätsanalyse vor und nach dem Eintreten
marktbeeinflussender Ereignisse erfasst. Im Gegensatz zu traditionellen
Methoden der Messung der Erneuerungskraft ist das Liquidity Based Resiliency
Measure von Veränderungen des Preisniveaus unabhängig und eröffnet damit eine neue
Sichtweise auf die Erneuerungskraft in Wertpapiermärkten. Der vorliegende
Beitrag beschreibt das Liquidity Based Resiliency Measure und wendet es im
Rahmen einer beispielhaften empirischen Analyse auf eine Stichprobe
verschiedener auf Xetra handelbarer Wertpapiere an.
Mean-Variance
Hedging under Additional Market Information
Frank Thierbach, University of Bonn, Germany
In this paper we analyze the mean-variance hedging approach in an
incomplete market under the assumption of additional market information, which
is represented by a given, finite set of observed prices of non-attainable
contingent claims. Due to no-arbitrage arguments, our set of investment
opportunities increases and the set of possible equivalent martingale measures
shrinks. Therefore, we obtain a modified mean-variance hedging problem, which
takes into account the observed additional market information. Solving this we
obtain an explicit description of the optimal hedging strategy and an
admissible, constrained variance-optimal signed martingale measure, that
generates both the approximation price and the observed option prices.
VALUATION WITH
RISK-NEUTRAL PROBABILITIES: ATTEMPTS TO QUANTIFY Q
Christian Timmreck, Frank Richter, University of Witten/Herdecke, Germany
An important and complex question in corporate finance is how to value
uncertain cash-flow streams. Common practice is to discount expected cash flows
with a constant risk-adjusted discount rate. The risk-adjusted discount rate
approach is the basis for discounted cash flow approaches applied in practice
for capital budgeting purposes or for the valuation of companies. The capital
asset pricing model is usually used to determine the discount rate. This model
has, however, theoretical and empirical shortcomings, as, for example, the
expected rate of return of the market portfolio and thereby the expected market
risk premium is not observable. An alternative approach is applied in the field
of option pricing theory: The risk neutral valuation approach does not require
an assumption on the risk premium. Instead, the analyst needs to quantify the
risk-neutral probability. The aim of this paper is to show the relation between
the two approaches and to find estimates for the risk-neutral probability by
using logical arguments and empirical data of the 30 German DAX companies. We
illustrate the risk-neutral valuation approach on the basis of an example that
we developed from publicly available valuation documentation of a recent merger
in Germany.
Tereza
Tykvova, Centre for European Economic Research (ZEW),
Mannheim, Germany
We analyze the venture capitalist’s decision on the timing of the IPO,
the offer price and the fraction of shares he sells in the course of the IPO. A
venture capitalist may decide to take a company public or to liquidate it after
one or two financing periods. A longer venture capitalist’s participation in a
firm (later IPO) may increase its value while also increasing costs for the
venture capitalist. Due to his active involvement, the venture capitalist knows
the type of firm and the kind of project he finances before potential new
investors do. This information asymmetry is resolved at the end of the second
period. Under certain assumptions about the parameters and the structure of the
model, we obtain a single equilibrium in which high-quality firms separate from
low-quality firms. The latter are liquidated after the first period, while the
former go public either after having been financed by the venture capitalist
for two periods or after one financing period using a lock-up. Whether a
strategy of one or two financing periods is chosen depends on the kind of
project (simple vs. complex). In the separating equilibrium, the offer price
corresponds to the true value of the firm.
Paolo Vanini, Silvan Ebnöther, Alexander McNeil, Pierre Antolinez-Fehr, Zürcher Kantonalbank,
Switzerland
The Basel Committee on Banking Supervision (”the Committee”) released a
consultative document that included a regulatory capital charge for operational
risk. The complexity of the object ”operational risk” led from the time of the
document’s release to vigorous and recurring discussions. We show that for a
production unit of a bank with well-defined workflow processes where a
comprehensive self-assessment based on six risk factors has been carried out,
operational risk can be unambiguously defined and modelled. Using techniques
from extreme value theory, we calculate risk measures for independent and
dependent risk factors, respectively. The results of this modelling exercise
are relevant for the implementation of a risk management framework: Frequency
dependence among the risk factors only slightly changes the independency
results, severity dependence on the contrary changes the independency results
significantly, the risk factor ”fraud” dominates all other factors and finally,
only 10 percent of all processes have a 98 percent contribution to the
resulting VaR. Since the definition and maintenance of processes is very
costly, this last results is of major practical relevance. Performing a
sensitivity analysis, it turns out that the key 10% of relevant processes is
rather robust under this stress testing.
Estimation of the tail index of
stationary, fat-tailed return distributions is non-trivial since the well-known
Hill estimator is optimal only under iid draws from an exact Pareto model. We
provide a small sample simulation study of recently suggested adaptive
estimators under ARCH-type dependence. The Hill estimator’s performance is
found to be dominated by a ratio estimator. Dependence increases estimation
error which can remain substantial even larger data sets. As small sample bias
is related to the magnitude of the tail index, recent standard applications may
have overestimated (underestimated) the risk of assets with low (high) degrees
of fat-tailedness.
Wolf
Wagner, Tilburg University, Netherlands
This paper develops a theory of the life
cycle of the firm based on incentive constraints. The optimal sale of the firm
is restricted by entrepreneurial moral hazard and a lack of commitment
regarding future divestment. This leads to a dynamic inefficiency that causes
the entrepreneur to delay and to stagger the sale of the firm. The analysis
provides a common explanation for a range of empirical phenomena related to
initial public offerings (IPO’s), such as the waiting time until firms go
public, lock-up periods, operating underperformance of IPO’s and post-IPO
divestment. The equilibrium divestment process is shown to be (constrained)
inefficient: entrepreneurs sell too late and too much of the firm.
Recommendations for financial regulation that restore efficiency are derived.
Laurent
Weill, Université Robert Schuman, Strasbourg, France
This paper aims to provide new empirical
evidence on a major corporate governance issue: the relationship between
leverage and corporate performance. We bring two major improvements to this
literature by applying frontier efficiency techniques to obtain performance
measures for companies from several countries (France, Germany and Italy). We
then proceed to regressions of corporate performance on a various set of
variables including leverage. We found mixed evidence depending on the country:
while significantly negative in Italy, the relationship between leverage and
corporate performance is significantly positive in France and Germany. This
tends to support the influence of some institutional characteristics on this
link.
EVALUATION
OF THE NEW BASEL CAPITAL ACCORD: IS IT A REMEDY REALLY OR A TRANQUILIZER ONLY?
Levent Yildiran, University of Toulouse, France
The paper questions if bank capital regulations in general and the new
Basel Capital Accord in particular can enhance market discipline and/or induce
banks to act in the society’s interests.
OPTIONS
PRICING ON PENSION INSURANCE
Rami Yosef, Uri Benzion, Ben-Gurion University of the Negev, Israel
We present a new concept regarding options
on pensions annuity, which enables the holders to buy their pension annuity
benefit for strike price at the age of retirement or at an earlier date, prior
to retirement. We present the model and calculate the pricing for particular
cases, using an extended multiperiod model to evaluate the option and compare
it to traditional pension contracts. We use methods from actuarial mathematics
and the mathematics of finance.