Knowledge that Transforms

This article considers the pricing and hedging of inflation-indexed swaps, and the pricing of inflation-indexed swaptions, and options on inflation-indexed bonds. To price the inflation-indexed swaps, we suggest an extended HJM model. The model allows both the forward rates and the consumer price index to be driven, not only by a standard multidimensional Wiener process but also by a general marked point process. Our model is an extension of the HJM approach proposed by Jarrow and Yildirim [Jarrow, R., Yildirim, Y., 2003. Pricing treasury inflation protected securities and related derivatives using an HJM model. Journal of Financial and Quantitative Analysis 38, 409–430] and later also used by Mercurio [Mercurio, F., 2005. Pricing inflation-indexed derivatives. Quantitative Finance 5 (3), 289–302] to price inflation-indexed swaps. Furthermore we price options on so called TIPS-bonds assuming the model is purely Wiener driven. We then introduce an inflation swap market model to price inflation-indexed swaptions. All prices derived have explicit closed-form solutions. Furthermore, we formally prove the validity of the so called foreign-currency analogy.

In this paper we consider two different mixed integer linear programming models for solving the single period portfolio selection problem when integer stock units, transaction costs and a cardinality constraint are taken into account. The first model has been formulated by using the maximization of the worst conditional expectation as objective function. The second model is based on the maximization of the safety measure corresponding to the mean absolute deviation. Extensive computational results are provided to compare the financial characteristics of the optimal portfolios selected by the two models on real data from European stock exchange markets. Some simple heuristics are also introduced that provide efficient and effective solutions when an optimal integer solution cannot be found in a reasonable amount of time.

This paper investigates the valuation and hedging of spread options on two commodity prices which in the long run are in dynamic equilibrium (i.e., cointegrated). The spread exhibits properties different from its two underlying commodity prices and should therefore be modelled directly. This approach offers significant advantages relative to the traditional two price methods since the correlation between two asset returns is notoriously hard to model. In this paper, we propose a two factor model for the spot spread and develop pricing and hedging formulae for options on spot and futures spreads. Two examples of spreads in energy markets – the crack spread between heating oil and WTI crude oil and the location spread between Brent blend and WTI crude oil – are analyzed to illustrate the results.

This paper provides an in-depth analysis of the use of foreign currencies in the lending activities of banks in transition economies. The impact of bank and firm variables on credit dollarization is studied in an optimal portfolio allocation model and estimated using new aggregate data for 21 transition economies for the period 1990–2003. Empirical results provide evidence that credit dollarization is the combined outcome of domestic deposit dollarization and banks’ desire for currency-matched portfolios beyond regulatory requirements. The effects of international financial factors and natural hedges are less robust across alternative specifications. The paper further discusses the role of regulations in affecting the impact of these factors on credit dollarization and calls for more developed domestic forward foreign exchange markets.

This paper examines the effects of the recent spate of financial exchange mutual-to-stock conversion phenomenon on the performance of listed exchanges and the quality of the stock market using the Australian Stock Exchange (ASX) as a case study. We find that the ASX stock significantly outperformed the stock index and the control group on a market-adjusted return basis. The stock market performance is driven by strong operating performance. The profitability ratios of the ASX have significantly improved in the five years following the demutualization and self-listing. The performance improvements remain significant even after controlling for growth in the Australian economy. From a market quality perspective, we document evidence of increased trading activity by foreign investors after ASX’s demutualization and self-listing. Interestingly, we also find that bid-ask spreads of the stock market have narrowed in the post-conversion period. In particular, small-cap firms have become more liquid. The results show that stock exchange conversion from mutual to publicly traded exchange is not only value enhancing for the exchange and its shareholders, but it is also beneficial for the stock market as a whole.

Extending previous work on asset-based style factor models, this paper proposes a model that allows for the presence of structural breaks in hedge fund return series. We consider a Bayesian approach to detecting structural breaks occurring at unknown times and identifying relevant risk factors to explain the monthly return variation. Exact and efficient Bayesian inference for the unknown number and positions of the breaks is performed by using filtering recursions similar to those of the forward–backward algorithm. Existing methods of testing for structural breaks are also used for comparison. We investigate the presence of structural breaks in several hedge fund indices; our results are consistent with market events and episodes that caused substantial volatility in hedge fund returns during the last decade.

The factors determining foreign bank efficiency are investigated using a three stage research method. It is found that host market incumbency reduces efficiency of foreign banks in Australia, resulting in over use of inputs. Factors underlying the limited global advantage hypothesis of Berger et al. [Berger, Allen N., DeYoung, Robert, Genay, Hesna, Udell, Gregory F., 2000. Globalisation of financial institutions: Evidence from cross-border banking performance. Brookings-Wharton Papers on Financial Service 3, 23–120] are identified, in that nationality specific factors represented by dummy variables are not significant once other relevant effects are controlled for. Parent profitability is not found to result in increased host nation efficiency, while parent credit rating effects are mixed. Some evidence is presented that banks from more financially sophisticated nations are more efficient. The implications of these results are explored from the perspectives of bank management and bank regulators.

This paper uses survival analysis to investigate the timing of a firm’s decision to issue for the first time in the public bond market. We find that firms that are more creditworthy and have higher demand for external funds issue their first public bond earlier. We also find that issuing private bonds or taking out syndicated loans is associated with a faster entry to the public bond market. According to our results, the relationships that firms develop with investment banks in connection with their private bond issues and syndicated loans further speed up their entry to the public bond market. Finally, we find that a firm’s reputation has a “U-shaped” effect on the timing of a firm’s bond IPO. Consistent with Diamond’s reputational theory, firms that establish a track record of high creditworthiness as well as those that establish a track record of low creditworthiness enter the public bond market earlier than firms with intermediate reputation.