This article provides an improvedmodel-independent lower bound of European call options written on defaultable assets. On the basis of static arbitrage arguments, improved lower bounds are established, which also depend on the probability of option-implied default. The results are also extended to dividend-paying stocks. Moreover, our findings imply that it is never optimal to exercise certain American call options. Finally, we discuss the implications of our results for constructing an arbitrage-free volatility surface and extracting risk-neutral densities from option prices.
The current article shows that CAC 40 index options (namely PXA) display some illiquidity problems. We examine daily data on PXA trades between May 2005 and August 2012. The study evidences the presence of a considerable number of outstanding PXA contracts; most of these options are long-term maturity options and are deep in or deep out the money options. To overcome the highlighted liquidity issues, we propose first to test the generalization of Gray and Whaley reset option introduced by François-Heude and Yousfi. The main idea is to reset the strike price PXA option to a new strike price given by the CAC 40 value at a pre-agreed point of time. Then we provide some additional measures regarding the number of the PXA strike price series and the PXA expiration dates. Finally, we test them on PXA market. Results show a significant and positive effect on the PXA liquidity.
In this study, we analyze the effects of Guaranteed Stop Orders (GSOs) on stocks in the German stock index DAX. We briefly explain how GSOs work and then we develop a jump process, based on a Variance Gamma Process, to model the share prices. We show through simulations that the payoff of a GSO is primarily governed by volatility in the underlying stocks’ intraday and overnight movements. We also demonstrate that the common linear approach to price-GSOs is too general and needs to be refined in order to show adequately differences between stocks. We show that recent turbulence in stock markets around the world has made the GSO more interesting and that, further during normal periods, this order type was nearly irrelevant.
In this article, Commodity Futures Trading Commission data on Bank Participation in Futures Markets is used to examine specific characteristics of futures hedging by financial firms at a level of detail that has not so far been reported in the literature. The article analyzes quantity and rate risks hedged by banks, the sensitivity of observed futures hedging positions to changes in market variables and the impact of risk aversion on hedging behavior. The results indicate that while bank futures hedging positions are insensitive to quantity risks they are far more sensitive to rate changes. I also find that commonly used simplifying assumptions in this literature (constant absolute risk aversion, forward market unbiasedness) are not supported by actual hedging data.
In this work, we derive an improved lower bound for European-style put options written on defaultable assets. Furthermore, we establish two additional no-arbitrage conditions, one for European-style puts and one for calls, which are tighter than the ones commonly reported in current literature. All of our results are based on static arbitrage arguments and have important implications for constructing arbitrage-free call or put option surfaces. In particular, we point out that the commonly stated conditions required for a call option surface are not always sufficient to generate an arbitrage-free call option surface.
Using an updated database that extends after the subprime crisis, we revisit the asymmetries of hedge fund behavior in recession compared with economic expansion. In this respect, we study the time-varying α’s and β’s associated with strategy returns using an innovative framework based on the Kalman filter and the multivariate GARCH. We find that hedge fund managers reduce drastically their risk exposure during financial crises while their behavior is much smoother in normal times. We also find that hedge funds continue to provide good prospects for investors in terms of risk-adjusted returns. Actually, the procyclicality of hedge fund strategies’ returns seems to decrease through time. Moreover, the strategies’ behavior in terms of α and β tends to become more heterogeneous in times of crisis. The strategy exposure to adverse shocks seems to recede even after accounting for the subprime crisis. Finally, many hedge fund strategies benefit from an increase in the volatility of stock market returns. Hedge fund strategies may thus constitute a way to offset the lower expected returns observed in the conventional financial markets and may contribute to portfolio diversification.
We present an original Probabilistic Monte Carlo (PMC) model for pricing European discrete barrier options and compound real options. On the basis of Monte Carlo (MC) simulation, for barrier options the PMC model computes the probability of not crossing the barrier for knock-out options and crossing the barrier for knock-in options. This probability is then multiplied by an average sample discounted payoff of a plain vanilla option that has the same inputs as the barrier option but barrier-free, and to which we have applied a filter. We test the consistency of our model with an analytical solution (Merton, 1973; Reiner and Rubinstein, 1991) adjusted for discretization by Broadie et al (1997) and a naïve numerical model using MC simulation presented by Clewlow and Strickland (2000). Our study shows that the PMC model accurately prices barrier options. Moreover, the idea behind the method is simple and can be applied to the pricing of complex derivatives, easing the valuation step significantly: we illustrate the versatility of the PMC model in pricing sequential compound real options. Market participants needing to select a reliable, versatile and simple numerical method for pricing options with embedded features will find our article appealing.
In the aftermath of the 2008 financial crisis, the need to consider more realistic risk models for derivative products has received renewed attention. We introduce a dynamic model for the pricing of European-style options with various attractive features such as a mixture of heavy-tails and Gaussian distribution along with a leverage effect property. We test the model on FTSE 100 stock index options during the period of January 2008 to June 2009. Our empirical results show that the model adequately fits the volatility smile dynamics particularly during stress periods. Furthermore, we find that the leverage effect form is driven by the sticky-strike rule.
Under unstable economic conditions, interest in the financial derivatives market is easy to understand. On the Russian forward market, derivatives such as options and futures are gaining increasing popularity as a means of managing the risks of business units in order to protect against possible financial losses. The competition created among the organizers of forward trading has encouraged the emergence of a technically effective trading method and an expanded range of available financial instruments. The need for an expanded range of risk-management instruments and the introduction onto the market of cutting-edge methods relying on a strict formalization of investor decisions has determined the current relevance of the article at hand. The aim of the article involves studying the latest methods of hedging financial options, comparing and contrasting the new methods with those traditionally used in the financial industry, and analyzing the opportunities for applying methods of imperfect hedging on the Russian forward market.
Previous studies indicate that traders in possession of important information are more likely to transact in option contracts rather than the underlying asset. This article examines stock option trading volume before significant price changes in the underlying stock for all S&P100 and FTSE 100 constituent stocks. Our findings indicate irregular option trading volume before a significant amount of large price changes. This effect is less pronounced in the UK market.
In this study, it is examined whether the manager description of a fund is related to its performance. It is hypothesized that the length of the manager description can be an indicator of both manager quality and overconfidence. Overall, the results of the study suggest that the manager description is related to fund performance when the performance is measured using the Sharpe ratio. In addition, the results reveal that past performance in particular explains the length of the manager description. This finding implies that fund managers attribute their performance to themselves making the manager description a potential indicator of overconfidence. However, when the alpha, which is a performance measure for a well-diversified fund investor, is used instead of the Sharpe ratio, the results suggest that it is rather the length of the strategy description that is an indicator of good fund performance.
Internal crossing of trades between multiple alpha streams results in portfolio turnover reduction. Turnover reduction can be modeled using the correlation structure of the alpha streams. As more and more alphas are added, generally turnover reduces. In this note we use a factor model approach to address the question of whether the turnover goes to zero or a finite limit as the number of alphas N goes to infinity. We argue that the limiting turnover value is determined by the number of alpha clusters F, not the number of alphas N. This limiting value behaves according to the "power law" ~ F^(-3/2). So, to achieve zero limiting turnover, the number of alpha clusters must go to infinity along with the number of alphas. We further argue on general grounds that, if the number of underlying tradable instruments is finite, then the turnover cannot go to zero, which implies that the number of alpha clusters also appears to be finite.
We analyze and value dual directional structured products – or simply dual directionals (DDs) – which have been issued in large amounts since the beginning of 2012. DDs evolved out of another type of structured product called absolute return barrier notes; however, DDs lack principal protection and have different embedded options positions, which are yet to be described in the literature. We find that DDs can be broadly organized into two categories: single observation dual directionals and knock-out dual directionals. We determine the appropriate option decomposition for these categories and provide analytical formulas for their valuation. We confirm our analytic results using Monte Carlo simulation and use both techniques to value a large sample of DDs registered with the Securities and Exchange Commission up to December 2012. Our results indicate that like many types of structured products, DDs tend to be priced at a significant premium to present value across issuers and underlying securities and that the present value of the decomposition is smaller than the face value net of commissions. We find that DDs with embedded leverage or a single observation feature tend to be worth less than products either without leverage or with a knock-out option.
The credit risk of a sovereign borrower is priced using bond spreads (BS) and credit default swaps (CDS). In this study, we investigate how structural breaks affect persistence of volatility of sovereign credit risk of seven countries. Using Kappa-1 and Kappa-2 tests, we identify multiple structural breaks in variance of both CDS and BS. Using exponential generalized autoregressive conditional heteroskedasticity model with and without structural breaks, we find that BS are more persistent than CDS hence informed trading takes place in sovereign bond market. The structural breaks are not only jointly significant in influencing volatility of sovereign credit but they reduce persistence of volatility and associated half-life of BS and CDS. The results have important implications on cost of borrowing of sovereigns, efficiency of CDS and BS markets as well as pricing of both credit risk measures.
This article measures the diversification benefits of increasing the number of managers in a hedge fund portfolio in three different historical periods. It shows that not only are returns and volatility markedly different in these different periods, but the usual relationship of higher risk with higher returns is sometimes reversed. Irrespective of the environment, this article posits a practical constraint for allocators to use in deciding the number of hedge funds in a portfolio using a measure of average allocator opportunity. The ‘average’ allocator constraint is then replaced by a skilled allocator and it shows that an increase in skill, all else being equal, allows more funds to be included in the portfolio, without decreasing the opportunity to outperform the average. The ‘allocator opportunity’ is used to compare the diversification benefit (trade-off) of adding managers (reducing opportunity) in portfolios of small managers versus large managers. It shows that in constructing portfolios with a given allocator opportunity, an allocator could allocate to a larger number of managers if picking from the universe of small managers rather than large managers.
We provide simple formulas for pricing both the European and American options.
We investigate the effects of drawdown risk reduction on the US hedge funds. Despite the existence of numerous evidences on the asymmetric distribution of portfolio returns, the asymmetric risk measures have been extensively applied in risk management during recent years with the considerable applications on the lower partial moment (LPM) methodology. Unlike prior literatures, we use the drawdown risk measure (DRM), which is a special case of LPM, to study the impacts of drawdown risk decrease on management styles of the US hedge funds. The monthly returns are applied for 1720 US hedge funds over the period 2000–2011. The optimization models in the DRM form are run to optimize the risk measures and investigate the effects of drawdown risk reduction. We find that the potential benefits of funds’ diversification may weaken decreases in tolerance levels of drawdown risk. Our findings increase the importance of risk (tolerance) perception, in particular drawdown risk, when making many investment decisions. We find that it can negatively affect portfolio returns. Our findings also show that skewness does not impose any significant problem in the DRM model. The DRM optimization model reduces investors’ risk more than the conventional models and can be accommodated with risk-averse investors’ approach.
We investigate the traders’ futures-only positions, options-only positions and futures-and-options-combined positions in crude oil to draw some implications with respect to the behavior of traders during the 2008 oil bubble. We find that: (iv) the Money Manager group primarily speculated in crude oil markets via options on crude oil futures; (v) the Swap Dealer group generally behaved as a typical institutional long-only investor in crude oil – they were long crude oil futures and hedged with the long protective put options on crude oil futures; (vi) the Producer/Merchant/Processor/User group, in addition to being a short hedger, possibly acted as a counterparty in crude oil options markets; (vii) Other Reportable traders possibly engaged in the protective call risk management strategy; and (viii) the Non-Reportable traders group actually showed the most sophisticated, almost neutral, hedged position in crude oil futures and options on crude oil futures.
This paper presents a new model for valuing hybrid defaultable financial instruments, such as, convertible bonds. In contrast to previous studies, the model relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.
