Financial Interpretation Research Articles

On the multidimensional extension of countermonotonicity and its applications

In a 2-dimensional space, Fréchet–Hoeffding upper and lower bounds define comonotonicity and countermonotonicity, respectively. Similarly, in the multidimensional case, comonotonicity can be defined using the Fréchet–Hoeffding upper bound. However, since the multidimensional Fréchet–Hoeffding lower bound is not a distribution function, there is no obvious extension of countermonotonicity in multidimensions. This paper investigates in depth a new multidimensional extension of countermonotonicity. We first provide an equivalent condition for countermonotonicity in 2-dimension, and extend the definition of countermonotonicity into multidimensions. In order to justify such extensions, we show that newly defined countermonotonic copulas constitute a minimal class of copulas. Two applications will be provided. First, we will study the relationships between multidimensional countermonotonicity and such well-known multivariate concordance measures as Kendall’s tau or Spearman’s rho. Second, we will give a financial interpretation of multidimensional countermonotonicity via the existing herd behavior index.

Roundaboutness Is Not a Mysterious Concept: A Financial Application to Capital Theory

We apply the EVA terminology to the concepts of roundaboutness and average period of production in capital theory. By doing this we show that these terms have a clear and well understood financial interpretation. A financial application to capital theory helps to clarify obscure and controversial economic terms. We then extend our financial interpretation of roundaboutness and average period of production to the Austrian business cycle theory and show how this approach can be used to shed light on the subprime crisis.

Predictable Uncertainty: The Relation between Unrecognized Tax Benefits and Future Income Tax Cash Outflows

This study examines competing arguments about whether Financial Interpretation No. 48 (FIN 48, now ASC 740-10-25) provides information to financial statements users regarding the realizability of future income tax cash outflows related to reserves for unrecognized tax benefits (UTBs). Critics believe FIN 48 provides substantial discretion in accruing UTBs, while proponents argue the Interpretation improves the reliability and comparability of UTBs. Our results show that, on average, UTBs are predictive of income tax cash outflows up to three years in the future. This link is economically significant as UTBs explain 8.2 percent as much of the variation in future income tax cash outflows as do contemporaneous income tax cash outflows. Using data provided by the IRS, these results hold in validation tests linking UTBs to future IRS audit settlements. In cross-sectional analyses, we find that UTBs are more informative for future income tax cash outflows in firms that (1) purchase tax services from their auditor; (2) engage in relatively less tax avoidance; and (3) are subject to greater IRS audit scrutiny. Our results should interest financial statement users, standard setters, and tax authorities as these parties estimate the future economic consequences of uncertain tax positions.

Doubly reflected BSDEs with call protection and their approximation

We study the numerical approximation of doubly reflected backward stochastic differential equations with intermittent upper barrier (RIBSDEs). These denote reflected BSDEs in which the upper barrier is only active on certain random time intervals. From the point of view of financial interpretation, RIBSDEs arise as pricing equations of game options with constrained callability. In a Markovian set-up we prove a convergence rate for a time-discretization scheme by simulation to an RIBSDE. We also characterize the solution of an RIBSDE as the largest viscosity subsolution of a related system of variational inequalities, and we establish the convergence of a deterministic numerical scheme for that problem. Due to the potentially very high dimension of the system of variational inequalities, this approach is not always practical. We thus subsequently prove a convergence rate for a time-discretisation scheme by simulation to an RIBSDE.

Tax Uncertainty and Voluntary Real-Time Tax Audits

ABSTRACT This study examines the empirical relation between voluntary participation in the Internal Revenue Service's (IRS) Compliance Assurance Process (CAP) audit program, and tax uncertainty disclosed in financial statements pursuant to Financial Interpretation No. 48 (FIN 48). Based on the findings of prior analytical and empirical research, we formulate and test hypotheses about the likelihood of voluntary CAP participation and the resulting effect on FIN 48 tax reserves. We find that firms with moderate-sized FIN 48 reserves are more likely to participate in CAP than firms with either small or large reserves, indicating an inverted U-shaped relation between CAP participation rates and firms' tax reserves. After controlling for non-random sample selection, we find that CAP firms significantly reduce their FIN 48 reserves by about 16.5 percent relative to non-CAP firms. However, this reduction is concentrated among firms with moderate-sized FIN 48 reserves. These cross-sectional differences are consistent with FIN 48 reserves reflecting both tax uncertainty and tax aggressiveness. JEL Classifications: M41; M42; M48; H25. Data Availability: FIN 48 data and confidential tax data on CAP participants are obtained from the Internal Revenue Service (IRS) Large Business & International (LB&I), Planning, Analysis, Inventory, and Research Division (PAIR). The CAP data are not publicly available; the FIN 48 data were compiled and validated by the IRS and made available to one of the authors. All other data are available from public sources identified in this treatise. Because tax data are confidential and protected by data nondisclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with three or fewer observations are disclosed. Any opinions are those of the authors and do not necessarily reflect the views of the IRS.

Independent Component Analysis for Realized Volatility: Analysis of the Stock Market Crash of 2008

This paper investigates the factors that drove the U.S. equity market returns from 2007 through early 2010. The period was highlighted by volatile energy and commodity prices, the collapse of insurance and banking firms, extreme implied volatility and a subsequent rally in the overall market. To extract the driving factors, we decompose the returns of the S&P 500 sector ETFs into statistically independent signals using independent component analysis. We find that the generated factors have interesting financial interpretations and are consistent with the major economic themes of the period. We find that there are two sets of general market betas during the period along with a dominant factor for energy and materials sector. In addition, we find that the EGARCH model which accommodates asymmetric responses between returns and volatility can plausibly fit the high levels of variance during the crash. Finally, estimated correlations dropped when commodity prices moved higher, but then spiked when the S&P 500 crashed in late 2008.

Quantum-Like Tunnelling and Levels of Arbitrage

We apply methods of wave mechanics to financial modelling. We proceed by assigning a financial interpretation to wave numbers. This paper makes a plea for the use of the concept of 'tunnelling' (in the mathematical formalism of quantum mechanics) in the modelling of financial arbitrage. Financial arbitrage is a delicate concept to model in social science (i.e. in this case economics and finance) as its presence affects the precision of benchmark financial asset prices. In this paper, we attempt to show how 'tunnelling' can be used to positive effect in the modelling of arbitrage in a financial asset pricing context.

Model-independent bounds for option prices—a mass transport approach

In this paper we investigate model-independent bounds for exotic options written on a risky asset using infinite-dimensional linear programming methods. Based on arguments from the theory of Monge–Kantorovich mass transport, we establish a dual version of the problem that has a natural financial interpretation in terms of semi-static hedging. In particular we prove that there is no duality gap.

INFORMATIONALLY DYNAMIZED GAUSSIAN COPULA

In order to dynamize the static Gaussian copula model of portfolio credit risk, we introduce a model filtration made of a reference Brownian filtration progressively enlarged by the default times. This yields a multidimensional density model of default times, where, as opposed to the classical situation of the Cox model, the reference filtration is not immersed into the enlarged filtration. In mathematical terms this lack of immersion means that martingales in the reference filtration are not martingales in the enlarged filtration. From the point of view of financial interpretation this means default contagion, a good feature in the perspective of modeling counterparty wrong-way risk on credit derivatives. Computational tractability is ensured by invariance of multivariate Gaussian distributions through conditioning by some components, the ones corresponding to past defaults. Moreover the model is Markov in an augmented state-space including past default times. After a discussion of different notions of deltas, the model is applied to the valuation of counterparty risk on credit derivatives.

Do Publicly Disclosed Tax Reserves Tell Us About Privately Disclosed Tax Shelter Activity?

ABSTRACTWe examine whether public disclosures of tax reserves recently made available through Financial Interpretation No. 48 (FIN 48) reflect corporate tax shelter activities. Understanding this relation is important to corporate stakeholders and researchers keen to infer the aggressive nature of a firm's tax positions from its tax reserve accrual. Our study links public disclosures of tax reserves with mandatory private disclosures of tax shelter participation as made to the Internal Revenue Service's Office of Tax Shelter Analysis. We find strong, robust evidence that the tax reserve is positively associated with tax shelters, while other commonly used measures of tax avoidance are not. Based on out‐of‐sample tests, we also show that the reserve is a suitable summary measure for predicting tax shelters. The tax benefits of tax shelters are economically significant, accounting for up to 48% of the aggregate FIN 48 tax reserves in our sample.

Option Pricing with Anomalous Scaling and Infinite-State Switching Volatility

Volatility clustering, long-range dependence, non-Gaussianity and anomalous scaling are all well-known stylized facts of financial assets return dynamics. These elements have a relevant impact on the aptness of models for the pricing of options written on financial assets. We make us of a model developed in physics that captures the previously cited returns features. The model allows deriving closed form equations for option pricing. We present the model providing a financial interpretation of its components and discuss the parameters estimation. We then derive pricing equations and use them in an empirical application based on a major equity index option dataset.

Capital Allocation and Per-Unit Risk in Inhomogeneousand Stressed Credit Portfolios

This article considers the application of gradient allocation and portfolio optimization to credit portfolios. The assumption of linearity of risk that is implied by the use of gradient allocation is challenged in a setting of inhomogeneity and stress scenarios. To see the effects of mathematically derived portfolio optimization on real-life examples, we consider a number of insightful examples. This challenges mathematical results and enables a financial interpretation of the latter. The results reveal that per-unit risk is not disturbed by moderate inhomogeneity in most cases, whereas a change in portfolio composition as well as stress can influence the portfolio optimization decision significantly. The importance of incorporating sensitivity analysis and stress testing into reporting structures and optimization decisions is emphasized. <b>TOPICS:</b>Credit risk management, portfolio construction, simulations

The impact of GAAP guidance on asset retirement obligations

In this study, we assess issues faced by accountants in implementing Statement of Financial Accounting Standard (SFAS) 143, Accounting for Asset Retirement Obligations (AROs) and Financial Interpretation Number (FIN) 47, which was issued to clarify accounting for conditional AROs. The assessments were made by accountants of companies belonging to the Edison Electric Institute (EEI) since the EEI originally initiated the Financial Accounting Standards Boards’ (FASB’s) ARO agenda item. The findings suggest that SFAS 143 and FIN 47 have provided accountants with increased clarity for ARO identification and have resulted in more meaningful recognition. In addition, more liabilities are reported even though it can be argued that ceteris paribus management will choose the method that minimizes the amount of the liability. Overall, the findings suggest that the FASB’s guidance on asset retirement obligations improved the reporting model and their implementation guidance improved companies’ application of the rules.

The Usefulness of Income Tax Disclosures Under IFRS versus U.S. GAAP for Predicting Changes in Future Earnings and Cash Flows

We examine whether income tax disclosures under International Financial Reporting Standards (IFRS) are useful for predicting changes in future earnings and cash flows, and whether such disclosures are more or less useful than disclosures made under U.S. Generally Accepted Accounting Principles (GAAP). We find that the ranked ratio of taxable income (minus taxes)-to-net income (i.e., the tax-book ranking) is useful for predicting changes in future earnings and cash flows under both IFRS and U.S. GAAP. However, the usefulness of this ratio differs between IFRS firms and U.S. GAAP firms only following the adoption of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). This suggests that tax information is more useful for predicting future performance under IFRS than under U.S. GAAP, and that the usefulness of the tax-book ranking for predicting future performance was reduced for firms reporting under U.S. GAAP following the adoption of FIN 48. Finally, our results suggest that tax disclosures are useful for detecting differences in earnings quality across firms reporting under IFRS and U.S. GAAP.

Risk Implications of Increased Off-Balance Sheet Disclosure: The Case of FIN 46 and SOX

This study investigates the impact of increased disclosures required by Financial Accounting Standards Board (FASB) Financial Interpretation No. 46 (FIN 46) Consolidation of Variable Interest Entities and the Sarbanes-Oxley Act of 2002 (SOX). Our results indicate that the maximum risk disclosures required under FIN 46 were only marginally priced, although differences exist across type of VIE and whether the structure was ultimately consolidated. Further, while all firms experienced decreases in idiosyncratic risk around this time of increasing regulatory scrutiny and upon adoption of SOX, only the off-balance sheet disclosures required by FIN 46 appear to have significantly altered firm idiosyncratic risk beyond the general provisions of SOX. Our study has implications for accounting regulators determined to design effective investor protection regulation.

The Joint Distribution of Stock Returns is Not Elliptical

Using a large set of daily US and Japanese stock returns, we test in detail the relevance of Student models, and of more general elliptical models, for describing the joint distribution of returns. We find that while Student copulas provide a good approximation for strongly correlated pairs of stocks, systematic discrepancies appear as the linear correlation between stocks decreases, that rule out all elliptical models. Intuitively, the failure of elliptical models can be traced to the inadequacy of the assumption of a single volatility mode for all stocks. We suggest several ideas of methodological interest to efficiently visualize and compare different copulas. We identify the rescaled difference with the Gaussian copula and the central value of the copula as strongly discriminating observables. We insist on the need to shun away from formal choices of copulas with no financial interpretation.

THE JOINT DISTRIBUTION OF STOCK RETURNS IS NOT ELLIPTICAL

Using a large set of daily US and Japanese stock returns, we test in detail the relevance of Student models, and of more general elliptical models, for describing the joint distribution of returns. We find that while Student copulas provide a good approximation for strongly correlated pairs of stocks, systematic discrepancies appear as the linear correlation between stocks decreases, that rule out all elliptical models. Intuitively, the failure of elliptical models can be traced to the inadequacy of the assumption of a single volatility mode for all stocks. We suggest several ideas of methodological interest to efficiently visualise and compare different copulas. We identify the rescaled difference with the Gaussian copula and the central value of the copula as strongly discriminating observables. We insist on the need to shun away from formal choices of copulas with no financial interpretation.

Changes in accounting and auditing for consolidation of variable interest entities

AbstractIn 2009, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 167 (ASC 810), which broadens the number of entities that will consolidate formerly unconsolidated off‐balance‐sheet assets and liabilities and otherwise changes greatly the framework for consolidated financial statements. Many entities had used qualifying special purpose entities and other vehicles to prevent them from applying the consolidation provisions of Financial Interpretation No. 46 (Revised) (FIN 46(R)), Consolidation of Variable Interest Entities. This article summarizes the provisions of the new standard and provides examples of its application in order to help practitioners implement these provisions and provide guidance to companies and clients. © 2012 Wiley Periodicals, Inc.

Quadratic hedging in an incomplete market derived by an influential informed investor

This paper presents a model with an influential and informed investor. A hedging problem is studied from the point of view of a non-informed agent in an influenced and informed market. Her lack of information makes the market incomplete. Obtained results, by means of Malliavin calculus and Clark–Ocone formula, as well as filtering theory, are the expressions and a comparison between the strategy of the non-informed trader and the strategy of the informed agent. An expression of the residual risk a non-informed trader keeps by detaining an option in this influenced and informed market is derived using a quadratic approach of hedging in incomplete market. Finally, the analysis leads to a measure of the lack of information that makes the market incomplete. The financial interpretation is explained throughout the theoretical analysis, together with an example of such influenced informed model.

Profitability, Liquidity and Solvency of M/S Synergies Castings Ltd.:An Overview of Specific Financial Analysis and Interpretations

The Financial Management is not only arranging of funds but also planning, forecasting, raising and allocation of funds for the business. The financial analysis is largely a study on the relationship among the various financial factors of a company which are disclosed in its financial statements. The trend of such factors is shown in different forms of statements viz. comparative statements, common size statements, trend percentages and financial ratio. Synergies Casting Ltd. gained a brand name in the field of alloy manufacturers and allied products. This case study is an attempts to analyze its financial performance of Synergies Casting Ltd through financial analysis and interpretations.