Portfolio Payoffs Research Articles

The higher you fly, the harder you try not to fall: An analysis of the risk taking behavior in social trading

In this article, we study the risk taking behavior under convex incentives in an innovative online trading setting. In particular, we empirically analyze how an infinite investment horizon and valuable outside options affect risk taking behavior. We find that traders choose the absolute and relative risk of the trading strategy depending on the proximity to the high-water mark (HWM), which represents a series of remuneration options on the assets under management. As a consequence, we observe more risk mitigating behavior the closer the HWM comes. Next, we show that the traders behave strategically and make their risk decisions based on their overall portfolio payoff. Finally, we find that social status indicators such as rankings and communication abilities significantly affect the risk taking behavior.

How Do Minority Presidents Manage Multiparty Coalitions? Identifying and Analyzing the Payoffs to Coalition Parties in Presidential Systems

The preponderance of minority presidents in modern democracies has concentrated the attention of researchers on the multiparty coalitions that presidents form to govern in legislative assemblies. This analysis of “coalitional presidentialism” has focused almost exclusively on presidential systems in Latin America, and Brazil in particular. It has understood multiparty presidential coalitions as cabinet-level constructs, which bind the support of parties in legislatures through portfolio payoffs. In this article, we explore this analysis in a non-Latin American context: post-Soviet Ukraine. Using original quantitative and qualitative data, we find that portfolio payoffs are an important tool for managing Ukrainian coalitions. But we also find that minority presidents have relied systematically on the support of legislative parties outside of the cabinet and have used different payoffs to manage their support. Given that this complexity also exists in other new democracies, we argue that there is a need to distinguish between cabinet-level and floor-level coalitions in minority presidential systems.

Can We Count on Accounting Fundamentals for Industry Portfolio Allocation?

The authors examine out-of-sample industry excess return predictability and portfolio allocation using forecasting combination methods of industry-level and aggregate accruals, book-to-market, earnings, investments, and gross profits. Out-of-sample combination forecasts generate significant industry return predictability. Substantial increases in Sharpe ratios and utility gains demonstrate that predictability is not driven primarily by higher risk. Real-time portfolio allocation strategies rotate into long positions in industries with high expected returns and short industries with low expected returns. Over the past thirty years, outof-sample combination forecasts of accounting variables have generated value-weighted industry portfolio payoffs five times greater than a buy-and-hold benchmark. The constructed portfolios consistently beat a buy-and-hold benchmark portfolio two-to-one while generating alphas that exceed 10%.

Delivering Left-Skewed Portfolio Payoff Distributions in the Presence of Transaction Costs

For pension-savers, a low payoff is a financial disaster. Such investors will most likely prefer left-skewed payoff distributions over right-skewed payoff distributions. We explore how such distributions can be delivered. Cautious-relaxed utility measures are cautious in ensuring that payoffs don’t fall much below a reference value, but relaxed about exceeding it. We find that the payoff distribution delivered by a cautious-relaxed utility measure has appealing features which payoff distributions delivered by traditional utility functions don’t. In particular, cautious-relaxed distributions can have the mass concentrated on the left, hence be left-skewed. However, cautious-relaxed strategies prescribe frequent portfolio adjustments which may be expensive if transaction costs are charged. In contrast, more traditional strategies can be time-invariant. Thus we investigate the impact of transaction costs on the appeal of cautious-relaxed strategies. We find that relatively high transaction fees are required for the cautious-relaxed strategy to lose its appeal. This paper contributes to the literature which compares utility measures by the payoff distributions they produce and finds that a cautious-relaxed utility measure will deliver payoffs that many investors will prefer.

Specialized Human Capital, Unemployment Risk, and the Value Premium

To determine whether negative shocks to specialized human capital are priced in the cross section of stock returns, this study measures shocks to industry-specific human capital by employment growth in that industry. In industries in which employment contracts, exposure to the value factor is significantly higher than in industries in which employment expands. Cross-sectional predictive regressions and hedging portfolio returns document that stocks belonging to industries with low employment growth have higher expected returns than stocks belonging to industries with high employment growth. The return premium related to employment growth is pervasive across small, big, and micro stocks, as well as when micro stocks are excluded. The premium cannot be explained by the capital asset pricing model, but the hedging portfolio's payoffs are inversely related to that of the value-minus-growth risk factor.

Comoment risk and stock returns

We estimate investable comoment equity risk premiums for the US markets. The stock's contribution to the asymmetry and the fat tails of the market portfolio's payoff are priced into a coskewness premium and a cokurtosis premium. We construct zero-investment strategies that are long and short in coskewness and cokurtosis equity risks; we infer from the spread the returns attached to a unit exposure to US equity coskewness and cokurtosis. The coskewness and cokurtosis premiums present positive monthly average returns of 0.27% and 0.14% from January 1959 to December 2011. Comoment risks appear to be significantly priced within the US stock market and display significant explanatory power regarding the US size and book-to-market effects. The premiums do not subsume, but rather complement the empirical capital asset pricing model. Our analysis relies on data collected from CRSP (Chicago Research Center for Security Prices) over December 1955 to December 2011. To our knowledge, the paper is the first to propose investable higher-moment risk factors over such an extensive time period.

Identifying key players in the government-formation process: strong and dominant parties in Central and Eastern Europe

Coalition governments are the norm across Central and Eastern Europe (CEE). While a number of empirical studies have attempted to understand why certain governments form in the region there has, as yet, been no consideration of why certain parties emerge as the key players in the government-formation process. This paper uses two models to identify key actors in government formation in CEE: the dominant and central players model; and the portfolio allocation model. The results show that each of these models contributes significantly to our understanding of which parties are key actors in CEE. The key actors identified by each model are overwhelmingly likely to become members of the cabinet and provide the Prime Minister of the government. Key players are also more likely to accrue a greater share of portfolio payoffs from the coalition bargaining process as well as acquiring the most salient portfolios.

Measuring the Effectiveness of Static Hedging Strategies for a Guaranteed Minimum Income Benefit

A guaranteed minimum income benefit (GMIB) is a long-dated option that can be embedded in a deferred variable annuity. The GMIB is attractive because, for policyholders who plan to annuitize, it offers protection against poor market performance during the accumulation phase. This paper analyzes the effectiveness of static hedging strategies for the GMIB. Using Monte Carlo simulation, the effectiveness of a static hedging strategy is measured by the empirical hedging loss distribution, where each hedging loss is defined as the difference between the GMIB payoff and the hedging portfolio payoff at the maturity date. Hedging portfolios are constructed by minimizing the Conditional Tail Expectation of the hedging loss distribution or minimizing the mean-squared hedging loss. The positions in the hedging portfolio instruments are determined at the outset from solving either portfolio optimization problem and are held fixed until the maturity date. Our results suggest which instruments are most important to achieve the best results. We backtest the performance of static hedging strategies for the GMIB over the period 1961 to 2012.

Increases in risk aversion and the distribution of portfolio payoffs

Abstract Oliver Hart proved the impossibility of deriving general comparative static properties in portfolio weights. Instead, we derive new comparative statics for the distribution of payoffs: A is less risk averse than B iff Aʼs payoff is always distributed as Bʼs payoff plus a non-negative random variable plus conditional-mean-zero noise. If either agent has nonincreasing absolute risk aversion, the non-negative part can be chosen to be constant. The main result also holds in some incomplete markets with two assets or two-fund separation, and in multiple periods for a mixture of payoff distributions over time (but not at every point in time).

Increases in Risk Aversion and the Distribution of Portfolio Payoffs

Hart proved the difficulty of deriving general comparative statics in portfolio weights. Instead, we derive new comparative statics for the distribution of payoffs: A is less risk averse than B iff A’s payoff is always distributed as B’s payoff plus a non-negative random variable plus conditional-mean-zero noise. If either agent has nonincreasing absolute risk aversion, the non-negative part can be chosen to be constant. The main result also holds in some incomplete markets with two assets or two-fund separation, and in multiple periods for a mixture of payoff distributionsover time (but not at every point in time).

Does the More Risk‐Averse Investor hold a Less Risky Portfolio?*

ABSTRACTWe study the suitability of using absolute risk aversion as a measure of willingness to take risk in the Arrow–Debreu portfolio framework. We define a global measure of risk for the Arrow–Debreu portfolio, which is measured by the sensitivity of an individual's Arrow–Debreu portfolio payoff to the change in the market return. We call this measure ‘conservatism’ and show that the concept of ‘more conservative’ is stronger than that of ‘more risk‐averse.’ A higher absolute risk aversion is only necessary but not sufficient to induce a less risky Arrow–Debreu portfolio. Our results not only challenge the well‐accepted notion that a more risk‐averse investor holds a less risky portfolio, but also suggest a stronger measure – conservatism – for evaluating the riskiness of portfolio.

Approximated Portfolio Choice - Do We Dance on a Pinhead?

HARA-utility investors allocate their money to a risk-free fund and to a risky fund (two fund separation). The paper shows that under weak conditions, the risky fund can be approximated by the risky fund derived from exponential utility, without material effects on the certainty equivalent of the portfolio payoff. Also, effects of changes in asset return parameters on the risky fund can be approximated using the exponential utility function, thereby simplifying the analysis. The approximation is of high quality if extreme portfolio returns have a very small probability and if the investor's level of relative risk aversion exceeds 2.

Party Size and Portfolio Payoffs: The Proportional Allocation of Ministerial Posts in Coalition Governments

Over 30 years ago, Eric Browne and Mark Franklin demonstrated that parties in a coalition tend to receive portfolio payoffs in almost perfect proportionality to their seat share. Even though this result has been confirmed in several studies, few researchers have asked what the underlying mechanism is that explains why parties receive a proportional payoff. The aim of this paper is to investigate the causal mechanism linking party size and portfolio payoffs. To fulfil this aim, a small-n analysis is performed. By analysing the predictions from a statistical analysis of all post-war coalition governments in 14 Western European countries, two predicted cases are selected, the coalitions that formed after the 1976 Swedish election and the 1994 German election. In these case studies two hypotheses are evaluated: that the proportional distribution of ministerial posts is the result of a social norm, and that parties obtain payoffs according to their bargaining strength. The results give no support to the social norm hypothesis. Instead, it is suggested that proportionality serves as a bargaining convention for the actors involved, thus rendering proportional payoffs more likely.

Experience and the distribution of portfolio payoffs in the European Commission

Abstract. This article tests four theories of portfolio distribution within the European Commission and assesses whether experience plays a role in the process of allocating policy responsibilities. The share of portfolios that each Member State is assigned, through its Commissioners, is strongly related to its resources and voting power, as predicted by the proportionality norm and bargaining theory, respectively. Additionally, Member States with Commissioners that have experience in the relevant portfolios are assigned shares that are significantly above what one may expect from these two theories. For half of the portfolios, Commissioners have moderate views along the dimension of the policy they manage, but appointed Commissioners also have significantly more experience in both supranational portfolios and similar national portfolios than the median Commissioner. The difference in experience in supranational and, more weakly, national portfolios significantly accounts for the difference in preference between the appointed and the median Commissioner. Finally, salience matters as well. Left/right leaning Commissioners are significantly more likely to be assigned portfolios with a left‐wing/right‐wing ideological profile, but this strong relation disappears for Commissioners with above average experience in the Commission, in the relevant supranational portfolios or in national governments.

A Note on Risk Aversion, Prudence and Portfolio Insurance

This paper examines some properties of optimal portfolio positioning that are linked with the risk aversion and the prudence of the investor. It introduces the ratio of the degree of absolute prudence on the absolute risk aversion. This one allows the analysis of the degree of convexity/concavity of the optimal portfolio payoff. The role of the prudence is also analyzed.

Risk, Reward and Asset Pricing

We construct two classes of risk-reward measures - one by generalizing the mean-variance model of Markowitz (1952), and the other by generalizing the gain-loss model of Bernardo & Ledoit (2000) - and develop, for these economies, the following: (i) a CAPM-like relative pricing equation; (ii) an analytical expression for the associated stochastic discount factor (pricing kernel) as a (generally) nonlinear function of the market excess return; (iii) explicit analytical solutions in the complete markets case for optimal portfolios, and the maximum possible reward-to-risk ratio (akin to the Sharpe ratio), as functions of the economy's complete markets discount factor; (iv) an equivalent non-Expected Utility Theory (non-EUT) value function, and (v) a simplified market factor model along the lines of Sharpe (1963). Multifactor extensions, and econometric considerations, are also taken up. It is argued that the generalized Markowitz model has the potential to outperform the Sharpe-Lintner CAPM, and to capture segmentation in asset markets via its variable risk proxy. The generalized Bernardo-Ledoit model's non-EUT value function is shown, in the appropriate parameter regime, to reduce to the S-shaped value function of a loss-averse investor (Prospect Theory, Kahneman and Tversky, 1979). It is further shown that a loss-averse representative agent's optimal zero-cost portfolio payoff (excess return) in a complete markets setting is strictly positive in all future states of nature except one, where it is strictly negative. The asymmetry in positive and negative state-specific payoffs is found to decrease as the market becomes more incomplete. Our CAPM-like models are in a sufficient state of development to be tested directly against market data.

Does the More Risk-Averse Investor Hold a Less Risky Portfolio?

We study the suitability of using absolute risk aversion as a measure of willingness to take risk in the Arrow–Debreu portfolio framework. We define a global measure of risk for the Arrow–Debreu portfolio, which is measured by the sensitivity of an individual's Arrow–Debreu portfolio payoff to the change in the market return. We call this measure ‘conservatism’ and show that the concept of ‘more conservative’ is stronger than that of ‘more risk-averse.’ A higher absolute risk aversion is only necessary but not sufficient to induce a less risky Arrow–Debreu portfolio. Our results not only challenge the well-accepted notion that a more risk-averse investor holds a less risky portfolio, but also suggest a stronger measure – conservatism – for evaluating the riskiness of portfolio.

On different aspects of portfolio optimization

Different aspects for the portfolio optimization (PO) problem are considered. The first aspect is multi-objective optimization. The second is dynamical re-balancing. The third is the evolutionary game aspect (Pioneered by Hens and Schenk-Hoppe [T. Hens, Schenk-Hoppe, Evolutionary stability of portfolio rules in incomplete market, J. Math. Econ. 41 (2005) 43–66].) since portfolio payoff depends not only on the investor’s strategy but also on the other investors’ strategies. We argue that both the different aspects included in the PO study and the basic assumptions made, significantly affect the outcome of the result For example the stochastic effects of mistakes and the change in players numbers are expected to change the results of Hens and Schenk-Hoppe.

On the Time Dimension of Investing

This paper explores how to structure choices for personal investment accounts that have a well-defined set of target dates. Key examples are investing for retirement or for a child's college education. We show that if the investor's objective is to minimize the ex ante cost of hitting specific targets at specific dates, the optimal portfolio strategy is to match the portfolio's payoffs to the time profile of those targets and not take any risk. Therefore to accommodate risk-averse investors with diverse time horizons, financial institutions ought to provide their clients with a term structure of risk-free investments to serve as clear points of reference. In structuring choices with different degrees of risk and reward, an important set of reference points is a term structure of exchange-traded index options and the corresponding set of implied volatilities. In framing the time dimension in this fashion, one avoids the need for explicit forecasts of the term structure of equity risk premia, which are notoriously difficult to forecast. Our approach is not vulnerable to the potential biases inherent in the use of historical time series, such as survivorship bias. Our approach and the mean-variance efficient frontier approach should be seen as complements rather than as substitutes. We view ours as a natural first step in structuring the time dimension of investment choice in personal investment accounts. Subsequent steps should include econometric modeling and some kind of tailoring to the preferences and circumstances of the end user.

Exploring Long-Run Abnormal Performance using Stochastic Dominance Criteria: Additional Evidence from IPOs

We re-visit long-run performance after IPOs using a model-free stochastic dominance approach that allows us to compare the empirical distribution of portfolio payoffs while incorporating assumptions about investors' preferences. Our main results are as follows. First, we find that investors, who prefer more wealth to less, are indifferent between an IPO firm portfolio and commonly used benchmark portfolios. Second, we find little evidence that risk-averse investors prefer small size and low book-to-market benchmark portfolios to an IPO portfolio. We conclude that, In the case of IPOs at least, the question of abnormal underperformance may remain unresolved empirically, even with better statistical methods and a well-specified asset pricing model, due to the latitude available in the ex ante choice of a benchmark to compare relative performance.