Investor's Utility Research Articles

Investor behavior and filter rule revisiting

The filter rule is a popular investment strategy, but its effectiveness and rationality are still controversial. We consider the process of the maximum stock price and the short loss aversion in the utility function and establish an optimal stopping time model. Our model describes the decision-making process of investors applying the filter rule strategy. The filter size of our model is dynamic and depends both on the characteristics of the price process and the investor utility function. A series of numerical simulations present the optimal times to sell the stock under different situations. We also conduct empirical analyses on the Shanghai Stock Exchange Index and the S&P 500 Index, and prove that the filter rule is effective.

Earnings management and investor reaction

The purpose of the article is to investigate the contraction between the behavior of managers and investors toward Iran's capital market and the focus on agency theory which ends up with the conflict between the utilities of manages and investors because a conflict of interest implies an attempt to spread opportunistic behavior. In the current study, the benefit of reducing capital cost (manager's utility) and return on assets (investor's utility) are considered variables of interest of either party, in that Osborne's game theory was used in a two-step manner. The study population consisted of the companies listed on the Tehran Stock Exchange and Iran Over-the-Counter Market, classified in the game table according to managers' behavior toward high or low earnings management and investor's behavior toward acceptance non-acceptance of stock. The experimental results presented in this paper uphold the agency theory, indicating a conflict between managers and investors in Iran's capital market, particularly in the Tehran Stock Exchange. According to game theory, Nash's dominant equilibrium comes to the fore when dealing with the manager's low earnings management and investor's choice of strategy to accept a share in Iran's capital market and Tehran Stock Exchange. Alternatively, the presentation of transparent financial statements and the acceptance of such a company stock can maximize parties' utilities.

Optimal investment strategy to maximize the expected utility of an insurance company under Cramer-Lundberg dynamic

In this work, we examine the combined problem of optimal portfolio selection rules for an insurer in a continuous time model where the surplus of an insurance company is modelled as a compound Poisson process. The company can invest its surplus in a risk free asset and in a risky asset, governed by the Black-Scholes equation. According to utility theory, in a financial market where investors are facing uncertainty, an investor is not concerned with wealth maximization per se but with utility maximization. It is therefore possible to introduce an increasing and concave utility function $\phi(x,t)$ representing the expected utility of a risk averse investor (insurance company). Therefore, the goal of this work is not anymore to maximize the expected portfolio value or minimize the ruin probability or maximizing the expectation of the present value of all dividends paid to the shareholders up to the ruin, but to maximize the expected utility stemming from the wealth during the life contract [0,T]. In this direction, using the Dynamic Programming Principle of the problem, we obtain the Hamilton-Jacobi-Bellman equation by our optimization problem (HJB). Finally, we present numerical solutions in some cases, obtaining as optimal strategy the well known Merton's strategy.

Design & Pricing of Islamic Asset-Based S. ukuk¯ Strips: An Endeavour towards Financial Development

Purpose: The efficiency of the Islamic Financial Industry suffers from a lack of liquidity instruments and shallow secondary markets. This paper reviews the financial intermediation theory and the complementary role of debt and money markets towards the broader goal of allocative efficiency, asset transformation, and diversification for the welfare of all economic agents. Separately Tradable Registered Interest & Principle (STRIPs), created by disintegrating coupon and principal payment to be traded as discount bonds, have been effectively employed in the west for liquidity management. This paper proposes a novel idea of ij¯arah s.uk¯uk STRIPS (ISS) that splits the payoffs of ij¯arah s.uk¯uk. Method: The design and pricing of ISS are modeled employing lease valuation, certainty equivalent (C.E.), and bootstrapping. Instead of the prevalent capital asset-pricing model, volatility of ij¯arah s.uk¯uk payoffs is modeled using certainty equivalents, which extend the analysis to micro-level investor utility function. Also, the viability of ISS design is substantiated by numerical illustrations. Findings: We found that the proposed ISS can serve as a short-term liquidity management instrument, facilitate price discovery and define the term structure in Islamic debt markets. For sovereign issues, ISS can enable efficient monetary policy transmission, market completeness, and public finances for the underdeveloped Muslim world. Significance: To the best of our knowledge, this is the first study proposing the ISS as a financial innovation. The ISS proposed in this study will be a valuable addition to the arsenal of Islamic Financial offerings - augmenting the financial deepening and development of Islamic Financial Markets.

Bubbles and dependence between international equity markets

In this study, we develop a copula-based Markov regime-switching model using information contained in asset price bubbles to explore the dynamic dependence between international equity markets. This is motivated by previous evidence that financial crises are often accompanied by the booms and busts of asset price bubbles, thus bubbles contain useful information on systematic risk. Using daily data from 1995 to 2019 for the US and 11 European countries, we show that the bubble indicator constructed from the MSCI index exhibits a significant impact on the dependence structure between international stock markets. Furthermore, the dependence generated by our model leads to a higher Sharpe ratio for a mean-variance utility investor in an asset allocation exercise than that without the bubble index. Thus asset price bubbles are highly relevant to the study of dependence in both statistical and economic terms.

Can Market Regimes Really be Timed with Historical Volatility?

Recent research findings suggest long-term investor utility benefits through scaling expected returns by recent realized volatility. We test for utility gains to volatility timing using a utility regime-based methodology to classify investor-specific market investment regimes based solely on recent realized volatility levels. Under this framework we find limited informational content in using recent realized volatility to forecast utility regimes for the market index. To reconcile our findings we replicate work by Moreira and Muir (2017) and find that their reported Sharpe ratio gains through volatility-managing the US market factor do not appear to be statistically significant. We find that their scheme under-performs buy and hold in terms of Sharpe ratio over 30 of the 70 twenty year sub-periods in our sample (58 out of 70 for an un-leveraged investor). Furthermore, the historical out-performance of volatility management for the market index is highly sensitive to the timing of re-balancing within a month, suggesting that the strategy may not be robust to the precise timing of key market events relative to volatility changes. Strategy adopters should be aware that this timing is not guaranteed to line up favorably over future investment periods.

Bond indifference prices

In a market with stochastic interest rates, we consider an investor who can either (i) invest all of his wealth in a money market account or (ii) purchase zero-coupon bonds and invest the remainder of his wealth in the money market account. The indifference price of the zero-coupon bond is the price at which the investor could achieve the same expected utility under both strategies. In an affine term structure setting, we show that the indifference price of the zero-coupon bond is the root of an integral equation, when the investor's utility function is of exponential or power form. As an example, we compute the indifference price and the corresponding indifference yield curve in the Vasicek model and conduct sensitivity analysis to study the impact of various parameters on the yield curve. Furthermore, we discuss the choice of numéraire and its impact on the indifference prices.

Style-changing behaviour in the socially responsible mutual fund industry: consequences on financial and sustainable performance

PurposeThis study aims to examine style-deviation practices in the socially responsible mutual funds (SMRF) industry i.e. how mutual funds game their stated financial objectives to earn a higher relative performance ranking. In addition, the consequences of such practices on sustainable scores and money flows are studied.Design/methodology/approachA sample of 454 US equity SRMFs is studied. This paper uses panel regressions controlling for time and style fixed-effects.FindingsThis study finds that 17.60% of SRMF managers in the sample are engaged in style deviation practices. These practices positively impact the sustainable performance of SRMFs and negatively impact their financial performance. One effect offsets the other and they consequently do not affect money flows. Another finding is that only investors with lower portfolio sustainability scores do show return-chaser behaviour.Practical implicationsThis paper reveals that SRMF managers deviating from their stated financial style face a dilemma that is non-existent for their conventional peers that is style deviation practices affect financial and sustainable performance in opposing ways, whereas SRMF investor utility depends positively on both dimensions. The findings are not conclusive about the effectiveness of style deviation practices in attracting SRMF money flows.Social implicationsSRMF industry has experienced tremendous growth in the past decade. The increased competition in this industry has led managers to strive to attract investors, sometimes by relying on irregular practices that enhance their portfolio results. Regulators should consider how to avoid such perverse behaviour with a view to improving mutual funds transparency.Originality/valueThis is the first research that analyses style deviation practices and their consequences for the SRMF industry.

A portfolio strategy of stock market based on mean-MF-X-DMA model

In this study, the multifractal detrended moving-average cross-correlation analysis (MF-X-DMA) is combined with the Mean-Semi-Variance model to establish a Mean-MF-X-DMA model. This model is used to construct portfolio strategies by the stocks with the larger market value in each sector of the Standard and Poor's 500 Index (S&P 500). The empirical test shows that: firstly, there are long memory and obvious multifractal characteristics in each stock returns; secondly, the portfolio strategy based on Mean-MF-X-DMA model performs better than the traditional portfolio model, such as returns, Sharpe ratio, βcoefficient and utility for different risk preference investors; finally, the risk will be lower when the time scale is smaller under the same expected returns.

Optimal Portfolio Selection With VaR and Portfolio Insurance Constraints Under Rank-Dependent Expected Utility Theory

This paper investigates two optimal portfolio selection problems for a rank-dependent utility investor who needs to manage his risk exposure: one with a single Value-at-Risk (VaR) constraint and the other with joint VaR and portfolio insurance constraints. The two models generalize existing models under expected utility theory and behavioral theory. To obtain explicit optimal solutions, the martingale method, quantile formulation, and relaxation method are used. We have specifically identified an equivalent condition under which the VaR constraint is effective. A numerical analysis is carried out to demonstrate theoretical results, and additional financial insights are presented. We find that, in bad market states, the risk of the optimal investment outcome is reduced when compared to existing models without or with one constraint.

Bond Indifference Prices

In a market with stochastic interest rates, we consider an investor who can either (i) invest all of his wealth in a money market account or (ii) purchase zero-coupon bonds and invest the remainder of his wealth in the money market account. The indifference price of the zero-coupon bond is the price at which the investor could achieve the same expected utility under both strategies. In an affine term structure setting, we show that the indifference price of the zero-coupon bond is the root of an integral equation, when the investor's utility function is of exponential or power form. As an example, we compute the indifference price and the corresponding indifference yield curve in the Vasicek model and conduct sensitivity analysis to study the impact of various parameters on the yield curve. Furthermore, we discuss the choice of numeraire and its impact on the indifference prices.

Broker routing decisions in limit order markets

I model investors who are only able to access equity markets through a broker. These brokers have an incentive to route based on the fees charged by exchanges, rather than on execution quality for their clients. This conflict of interest reduces investor utility, as they must pay higher commissions to have orders sent to exchanges with the best market quality. I show that regulators may be able to improve investor utility by allowing investors to self-direct order flow.

Benefits and costs of a utility-ownership business model for residential rooftop solar photovoltaics

The rapid growth of rooftop solar photovoltaic systems can pose a number of financial challenges for electric utility shareholders and their customers. One potential pathway to resolving these perceived challenges involves allowing utilities to own and operate rooftop solar systems. However, the financial benefits and costs of this business model are not well understood. Here we model the financial performance of a large-scale utility-owned residential rooftop solar programme. Over a 20 yr period, the programme increases shareholder earnings by 2–5% relative to a no-solar scenario, compared to a 2% earnings loss when an equivalent amount of rooftop solar is instead owned by non-utility parties. Such a programme could therefore be attractive from the perspective of utility investors. The impacts on utility customers, however, are more mixed, with average bills of non-solar customers increasing by 1–3% compared to the no-solar scenario, similar to the 2% increase under traditional, non-utility-ownership structures. Utility ownership of rooftop solar can potentially align utility financial interests with solar photovoltaic uptake, but the economic implications are not well understood. Now, G. Barbose and A. Satchwell evaluate the potential benefits of this model for utility shareholders and customers and show viability.

A comparison of non-Gaussian VaR estimation and portfolio construction techniques

Abstract We propose a multivariate model of returns that accounts for four of the stylised facts of financial data: heavy tails, skew, volatility clustering, and asymmetric dependence with the aim of improving the accuracy of risk estimates and increasing out-of-sample utility of investors’ portfolios. We accommodate volatility clustering, the generalised Pareto distribution to capture heavy tails and skew, and the skewed-t copula to provide for asymmetric dependence. The proposed approach produces more accurate VaR estimates than seven competing approaches across eight data sets encompassing five asset classes. We show that this produces portfolios with higher utility, and lower downside risk than alternative approaches including mean–variance. We confirm that investors can substantially increase utility by accounting for departures from normality.

Understanding Volatility-Managed Portfolios

Contrary to the intuition that the standard risk-return tradeoff should lead to underperformance of a portfolio that scales down exposure during volatile periods a recent paper by Moreira and Muir (2017) actually shows that volatility-managed portfolios produce robust and significant alphas. The present paper investigates the mechanisms that lead to the outperformance of volatility management. By implementing timing regressions and relating returns of a volatility-managed portfolio to discount-rate, cash-flow and expected volatility news we provide evidence that volatility management outperforms by levering up good times without increasing downside exposure to fundamental risk drivers. On the contrary, during the most severe cumulative news shocks (either to cash flows, discount rates or expected volatility) the scaling strategy suffers less than the buy-and-hold portfolio and, thus, increases investor utility. Furthermore, we relate volatility-managed strategies to popular timing strategies based on a measure of risk-neutral variance as a lower bound for the expected equity risk premium. We find that strategies that combine elements from both, volatility management and timing based on risk-neutral variance, outperform over a recent sample period and produce significant alphas in spanning regressions, posing further puzzles for the asset pricing literature.

Optimal consumption and portfolio decision with stochastic covariance in incomplete markets

Abstract This paper investigates finite and infinite horizon optimal consumption and portfolio choice problems in incomplete markets with stochastic covariance among stock returns. The stock price dynamics are assumed to follow a multivariate stochastic volatility process. The Hamilton-Jacobi-Bellman (HJB) equation is derived by using dynamic programming method and the closed-form expressions for portfolio–consumption strategies are derived in the case of logarithmic utility. In the case of infinite time horizon, we prove the existence of a classical solution and provide a verification theorem. The closed form approximate solutions to the optimal consumption and portfolio polices for a power utility investor are obtained by solving the same utility maximization problem in two fictitious complete markets. Moreover, we verify the existence and optimality of the solution of the original incomplete market and also provide the upper bound of the utility loss of approximate rules. Finally, a numerical application to an incomplete market with stochastic factors show that the utility loss of the approximation rules is small and the performance of the approximate rules is close to optimal.

A macroeconomic hedge portfolio and the cross section of stock returns

AbstractWe use a stock's returns on days when important macroeconomic news is released to form a hedge portfolio, which is long (short) in stocks which have a sensitive (insensitive) reaction to the surprise component of the macroeconomic news. This macroeconomic hedge portfolio (MHP) earns a risk premium of about 5% p.a. over time and a similar premium when used as a risk factor in an asset pricing model. This premium can be interpreted as a cost of an insurance against unexpected changes in an investor's marginal utility. We show that risk premiums associated with the MHP are estimated with a higher precision than traditional macroeconomic tracking portfolios. Furthermore, when the MHP is present in a common factor model, risk factors like high minus low lose much of their ability to explain the cross section of stock returns.

A Risk-based Theory of Exchange Rate Stabilization

We develop a novel, risk-based theory of the effects of exchange rate stabilization. In our model, the choice of exchange rate regime allows policymakers to make their currency, and by extension, the firms in their country, a safer investment for international investors. Policies that induce a country's currency to appreciate when the marginal utility of international investors is high lower the required rate of return on the country's currency and increase the world-market value of domestic firms. Applying this logic to exchange rate stabilizations, we find a small economy stabilizing its bilateral exchange rate relative to a larger economy can increase domestic capital accumulation, domestic wages, and even its share in world wealth. In the absence of policy coordination, small countries optimally choose to stabilize their exchange rates relative to the currency of the largest economy in the world, which endogenously emerges as the world's “anchor currency.” Larger economies instead optimally choose to oat their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.

Macroeconomic forecasts and commodity futures volatility

We examine the impact of macroeconomic expectations on the volatility of Chinese commodity futures. As commodity futures are forward-looking, we expect them to be influenced by market expectations of the future economic situation, which we capture using a data set of professional macroeconomic forecasts. We analyze 15 commodity futures contracts using a GARCH-MIDAS model that contains daily price volatility and monthly macroeconomic forecasts. We find that the volatility of commodity futures is impacted more strongly by macroeconomic forecasts than by concurrent economic conditions. Furthermore, augmenting the volatility model with the macroeconomic forecasts improves the model ability to predict future volatility. These volatility predictions also offer economic gains to a mean-variance utility investor in a portfolio setting. Finally, the impact of macroeconomic forecasts is dependent on the state of the economy.

Optimal Convergence Trading for Cross-listed Stocks

With the intention of maximizing an investor's terminal utility, we construct a non-threshold ased trading model within which the optimal trading weights for daily rebalancing are derived analytically via stochastic optimal control. Having released the constraint that the cointegrating vector is equal to one, we propose a more practical trading strategy that applies to a much wider range of categories of cointegrated assets. We explore extensive out-of-the-sample experiments on the cross-listed stock portfolios, facilitating comparative studies among Chinese and European, UK and US stock markets. We further test the time-delay arbitrage of the strategy using the cross-listed stocks by employing two parallel trading mechanisms, respectively equity-based contracts for difference (CFD) and real shares trading. Our empirical results illustrate that the time-delay arbitrage of the cross-listed stocks strategy based on the analytical solution of weights yields relatively stable and better performance than that of the home market index. Our research is instructive for the practitioner's trading decision in cross-listed stocks and other kinds of convergence investment.