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This paper investigates the information in corporate credit ratings. If ratings are to be informative indicators of credit risk they must reflect what a risk-averse investor cares about: both raw default probability and systematic risk. We find that ratings are relatively inaccurate measures of raw default probability - they are dominated as predictors of failure by a simple model based on publicly available financial information. However, ratings do contain relevant information since they are related to a measure of exposure to common (and undiversifiable) variation in default probability ('failure beta'). Systematic risk is shown to be related to joint default probabilities in the context of the Merton (1974) model. Empirically, it is related to CDS spreads and risk premia. Given the multidimensional nature of credit risk, it is not possible for one measure to capture all the relevant information.

This paper evaluates various explanations for the profitability of momentum strategies documented in Jegadeesh and Titman (1993). The evidence indicates that momentum profits have continued in the 1990's suggesting that the original results were not a product of data snooping bias. The paper also examines the predictions of recent behavioral models that propose that momentum profits are due to delayed overreactions which are eventually reversed. Our evidence provides support for the behavioral models, but this support should be tempered with caution. Although we find no evidence of significant return reversals in the 2 to 3 years following the following formation date, there are significant return reversals 4 to 5 years after the formation date. Our analysis of post-holding period returns sharply rejects a claim in the literature that the observed momentum profits can be explained completely by the cross-sectional dispersion in expected returns.

This study assesses the validity of widespread criticisms of the large, nationally recognized credit rating agencies (CRAs). The criticisms focus on these CRAs' (1) disclosure practices (such as related to the assumptions underlying their ratings decisions); (2) potential conflicts of interest; (3) alleged anticompetitive or unfair practices; and (4) diligence and competence. This paper focuses on two questions. First, to what extent does empirical evidence support the criticisms? Second, what additional evidence might be useful? Although little rigorously-gathered empirical evidence supports the criticisms, the absence of such evidence does not indicate that the criticisms are invalid. First, powerful tests related to potential conflicts of interest and alleged unfair practices are exceptionally difficult to design. Second, criticisms related to the adequacy of CRAs' disclosure practices have not yet been, but could be, investigated by empirical researchers. Third, many criticisms, particularly those focusing on the adequacy of CRAs' disclosure practices, diligence, and competence, are based on subjective benchmarks that are difficult to quantify (and that themselves are open to question). Empirical evidence does support the view that the large CRAs' dual roles of (1) providing timely information to market participants; and (2) serving regulatory and contracting functions, create conflicting incentives. Note, however, that the costs of these conflicts may be less than those of other alternatives. Researchers should further investigate how conflicting incentives affect CRA practice, and develop and test models of how CRAs optimize across their conflicting rating goals. Researchers have many other opportunities to make important contributions. For example, further study of factors that influence characteristics of credit ratings, such as timeliness, stability, and accuracy, is warranted.

There is a wealth of literature about discounted cash flow valuation. In this paper, we will discuss the most important papers, highlighting those that propose different expressions for the value of the tax shield (VTS). The discrepancies between the various theories on the valuation of a company's equity using discounted cash flows originate in the calculation of the value of the tax shield (VTS). This paper illustrates and analyzes 7 different theories and presents a new interpretation of the theories.

Spanish Abstract: Se definen la duración y la convexidad y se analiza su variación debida a cambios en las características de los bonos (plazo, cupón, nominal, rentabilidad exigida). En los casos en que es posible, se utilizan imágenes analógicas, más o menos intuitivas, para representar los fenómenos que afectan a la duración del bono a lo largo de su vida, tales como el pago de un cupón. Los conceptos de duración y convexidad permiten caracterizar la volatilidad de un bono, esto es, la sensibilidad de su precio de mercado ante cambios en los tipos de interés. Por ello el conocimiento de su magnitud ayuda a la gestión de una cartera de renta fija. La duración también se aplica a la renta variable como se muestra en el apartado 3 aunque su utilidad es, como veremos, relativa. English Abstract: We define duration and convexity and analyze their changes due to the characteristics of the bonds. We also apply the concept of duration to shares and show that its usefulness is quite limited.

ESG is under attack from all sides. True believers wish to keep practicing ESG but call it something different; opportunists recognize that an ESG label no longer helps launch funds or attract customers; opponents seek to ban ESG outright. But if ESG is to be scrapped, what do we replace it with? Retiring the term but continuing the practice fails to address the legitimate challenges to ESG; abandoning the practice throws the baby out with the bathwater. This article proposes an alternative: “Rational Sustainability”. Sustainability refers to the goal – the creation of long-term value rather than the ticking of ESG boxes – which is of interest to all job titles and political leanings. Rational refers to the approach: it recognizes diminishing returns and trade-offs; it is based on evidence and analysis; and guards against irrational sustainability bubbles. Rational Sustainability is not a rebranding or a name change, but a fundamental shift in the practice of ESG to the informed creation of long-term value.

This paper develops a model for volatility sensitivity to the underlying asset price. It has applications to option pricing and dynamic delta hedging under stochastic volatility. The model allows at-the-money volatility sensitivity to change continuously with S and this corresponds to a quadratic parameterization to the volatility surface. The extension to fixed strike volatility sensitivities is achieved using a principal component analysis on the deviation of fixed strike volatilities from at-the-money volatility.

Financial planners and advisors have recently started to recognize that human capital must be taken into account when building optimal portfolios for individual investors. But human capital is not just another pre-endowed asset class that must be included as part of the portfolio frontier. An investor's human capital contains a unique mortality risk, which is the loss of all future income and wages in the unfortunate event of premature death. However, life insurance in its various guises and incarnations can hedge against this mortality risk. Thus, human capital affects both the optimal asset allocation and the optimal demand for life insurance. Yet historically, asset allocation and life insurance decisions have consistently been analyzed separately both in theory and practice. In this paper, we develop a unified framework based on human capital in order to enable individual investors to make both decisions jointly. We investigate the impact of the magnitude of human capital, its volatility, and its correlation with other assets as well as bequest preferences and subjective survival probabilities on the optimal portfolio of life insurance and traditional asset classes. We do this through five case studies that implement our model. Indeed, our analysis validates some intuitive rules of thumb but provides additional results that are not immediately obvious.

We clarify the rationale and differences between the two main categories of linear factor models, namely dominant-residual and systematic-idiosyncratic. We discuss the five different, yet interconnected areas of quantitative finance where linear factor models play an essential role: multivariate estimation theory, asset pricing theory, systematic strategies, portfolio optimization, and risk attribution. We present a comprehensive list of common pitfalls and misunderstandings on linear factor models. An appendix details all the calculations. Supporting code is available for download.

We investigate statistical arbitrage strategies for index options. To test the efficiency of markets in pricing relative implied volatilities in highly correlated markets, U.S. stock indices for which listed options are available are matched into pairs according to their degree of correlation. The interrelationship over time of the three most highly correlated and liquid index pairs is then analyzed. Based on this analysis, the relative implied volatility relationships are calculated. If such a relationship is violated, a relative mispricing is identified. We find that, although many theoretical mispricings can be observed, only a fraction of them are large enough to be used profitably in the presence of bid-ask spreads and transaction costs. A simple no-arbitrage barrier is thus used to identify significant mispricings and a statistical arbitrage trade is implemented every time such a mispricing was recorded, the trades being on average profitable after deduction of transaction costs.

This paper studies the interaction of the five most well-established calendar effects: the Halloween effect, January effect, turn-of-the-month effect, weekend effect and holiday effect. We find that Halloween and turn-of-the month (TOM) are the strongest effects fully diminishing the other three effects to zero. The equity premium over the sample 1963-2008 is 7.2% if there is a Halloween or TOM effect, and -2.8% in all other cases. These findings are robust with respect to transactions costs, across different samples, market segments, and international stock markets. Our empirical research narrows down the number of calendar effects from five to two, leading to a more powerful and puzzling summary of seasonal effects.

This paper evaluates investment strategies that exploit the deviations from theoretical price parity in a sample of 12 dual-listed companies (DLCs) in the period 1980-2002. We show that simple trading rules produce abnormal returns of up to almost 10% per annum adjusted for systematic risk, transaction costs, and margin requirements. However, arbitrageurs face uncertainty about the horizon at which prices will converge and deviations from parity are very volatile. As a result, DLC arbitrage is characterized by substantial idiosyncratic return volatility and a high incidence of large negative returns, which are likely to impede arbitrage.

Using a new database of hedge funds, this paper provides a comprehensive analysis of the risk-return characteristics, risk exposures, style analysis and performance persistence of various hedge fund strategies. We conduct a mean-variance analysis to find that a combination of alternative investments and passive indexing provides significantly better risk-return tradeoff than passively investing in the different asset classes. Using a broad asset class factor model, we find that the hedge fund strategies outperform the benchmark by a range of 6% to 15% per year. We infer the significant risk exposures of different hedge fund strategies using generalized style analysis and find results consistent with their investment objectives. Finally, using parametric and non-parametric methods, we examine persistence in the performance of hedge fund managers. We find a reasonable degree of persistence which seems to be attributable more to the losers continuing to be losers instead of winners continuing to be winners.

International Financial Reporting Standards (IFRS) and their predecessor, International Accounting Standards (IAS) are gaining in worldwide recognition. All publicly traded companies in the EU must adopt them by 2005 and many other countries either have adopted them or plan to do so in the near future. In 2002, the Russian Prime Minister announced that all Russian companies and banks must prepare their financial statements in accordance with international standards starting January 1, 2004. Implementing that decision will not be easy, for a variety of reasons. Not all international standards have been translated into Russian. Many Russian accountants are not sufficiently familiar with international standards to implement them. Some Russian universities have only recently started teaching international standards and the continuing education programs of the various Russian accounting associations are not yet prepared to offer comprehensive courses on international standards. Current Russian accounting standards conflict with international standards in several important ways and these conflicts will not be resolved in the near future. This paper reviews the literature on this subject and incorporates the results of interviews conducted of Russian accounting firms, enterprises and university professors in July and August 2003.

Initial Coin Offerings (ICOs) are a new and unregulated form of crowdfunding that raises funds through a blockchain by selling venture-related tokens or coins in exchange for legal tender or cryptocurrencies. In this paper, we establish token or coin tradability as the primary ICO success measure, and we develop a theoretical framework for how venture uncertainty, venture quality, and investor opportunity set interrelate. We use the largest available dataset to date, consisting of 1,009 ICOs from 2015 to March 2018. Our data highlights that venture uncertainty (not being on Github and Telegram, shorter whitepapers, higher percentage of tokens distributed) is negatively correlated, while higher venture quality (better connected CEOs and larger team size) is positively correlated, with ICO success. Moreover, providing a hard cap in a pre-ICO can help investors measure success in the pre-sale. This is another positive signal of funding success.

Striving for maximum diversification we follow Meucci (2009) in measuring and managing a multi-asset class portfolio. Under this paradigm the maximum diversification portfolio is equivalent to a risk parity strategy with respect to the uncorrelated risk sources embedded in the underlying portfolio assets. Our paper characterizes the mechanics and properties of this diversified risk parity strategy. Moreover, we explore the risk and diversification characteristics of traditional risk-based asset allocation techniques like 1/N, minimum-variance, or risk parity and demonstrate the diversified risk parity strategy to be quite meaningful when benchmarked against these alternatives.

Spanish Abstract: Una opción es un contrato que proporciona a su poseedor (el comprador) el derecho (no la obligación) a comprar (opción de compra) o vender (opción de venta) una cantidad de activos, a un precio establecido, en una fecha determinada. El tipo y número de activos, el precio de ejecución del contrato y la fecha hasta la que el contrato tiene validez, son las características fundamentales de la opción. Un contrato “forward” es un acuerdo entre un comprador y un vendedor para realizar una compra-venta en el futuro a un precio fijado hoy. Dicho de otro modo, es un contrato que obliga a su poseedor (el comprador) a comprar una determinada cantidad de cierto activo, en una fecha futura especificada, pagando una cantidad prefijada. El vendedor del “forward” queda obligado a vender el activo en las condiciones establecidas en el contrato. Un contrato de futuros es muy similar a un contrato “forward”. El objetivo de este documento es entender el funcionamiento de estos tres contratos y las diferencias entre ellos. English Abstract: The objectives of this document are to understand how options, futures and forwards work and to highlight their differences. We also define arbitrage and show how it can be done.

We study the trading behavior of individual investors using the Trade and Quotes (TAQ) and Institute for the Study of Security Markets (ISSM) transaction data over the period 1983 to 2001. We document four results: (1) Order imbalance based on buyer- and sellerinitiated small trades from the TAQ/ISSM data correlates well with the order imbalance based on trades of individual investors from brokerage firm data. This indicates trade size is a reasonable proxy for the trading of individual investors. (2) Order imbalance based on TAQ/ISSM data indicates strong herding by individual investors. Individual investors predominantly buy (sell) the same stocks as each other contemporaneously. Furthermore, they predominantly buy (sell) the same stocks one week (month) as they did the previous week (month). (3) When measured over one year, the imbalance between purchases and sales of each stock by individual investors forecasts cross-sectional stock returns the subsequent year. Stocks heavily bought by individuals one year underperform stocks heavily sold by 4.4 percentage points in the following year. For stocks for which it is most difficult to arbitrage mispricings, the spread in returns between stocks bought and stocks sold is 13.1 percentage points the following year. (4) Over shorter periods such as a week or a month, a different pattern emerges. Stocks heavily bought by individual investors one week earn strong returns in the subsequent week, while stocks heavily sold one week earn poor returns in the subsequent week. This pattern persists for a total of three to four weeks and then reverses for the subsequent several weeks. In addition to examining the ability of small trades to forecast returns, we also look at the predictive value of large trades. In striking contrast to our small trade results, we find that stocks heavily purchased with large trades one week earn poor returns in the subsequent week, while stocks heavily sold one week earn strong returns in the subsequent week.

This paper captures poor environmental, social, and governance (ESG) practices based on a firm’s history of negative ESG incidents. I find that firms’ past ESG incident rates predict more future incidents, weaker profitability, and lower risk-adjusted stock returns. These abnormal returns are consistent with markets underreacting to incidents, as past incident rates also predict larger analyst forecast errors, more negative stock price reactions when firms announce their quarterly earnings or have subsequent incidents, and more pronounced abnormal returns in firms with weaker investor attention. I further document that ESG-aware mutual funds profit from this underreaction. Overall, these findings suggest that the negative long-term value implications of poor ESG practices are not fully reflected in stock prices.

We examine the impact of interest rates benchmark reform and upcoming Libor transition on options markets. We address various modelling challenges the transition brings. We specifically focus on the impact of the clearing houses' discounting switch on swaptions, and the consequences of Libor transition on Libor-in-arrears swaps, caps, and range accruals as typical representatives of a very wide range of Libor derivatives.

This paper discusses the causes and impacts of the financial crisis of 2007–2010 and examines the reforms aimed at the prevention of its recurrence. The causes to be discussed include housing and commodity bubbles, easy credit conditions, subprime lending, predatory lending, deregulation and lax regulation, incorrect risk pricing, collapse of the shadow banking system and systemic risk. The impacts to be examined include the major financial institutions, the financial wealth, the economies of the U.S. and other countries — Iceland, Hungary, Russia, Spain, Ukraine, Dubai, and Greece. The paper further discusses emergency policy responses, principles of financial reforms and various regulatory proposals. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the Basel III accord are also discussed. Concluding remarks provide a brief discussion of the latest economic problems in 2011.

We provide evidence for risk management as a value creation activity. To test this proposition, we introduce risk control in portfolio decision making where in order to assess risk we developed a VaR model that is able to take in multidimensional risks. Then we ran out a simulation according to Italian banking operational procedures: our evidence shows a better performance both as total return and as Sharpie ratio. We argue that Basle standard requirements are less heavier than ones granted by internal models, modified by prudential coefficients.

Based on the invisible hand of the market, this paper proposes a general microeconomic theory of investments under the framework of neoclassical microeconomics. The theory requires minimum assumptions and allows investors to have time-variant and heterogeneous investment utilities and expectations. It prescribes a set of static and dynamic General Capital Asset Pricing (Theorems and) Models - collectively labeled as GCAPM. GCAPM unifies currently seemingly-conflicting modern finance theories and connects them more closely to real-world finance. GCAPM independently derives a set of new CAPM paradigms under its heterogeneous world and shows that Sharpe's CAPM paradigms are alive and well but were overzealously misinterpreted for decades. The most noticeable misinterpretation is the widely accepted CAPM beta risk premium hypothesis, which wrongfully asserts that holding higher-beta-risk assets should generate higher ex-post returns. GCAPM shows that, as far as beta risk is concerned, it is "prudent beta risk management" rather than "reckless beta risk taking" that produces higher ex-post returns. GCAPM's general equilibrium also supports Ross and Roll's APT, which has been criticized as an arbitrage-free hypothesis without supporting equilibrium theories. GCAPM shows that the quality of a capital market equilibrium is only as good as the quality of its member investors. It agrees with the nascent behavioral finance theory that investors' psychological weaknesses and cognitive biases can influence capital asset pricing. However, GCAPM shows that competitive capital markets share a common evolutionary force that will eliminate known irrational investment behavior over time and "mature" capital markets should mainly reflect investors' normative financial needs, investment objectives, risk tolerances, and best forecasts of future economic states. Release Note: I had made substantial structural changes to the previous edition of GCAPM (I) paper. The static and dynamic cases of GCAPM are now thoroughly discussed in two separate Sections. A new Section, titled "The Quality of Capital Market and Behavioral Finance," is added to address the flaws of human investment behavior and capital markets' evolution forces. The old Section regarding canonical asset pricing is removed from the paper and will be published in a separate paper tilted "Canonical Asset pricing and Asset Allocation Theorems." Except for the misinterpreted beta risk premium hypothesis, whose empirical tests prematurely declared the death of CAPM, materials regarding other CAPM misinterpretations are removed and will be discussed in a separate paper titled "CAPM Paradoxes and their GCAPM Interpretations." A 1997 version of this paper was titled: "General Capital Asset Pricing Model (GCAPM): A Complete Mathematical Appendix" A 2001 version of this paper was titled: "General Capital Asset Pricing Models (GCAPM) - Part I: A Microeconomic Theory of Investments (Mathematical Edition)"

Valuation of mortgage backed securities (MBSs) and collateralized mortgage obligations (CMOs) is the big science of the financial world. There are many moving parts, each one drawing on expertise in a different field. Prepayment modeling draws on statistical modeling of economic behavior. Data selection draws on risk analysis. Interest rate modeling draws on classic arbitrage pricing theory applied to the fixed income market. Index projection draws on statistical analysis. Making the Monte Carlo analysis tractable requires working with numerical methods and investigation of a variety of variance reduction techniques. Tractability also requires parallelization, which draws on computer science in building computation clusters, applying new technology such as graphical processing units (GPUs), and analysis and optimization of parallel algorithms. Here we detail the different components, describing the approach we have taken in each area. Of particular interest is how the credit crisis that started in 2007 has impacted the modeling. The end result is that accurate price calculations on individual securities can be done in real time, and the entire universe of CMOs and MBSs can be analyzed overnight.

When analyzing or the value of a firm, there are three basic questions that we need to address: How much is the firm generating as earnings? How much capital has been invested in its existing investments? How much has the firm borrowed? In answering these questions, we depend upon accounting assessments of earnings, book capital and debt. We assume that the reported operating income is prior to any financing expenses and that all debt utilized by the firm is treated as such on the balance sheet. While this assumption, for the most part, is well founded, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease payments are treated as part of operating expenses, but we will argue that they are really financing expenses. Consequently, the stated operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have far reaching implications for profitability, financial leverage and assessed value at firms.