Research articles for the 2019-04-21

ADOL - Markovian approximation of rough lognormal model
Peter Carr,Andrey Itkin
arXiv

In this paper we apply Markovian approximation of the fractional Brownian motion (BM), known as the Dobric-Ojeda (DO) process, to the fractional stochastic volatility model where the instantaneous variance is modelled by a lognormal process with drift and fractional diffusion. Since the DO process is a semi-martingale, it can be represented as an \Ito diffusion. It turns out that in this framework the process for the spot price $S_t$ is a geometric BM with stochastic instantaneous volatility $\sigma_t$, the process for $\sigma_t$ is also a geometric BM with stochastic speed of mean reversion and time-dependent colatility of volatility, and the supplementary process $\calV_t$ is the Ornstein-Uhlenbeck process with time-dependent coefficients, and is also a function of the Hurst exponent. We also introduce an adjusted DO process which provides a uniformly good approximation of the fractional BM for all Hurst exponents $H \in [0,1]$ but requires a complex measure. Finally, the characteristic function (CF) of $\log S_t$ in our model can be found in closed form by using asymptotic expansion. Therefore, pricing options and variance swaps (by using a forward CF) can be done via FFT, which is much easier than in rough volatility models.

Economics of disagreement -- financial intuition for the R\'enyi divergence
Andrei N. Soklakov
arXiv

Disagreement is an essential element of science and life in general. The amount of disagreement is often quantified by highly abstract entropic measures such as the R\'enyi divergence. Despite their widespread use in science and engineering, such quantities lack numerical intuition and their axiomatic definitions contain no practical insight as to how the disagreement can be resolved. An economic approach addresses both of these problems by transforming disagreements into tangible investment opportunities. The R\'enyi divergence appears connected to the optimized performance of such investments. Optimization around individual opinions provides a social mechanism by which funds flow naturally to support a more accurate view. Such social mechanisms can help to resolve difficult disagreements (e.g., financial arguments concerning future climate).

Equity Risk Premium. An Estimate Inspired on Behavioural Finance
SSRN
Although Capital Asset Pricing Model is very convenient for estimating the Cost of Capital for long-term investments, it requires the determination and use of a value for the equity risk premium (ERP). Using Prospect Theory introduced by Kahneman and Tversky and assuming a Brownian motion for any volatile asset, it seems possible to estimate such a premium from two market parameters â€" volatility and risk-free rate â€" and from the estimates of two human characteristics â€" the multiple of the valuation of the pain produced by losses in comparison to the satisfaction extracted from the alternative gains, plus the non-linearity of the risk-aversion/risk-loving curve. Under common values for these parameters, the ERP should be 7% p.a. Therefore, it seems that Mehra and Prescott estimated an insufficient premium, because they considered only that non-linearity, and not the gains-losses asymmetry.

Forecasting the Impact of Connected and Automated Vehicles on Energy Use: A Microeconomic Study of Induced Travel and Energy Rebound
Morteza Taiebat,Samuel Stolper,Ming Xu
arXiv

Connected and automated vehicles (CAVs) are expected to yield significant improvements in safety, energy efficiency, and time utilization. However, their net effect on energy and environmental outcomes is unclear. Higher fuel economy reduces the energy required per mile of travel, but it also reduces the fuel cost of travel, incentivizing more travel and causing an energy "rebound effect." Moreover, CAVs are predicted to vastly reduce the time cost of travel, inducing further increases in travel and energy use. In this paper, we forecast the induced travel and rebound from CAVs using data on existing travel behavior. We develop a microeconomic model of vehicle miles traveled (VMT) choice under income and time constraints; then we use it to estimate elasticities of VMT demand with respect to fuel and time costs, with fuel cost data from the 2017 United States National Household Travel Survey (NHTS) and wage-derived predictions of travel time cost. Our central estimate of the combined price elasticity of VMT demand is -0.4, which differs substantially from previous estimates. We also find evidence that wealthier households have more elastic demand, and that households at all income levels are more sensitive to time costs than to fuel costs. We use our estimated elasticities to simulate VMT and energy use impacts of full, private CAV adoption under a range of possible changes to the fuel and time costs of travel. We forecast a 2-47% increase in travel demand for an average household. Our results indicate that backfire - i.e., a net rise in energy use - is a possibility, especially in higher income groups. This presents a stiff challenge to policy goals for reductions in not only energy use but also traffic congestion and local and global air pollution, as CAV use increases.

Inefficiency of the Brazilian Stock Market: the IBOVESPA Future Contracts
Tarcisio M. Rocha Filho,Paulo M. M. Rocha
arXiv

We present some indications of inefficiency of the Brazilian stock market based on the existence of strong long-time cross-correlations with foreign markets and indices. Our results show a strong dependence on foreign markets indices as the S\&P 500 and CAC 40, but not to the Shanghai SSE 180, indicating an intricate interdependence. We also show that the distribution of log-returns of the Brazilian BOVESPA index has a discrete fat tail in the time scale of a day, which is also a deviation of what is expected of an efficient equilibrated market. As a final argument of the inefficiency of the Brazilian stock market, we use a neural network approach to forecast the direction of movement of the value of the IBOVESPA future contracts, with an accuracy allowing financial returns over passive strategies.

Price Discovery in Commodity Futures and Cash Markets with Heterogenous Agents
van Huellen, Sophie
SSRN
The paper develops a price discovery model for commodity futures markets that accounts for two forms of limits to arbitrage caused by transaction costs and noise trader risk. Four market regimes are identified: (1) effective arbitrage, (2) transaction costs but no noise trader risk, (3) no transaction costs but noise trader risk and (4) both transaction costs and noise trader risk. It is shown that commodity prices are driven by both market fundamentals and speculative trader positions under the latter two regimes. Further, speculative effects spill over to the cash market under regime (3) but are confined to the futures market under regime (4). The model is empirically tested using data from six grain and soft commodity markets. While regime (4) is rare and short lived, regime (3) with some noise trader risk and varying elasticity of arbitrage prevails.

Price Non-Convergence in Commodities: A Case Study of the Wheat Conundrum
van Huellen, Sophie
SSRN
The close relationship between commodity future and cash prices is critical for the effectiveness of risk management and the functioning of price discovery. However, in recent years, commodity futures prices, across the board, have appeared increasingly detached from prices on physical markets. This paper argues that while various factors, identified in previous literature, which introduced limits to arbitrage have facilitated non-convergence, the actual extent of non-convergence in these markets is caused by essential differences in the mechanisms of price formation on physical and derivative markets. With reference to the particular case of the CBOT wheat market, the paper shows that the size of the spread between futures and cash prices can be theoretically and empirically linked to the increasing inflow of financial investment into commodity futures markets.

Simulation-based Value-at-Risk for Nonlinear Portfolios
Junyao Chen,Tony Sit,Hoi Ying Wong
arXiv

Value-at-risk (VaR) has been playing the role of a standard risk measure since its introduction. In practice, the delta-normal approach is usually adopted to approximate the VaR of portfolios with option positions. Its effectiveness, however, substantially diminishes when the portfolios concerned involve a high dimension of derivative positions with nonlinear payoffs; lack of closed form pricing solution for these potentially highly correlated, American-style derivatives further complicates the problem. This paper proposes a generic simulation-based algorithm for VaR estimation that can be easily applied to any existing procedures. Our proposal leverages cross-sectional information and applies variable selection techniques to simplify the existing simulation framework. Asymptotic properties of the new approach demonstrate faster convergence due to the additional model selection component introduced. We have also performed sets of numerical results that verify the effectiveness of our approach in comparison with some existing strategies.

The Effects of the Appointment of Independent Directors Professionally Affiliated with Their Predecessors: Evidence from China
Li, Yanlin,Tian, Gary Gang,Wang, Xin
SSRN
The function of independent directors has been extensively documented, but the general question of how they are appointed remains insufficiently explored. We find that the likelihood of the appointment of candidates is higher when those candidates are professionally affiliated with departing independent directors, and this is more pronounced when there are personal ties between predecessors and insiders, an entirely compliant record of voting on the part of candidates or predecessors, and particularly in firms with higher-concentrated ownership and that are located in areas with a weak market environment. Moreover, the appointment of independent directors affiliated with their predecessors results in fewer dissenting votes, more related-party transactions, and a higher incidence and greater severity of violations. Our research shows that predecessorâ€"candidate affiliation helps construct a reciprocity norm between successors and insiders, leading to weak board independence.

The impact of proportional transaction costs on systematically generated portfolios
Johannes Ruf,Kangjianan Xie
arXiv

The effect of proportional transaction costs on systematically generated portfolios is studied empirically. The performance of several portfolios (the index tracking portfolio, the equally-weighted portfolio, the entropy-weighted portfolio, and the diversity-weighted portfolio) in the presence of dividends and transaction costs is examined under different configurations involving the trading frequency, constituent list size, and renewing frequency. Moreover, a method to smooth transaction costs is proposed.

Time Consistent Stopping For The Mean-Standard Deviation Problem --- The Discrete Time Case
Erhan Bayraktar,Jingjie Zhang,Zhou Zhou
arXiv

Inspired by Strotz's consistent planning strategy, we formulate the infinite horizon mean-variance stopping problem as a subgame perfect Nash equilibrium in order to determine time consistent strategies with no regret. Equilibria among stopping times or randomized stopping times may not exist. This motivates us to consider the notion of liquidation strategies, which lets the stopping right to be divisible. We then argue that the mean-standard deviation variant of this problem makes more sense for this type of strategies in terms of time consistency. It turns out that an equilibrium liquidation strategy always exists. We then analyze whether optimal equilibrium liquidation strategies exist and whether they are unique and observe that neither may hold.

Too Much of a Good Thing? Speculative Effects on Commodity Futures Curves
van Huellen, Sophie
SSRN
The increasing inflow of institutional investors replicating broad based indices into commodity futures markets has been linked to excessive calendar spreads and anomalies in futures curves. At the same time, these investors have been welcomed as liquidity providers. This paper hypothesises that this apparent dissent can be reconciled by considering the relative size of index positions to hedging positions, rather than the presence of index traders alone. The hypothesis is tested empirically for three soft commodity markets: cocoa, coffee, and cotton. By use of factor decomposition, the paper shows empirically that (a) index and hedging positions have inverse and offsetting effects on futures curves, and (b) index positions, net of hedging positions, are associated with upward sloping and peaked futures curves and occasionally wave-like shapes linked to roll-effects. The paper concludes that index traders are welcomed liquidity providers but can become â€˜too much of a good thingâ€™ if exceeding hedgersâ€™ demand for counterparty.