Knowledge that Transforms

This paper finds that the returns of the world's 14 major stock markets are not normally distributed, and that the correlation matrix of these stock markets was stable during the January 1988–December 1993 time period. Polynomial goal programming, in which investor preferences for skewness can be incorporated, is utilized to determine the optimal portfolio consisting of the choices of 14 international stock indexes. The empirical findings suggest that the incorporation of skewness into an investor's portfolio decision causes a major change in the construction of the optimal portfolio. The evidence also indicate that investors trade expected return of the portfolio for skewness.

We value American options on bonds using a generalization of the Geske–Johnson (Geske, R., Johnson, H., 1984. Journal of Finance 39, 1151–1542) (GJ) technique. The method requires the valuation of European options, and options with multiple exercise dates. It is shown that a risk-neutral valuation relationship (RNVR) along the lines of Black–Scholes (Black, F., Scholes, M., 1973. Journal of Political Economy 81, 637–659) model holds for options exercisable on multiple dates, even under stochastic interest rates, when the price of the underlying asset is lognormally distributed. The proposed computational procedure uses the maximized value of these options, where the maximization is over all possible exercise dates. The value of the American option is then computed by Richardson extrapolation. The volatility of the underlying default-free bond is modeled using a two-factor model, with a short-term and a long-term interest rate factor. We report the results of simulations of American option values using our method and show how they vary with the key parameter inputs, such as the maturity of the bond, its volatility, and the option strike price.

A model of mean reversion of exchange rates to purchasing power parity is developed and tested where exchange rates are assumed to follow a mean reverting elastic random walk toward a stochastic PPP rate. The model recognizes the possibility that mean reversion towards PPP may be nonlinear which allows greater flexibility in the adjustment process. Regression equations consistent with the theoretical model are derived. The model is tested using long- and short-term data for six countries. While the results are generally consistent with the findings of previous studies, evidence is presented which demonstrates that the mean reversion process is not linear for some countries.

This paper traces developments in the credit risk measurement literature over the last 20 years. The paper is essentially divided into two parts. In the first part the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans is traced by way of reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. In the second part, a new approach built around a mortality risk framework to measuring the risk and returns on loans and bonds is presented. This model is shown to offer some promise in analyzing the risk-return structures of portfolios of credit-risk exposed debt instruments.

The last two decades have witnessed a tremendous growth in the volume of assets and liabilities whose cash flows depend, in a variety of ways, on the path of interest rates. Some of these, including floating-rate notes and swap agreements, contractually base cash flows on current and past interest rates and contain caps, floors, and other, more complex features. Others, including mortgages, many corporate bonds, and time deposits, are fixed-rate instruments that contain embedded options, such as those to prepay, call, or withdrawal. The irregular exercise of these options causes cash flows to vary as time proceeds and interest rates rise or fall. This paper develops a state-contingent claims technique for valuing such securities. It is derived from the option-based model of Breeden and Litzenberger (1978) using the transition matrix approach of Banz and Miller (1978). Particular attention is paid to valuing so-called path-dependent securities whose contemporaneous cash flows depend on the historical path of interest rates as well as their current level. A detailed example is provided in which an adjustable-rate mortgage is valued under a variety of economic and security specific assumptions.

We estimate daily Vasicek, CIR, and spline models on Belgian data and compare the trading profits that can be made on the basis of their residuals. Abnormal returns, measured using three different benchmarks, are negatively related to once- and twice-lagged mispricing. Buying underpriced bonds and (especially) selling overpriced bonds yields significant abnormal returns even when the trade is delayed by up to five days after observing the mispricing. The traditional spline model overfits the data and is least able to detect mispricing. Large model residuals are more likely to be the result of model misspecification or -estimation than are small or medium-sized residuals.

We use data uniquely available from the Commodity Futures Trading Commission (CFTC) to document the intraweek trading patterns of large speculators in five futures markets. These markets include futures traded against the Standard and Poor's 500 stock index, Treasury Bonds, gold, corn, and soybeans. We also examine the influence of large speculator trades on the patterns of volume and volatility for the contracts in our sample. Though we detect the familiar U-shaped and inverted U-shaped patterns across weekdays for volatility and aggregate volume, the association between volume and volatility becomes stronger when we separate large speculator volume from volume associated with other traders. The coefficient on large speculator volume is much larger than the coefficient on other volume in these regressions. Compared with total volume, large speculator volume is greater on Mondays than on the other days of the week in all five markets.

Estimates of central bank intervention losses or profits vary widely; some estimates find substantial losses, others profits. In most cases, estimated profits are not risk-adjusted, and risk adjustment can have large effects. Furthermore, profit estimates involve variables integrated of order one, and because of this test-statistics may have nonstandard distributions; few studies take this into account. Estimates of risk-adjusted profits for the US Fed and the Swedish Riksbank, with allowances for possible nonstandard distributions, suggest that neither made losses and might have made significant profits.