Return Trade-off Research Articles

The Term Structure of the Risk–Return Trade-Off

Expected excess returns on bonds and stocks, real interest rates, and risk shift over time in predictable ways. Furthermore, these shifts tend to persist for long periods. Changes in investment opportunities can alter the risk–return trade-off of bonds, stocks, and cash across investment horizons, thus creating a “term structure” of the risk–return trade-off. This term structure can be extracted from a parsimonious model of return dynamics, as is illustrated with data from the U.S. stock and bond markets.

Enhancing Agriculture?s Potential to Sequester Carbon: A Framework to Estimate Incentive Levels for Reduced Tillage

The objectives of this study are to develop and test a framework to estimate the cost of enhancing agriculture’s potential as a carbon sink through the implementation of reduced tillage productive systems. A major factor inhibiting the adoption of reduced tillage practices is the additional risk perceived by farmers and its effect on net revenues. The expected utility model provides a useful means for evaluating risk–return tradeoffs of agricultural production systems. Incentive levels required to induce implementation of reduced tillage practices are calculated using estimated certainty equivalents. The framework developed is applied to eight case studies across the United States. Results indicate that in the Corn Belt, the required incentive payment for corn/soybeans would have to be $10.20 and $8.30 per acre for poorly drained and well-drained soils, respectively. Continuous corn incentive payments for poorly drained soils were found to be $40.40 and $26.70 for well-drained soils. In the central Great Plains, an incentive level of $14.60 per acre was required for continuous sorghum. Although the mean yields for conventional and reduced tillage practices are fairly close in this case, the higher costs associated with no-till sorghum result in the high incentive level. In the wheat/fallow and wheat/sorghum/fallow rotations of the western Great Plains, the yields associated with no-till were higher than intensive till. Thus, incentive levels near $6.00 per acre are the result of higher costs of no-till in these rotations. In the Mississippi River Corridor region, results show that the switch from corn/soybean to the same no-till rotation would require an incentive level of $7.90 per acre.

Conducting Business in Eastern Europe:: Risk–Return Perspectives of Senior Financial Executives

Ten years ago we published an article that documented the views of chief financial officers about doing business in Eastern Europe. Since then there has been progress toward economic stabilization and the development of market economies in the region. These changes and other significant events in the last decade have affected the conduct of business in Eastern Europe. In this present paper, we update the findings of our earlier study and add new perspectives. A mail survey targeting senior US financial executives and follow up interviews were utilized. It appears the risk–return tradeoff for US firms of investment in Eastern Europe has changed. The classic tradeoff now seems to exist in product and service markets: for a variety of reasons risk is perceived to be lower than a decade ago, but so are returns. However, the same does not appear to hold true for financial markets in Eastern Europe where financial executives still perceive market inefficiencies and ineffectiveness. EU accession and adoption of the Euro by Eastern European countries are viewed very positively by US financial executives, and these events may serve to improve the functioning of financial markets there as well.

Dynamic derivative strategies

We study optimal investment strategies given investor access not only to bond and stock markets but also to the derivatives market. The problem is solved in closed form. Derivatives extend the risk and return tradeoffs associated with stochastic volatility and price jumps. As a means of exposure to volatility risk, derivatives enable non-myopic investors to exploit the time-varying opportunity set; and as a means of exposure to jump risk, they enable investors to disentangle the simultaneous exposure to diffusive and jump risks in the stock market. Calibrating to the S&P 500 index and options markets, we find sizable portfolio improvement from derivatives investing.

Multi–objective Evolutionary Algorithms for the Risk–return Trade–off in Bank Loan Management

Multi–criteria decision–making is an increasingly accepted tool for decision–making in management. In this work, we highlight the application of a novel multi–objective evolutionary algorithm, NSGA–II, to the risk–return trade–off for a bank–loan portfolio manager. The manager of a bank operating in a competitive environment faces the standard goal of maximizing shareholder wealth. Specifically, this attempts to maximize the net worth of the bank, which in turn involves maximizing the net interest margin of the bank (among other factors, such as non–interest income). At the same time, there are significant regulatory constraints placed on the bank, such as the maintenance of adequate capital, interest–rate risk exposure, etc. The genetic algorithm–based technique used here obtains an approximation to the set of Pareto–optimal solutions which increases the decision flexibility available to the bank manager, and provides a visualization tool for one of the trade–offs involved. The algorithm is also computationally efficient and is contrasted with a traditional multi–objective function — the epsilon–constraint method.

The monetary appreciation of paintings: from realism to Magritte

This study investigates how investments in painted arts compare to those in stocks in terms of risk return trade off using Sharpe and Treynor ratios and Markowitz efficient frontiers. A large database was analysed consisting of more than 10500 auction prices of Belgian painted art over the period 1970-1997. Hedonic art returns are influenced by auction location and auction house, current of art, painters’ reputation, medium, signature and painting size. Surrealism and luminism were the most popular currents of art (in monetary terms), while expressionism and symbolism gained (financial) esteem. This study concludes that art investments underperform equity market investments due to high riskiness, transaction costs, capital gains, resale rights, and insurance premia. In addition, the Markowitz efficient frontier shows limited diversification potential for art.

Viability of infeasible portfolio selection problems: A fuzzy approach

This paper deals with fuzzy optimization schemes for managing a portfolio in the framework of risk–return trade-off. Different models coexist to select the best portfolio according to their respective objective functions and many of them are linearly constrained. We are concerned with the infeasible instances of such models. This infeasibility, usually provoked by the conflict between the desired return and the diversification requirements proposed by the investor, can be satisfactorily avoided by using fuzzy linear programming techniques. We propose an algorithm to repair infeasibility and we illustrate its performance on a numerical example.

Dynamic Derivative Strategies

This paper studies the optimal investment strategy of an investor who can access not only the bond and the stock markets, but also the derivatives market. We consider the investment situation where, in addition to the usual diffusive price shocks, the stock market experiences sudden price jumps and stochastic volatility. The dynamic portfolio problem involving derivatives is solved in closed-form. Our results show that derivatives are important in providing access to the risk and return tradeoffs associated with the volatility and jump risks. Moreover, as a vehicle to the volatility risk, derivatives are used by non-myopic investors to exploit the time-varying opportunity set; and as a vehicle to the jump risk, derivatives are used by investors to disentangle their simultaneous exposure to the diffusive and jump risks in the stock market. In addition, derivatives investing also affects investors' stock position because of the interaction between the two markets. Finally, calibrating our model to the S&P 500 index and options markets, we find sizable portfolio improvement for taking advantage of derivatives.

Owner-Occupied Housing and the Composition of the Household Portfolio

For most homeowners, the house is the single most important consumption good appearing as an argument of the utility function, and, at the same time, the dominant asset in the portfolio. This paper uses a mean-variance efficiency framework to examine the household’s optimal portfolio problem when owner-occupied housing is included in the list of available assets. Housing differs from stocks and bonds in a crucial way: since the household’s ownership of residential real estate determines the level of its consumption of housing services, the household’s demand for real estate is “overdetermined” in the sense that the level of real estate ownership which is optimal from the point of view of the consumption of housing services may differ from the optimal level of housing assets from a portfolio point of view. With rental markets for housing, a household can, in principle, divorce the size of its holdings of real estate assets from the level of housing services it consumes. However, rental housing is by no means a perfect substitute for owner-occupied housing. We assume, instead, that the preferential tax treatment of owner-occupied housing and the transactions costs and agency costs involved in the rental market for housing create frictions large enough to effectively constrain the household to include in its asset portfolio the level of housing consistent with its consumption of housing services. The paper focuses on the impact of the portfolio constraint imposed by the consumption demand for housing on the household’s optimal holdings of financial assets. Section II of the paper is similar in spirit to a recent paper by Jan K. Brueckner (1997), which analyzes the interaction between the consumption demand and the investment demand for housing in a mean-variance portfolio model. Brueckner considers a general covariance matrix and mean vector of returns and a general utility function, and derives analytical results. In contrast, our implementation of the meanvariance framework is quantitative. That is, we estimate the covariance matrix and vector of expected returns for housing and financial assets and solve for the efficient frontiers and optimal portfolios numerically. The risk characteristics of housing are estimated using two distinct sources: data from the Panel Study of Income Dynamics (PSID) and data from Karl E. Case and Robert J. Shiller (1989) based on repeat sales transactions prices for four U.S. cities. Both data sources indicate that housing prices have a large idiosyncratic component; the standard deviation of the return to housing, at the level of the individual house, is about 0.14. In addition to housing, the portfolio can include nonnegative amounts of Treasury bills, Treasury bonds, and stocks. The household can borrow only in the form of a mortgage, which is limited to 100 percent of the value of the house. Using the estimated vector of expected returns and covariance matrix of asset returns, we plot the constrained meanvariance efficient frontiers for various values of the household’s ratio of house value to wealth, h (the “housing constraint”). The housing constraint has an enormous effect on the risk and return trade-off available to the household. Young households, which typically have large holdings of real estate relative to their net worth, are highly leveraged and therefore forced into a situation of high risk (and return). As a result, these young households have a strong incentive to reduce the risk of their portfolio by using their net worth to either pay down their * Flavin: Department of Economics, University of California, San Diego, CA 92093, and National Bureau of Economic Research (e-mail: mflavin@ucsd.edu); Yamashita: Department of Economics, University of Nevada, Las Vegas, NV 89154 (e-mail: tyamashi@ccmail.nevada.edu). We thank Elena Bisagni, Jan Brueckner, Wouter den Haan, James Hamilton, Bruce Lehmann, Greg Mankiw, and the referees for comments, and Robert Shiller for providing the house price transactions data. 1 The implications of the dual role of housing (as both a consumption good and an investment good) for tenure decisions of households were first analyzed by J. Vernon Henderson and Yannis M. Ioannides (1983).

Diversification in the Presence of Taxes

A common problem for taxable investors is how much to diversify either a low cost basis single–asset or concentrated portfolio. While tax–exempt theory is clear on the benefits of diversification, and there are useful industry methods for addressing this, in the presence of taxes there are no standard approaches to arriving at a considered choice. The authors propose an analytic and intuitive framework for addressing the problem, considering only two investment alternatives. By defining a tax–deferred equivalent of the taxable investor, they are able to adapt standard analytical methods and view the diversification decision in the presence of taxes as a conventional risk–return trade–off, provided the appropriate tax–deferred performance measures are used. Greater diversification is needed with greater initial asset volatility, with longer investment horizons, with lower expected return of the initial asset, and with a higher cost basis. Less diversification is needed when the investor receives a step–up in basis at the horizon. The results highlight the substantial risks incurred in concentrated holdings and often support high levels of diversification, even in the face of taxes.

On Taking the “Alternative” Route

The risk–return characteristics, risk exposures, and performance persistence of various hedge fund strategies remains an area of interest to alternative asset investors. Using a database on hedge fund indices and individual hedge fund managers in a mean–variance framework, results show that a combination of alternative investments and passive indexing provides a significantly better risk–return tradeoff than passively investing in the different asset classes. Moreover, using parametric and non–parametric methods, a reasonable degree of persistence is found for hedge fund managers. This seems to be attributable more to the losers continuing to be losers instead of winners continuing to be winners and highlights the importance of manager selection in case of hedge funds.

Applying Modern Portfolio Theory to Upstream Investment Decision Making

Nobel laureate Harry Markowitz provided investors with a framework to optimize risk and return of their portfolios of stocks and bonds. With a small portfolio of upstream investments as an example, this paper demonstrates how E&P companies can use similar portfolio-optimization methods to determine a mix of projects that provides the minimum risk for a given level of return. Contrasting this portfolio with investments selected by use of traditional capital-allocation techniques, the paper demonstrates how modern portfolio theory provides management with a superior setting for allocating capital by illuminating risk at the portfolio level.

A Stochastic Optimal Control Approach to International Finance and Foreign Debt

The recent financial crises, especially the debt crisis in Asia, have led to questions such as: what are their causes, what is an excessive debt and how vulnerable is an economy to external shocks; We develop an economic model of international finance and debt based upon two sources of uncertainty: the productivity of capital and the real interest rate. We use stochastic optimal control-dynamic programming to derive the: optimal consumption, foreign debt, capital, the growth of net worth and the current account. The objective is to maximize the expectation of the discounted value of the utility of consumption over an infinite horizon. Crises ; and associated social unrest ; occur when the unanticipated shocks produce a significant decline in the utility of consumption. We relate our optimality conditions to the vulnerability of the economy to crises. The major conclusions are as follows. (1) We derive explicit and implementable closed form equations for the optimum debt/net worth, which maximize the expectation of the discounted value of utility over an infinite horizon. (2) The derived debt/net worth ratio also maximizes the expected growth of net worth, given any fixed consumption/net worth ratio. (3) The vulnerability of an economy to shocks is positively related to the variance of the utility of consumption at any time. We derive a risk-expected return tradeoff. When the debt exceeds the optimum, there is inefficiency. The expected growth of the utility of consumption can be increased, and the vulnerability of the economy ; measured by the variance of the utility of consumption ; can be decreased by decreasing the debt/net worth ratio.

Simple Rules for Optimal Portfolio Selection: The Multi Group Case

The inception of modern portfolio theory dates from Markowitz's pioneering article [7] and subsequent book [8]. Yet despite the early development of a full theory of portfolio management, this theory has rarely been implemented. One problem arises from the difficulty in generating inputs to the general portfolio model. Index models and simple structures for correlation relationships, which go a long way towards solving this problem, have been developed. Yet the time and cost of solving actual portfolio problems (involving the solution of a quadratic programming problem) and more importantly the difficulty of educating portfolio managers to relate to risk return trade-offs in terms of covariances has virtually brought the application of portfolio theory to a halt.