Knowledge that Transforms

The pricing of derivative securities in the presence of market frictions has always been a question of fundamental importance. The reason is twofold: market frictions are present in numerous practical applications and, in such settings, the classical valuation theories break down entirely. Examples of market frictions include among others, transaction costs, non-traded assets and portfolio constraints. Alternative valuation criteria have been proposed and a variety of methods have been developed in order to define coherent derivative prices and, ultimately, to specify the hedging strategies. Three main valuation methods have been developed up to date: the superreplication approach, the imperfect-replication method and the utility maximization theory. The super-replication approach looks for hedging strategies that super-replicate, instead of replicating exactly, the payoff of the derivative security. The motivation for such a pricing mechanism comes from the fact that exact replication might result in an infinite derivative price, like for example in the presence of transaction costs (Soner et al., 1995). The imperfect replication method allows

Many evaluation techniques typically measure performance as deviations of average returns on actively managed funds from those predicted by some asset pricing model. Empirical evidence, however, has so far suggested that all asset pricing models lack empirical support, implying that the models contain mis-specification errors to various degrees. Evaluating mutual fund performance relative to any of these models thus becomes problematic. In this paper, we propose an approach to performance measurement that emphasizes minimizing explicitly the pricing error associated with an asset pricing function which is employed to compute performance measures. This approach is henceforth called the minimum specification-error (MSE) method. We also discuss the statistical properties for implementing MSE performance measure. To demonstrate the significance of the pricing error confounded in evaluation measurement, we contrast our methodology with the Grinblatt and Titman (1989) period weighting approach and with the empirical implementation of Chen and Knez (1996). We find that the greater the pricing error of passive assets, the larger the performance measures. Given the average pricing error generated from a collection of 163 diverse passive portfolios used in this analysis the performance values assigned to a large number of the funds become statistically and economically insignificant.

We study a financial market containing an infinite number of assets, where each asset price is driven by an idiosyncratic random source as well as by a systematic noise term. Introducing ”asymptotic assets“ which correspond to certain infinitely well diversified portfolios we study absence of (asymptotic) arbitrage, and in this context we obtain continuous time extensions of atemporal APT results. We also study completeness and derivative pricing, showing that the possibility of forming infinitely well diversified portfolios has the property of completing the market. It also turns out that models where the all risk is of diffusion type are qualitatively quite different from models where one risk is of diffusion type and the other is of Poisson type. We also present a simple martingale based theory for absence of asymptotic arbitrage.

The model of Foster-Viswanathan (1990, FV) predicts that information heterogeneity among market participants generates patterns in volume, trading costs and volatility. In the Italian Treasury bond market, periodic information asymmetry is related to the arrival of block orders from international investors, which cluster soon after the opening of the market and, respectively, of the US market. Our evidence is that volume is lower and trading costs are higher after the two openings, consistent with FV. We find only weak evidence that volatility behaves as implied by the model.

This paper analyzes the effect of uncertainty about the mean return on the risky asset on the portfolio decisions of an investor who has a long investment horizon. Building on the earlier work of Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986), it is shown that the possibility of future learning about the mean return on the risky asset induces the investor to take a larger or smaller position in the risky asset than she would if there were no learning, the direction of the effect depending on whether the investor is more or less risk tolerant than the logarithmic investor whose portfolio decisions are unaffected by the possibility of future learning. Numerical calculations show that uncertainty about the mean return on the market portfolio has a significant effect on the portfolio decision of an investor with a 20 year horizon if her assessment of the market risk premium is based solely on the Ibbotson and Sinquefield (1995) data.

A three parameter stochastic process, termed the variance gamma process, that generalizes Brownian motion is developed as a model for the dynamics of log stock prices. Theprocess is obtained by evaluating Brownian motion with drift at a random time given by a gamma process. The two additional parameters are the drift of the Brownian motion and the volatility of the time change. These additional parameters provide control over the skewness and kurtosis of the return distribution. Closed forms are obtained for the return density and the prices of European options.The statistical and risk neutral densities are estimated for data on the S&P500 Index and the prices of options on this Index. It is observed that the statistical density is symmetric with some kurtosis, while the risk neutral density is negatively skewed with a larger kurtosis. The additional parameters also correct for pricing biases of the Black Scholes model that is a parametric special case of the option pricing model developed here.

This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that her front-running activity reduces the liquidity costs of her customers, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, however, for those investors who are not subject to front-running. In aggregate, front-running has either no or positive consequences for welfare. JEL Classification. G14, G23.

In rational, efficiently functioning and complete markets, returns on derivative and underlying securities should be perfectly contemporaneously correlated. Due to market imperfections, one of these markets may reflect information faster. The use of high-frequency data and the choice for a small unit time interval to measure these lead-lag relations comes at the cost of some or many missing observations, causing traditional estimators to either under- or overestimate covariances and correlations. We use a new estimator to estimate lead-lag relationships between the cash AEX index, options and futures. We find that futures returns lead both options and cash index returns by approximately 10 minutes. The relationship between options and the cash market is not completely unidirectional.

This paper uses a large sample containing the complete return histories of 2300UK openended mutual funds over a 23-year period to measure fund performance. We find some evidence of underperformance on a risk-adjusted basis by the average fund manager, persistenceof performance and the existence of a substantial survivor bias. Similar findings have been reported for US equity mutual funds. New findings not previously documented for other markets include evidence that mutual fund performance varies substantially across different asset categories, especially foreign asset categories. We also identify some new patterns in performance related to the funds' distance from their inception and termination dates: underperformance intensifies as the fund termination date approaches, while, in contrast, there is some evidence that funds (weakly) outperform during their first year of existence.