Riskless Investment Research Articles

Managing the shortfall risk of target date funds by overfunding

Abstract Is it possible to achieve almost riskless, nonfluctuating investment payoffs in the long run, at a fraction of the traditional funding requirement, using equity investments? What is their shortfall risk? These questions are motivated by the need to increase yields, while limiting the variability of investment results. We show how to use contingent claims, denominated in units of a stock index, to achieve an almost riskless investment outcome. To control the risk of the proposed hedge portfolios, we introduce an overfunded scheme and show its reliability using bootstrapping. Results show that a modest amount of overfunding is an effective risk-management approach that brings the probability of not achieving the target to less than 1 percent. Our results are based on the use of the minimal market model and a change of numeraire. Robustness tests support their validity under different market specifications.

Turning on Dimensional Prominence in Decision Making: Experiments and a Model

Could introducing a tiny interest rate on positive balances of checking accounts affect investment decisions? We suggest, counterintuitively, that it might decrease allocations to checking accounts and increase riskless investments with higher returns. This violation of monotonicity is a potential outcome of a novel behavioral phenomenon that we formalize and investigate experimentally. It posits that even a small interest rate highlights or turns on the safe gains dimension, bumping up its decision weight while shrouding other considerations, such as liquidity. Consequently, choices may shift from the most liquid option, the checking account, to safe investments with superior returns. Our exploration of this phenomenon covers three different choice environments: investment decisions, social preferences, and choice under uncertainty. This paper was accepted by Yan Chen, behavioral economics and decision analysis.

The impact of long-term riskless asset on ensuring liquidity and preventing banking fragility

PurposeThrough portfolio diversification, the author identifies the risk sharing deposit contract in a three-period model that maximizes the ex ante expected utility of depositors.Design/methodology/approachIn this paper, the author extends the study by Allen and Gale (1998) by adding a long-term riskless investment opportunity to the original portfolio of a short-term liquid asset and a long-term risky illiquid asset.FindingsUnlike Allen and Gale, there are no information-based bank runs in equilibrium. In addition, the model can improve consumers' welfare over the Allen and Gale model. The author also shows that the bank will choose to liquidate the cheaper investments, in terms of the gain-loss ratios for the two types of existing long-term assets, when there is liquidity shortage in some cases. Such a policy reduces the liquidation cost and enables the bank to meet the outstanding liability to depositors without large liquidation losses.Originality/valueThe author believe that the reader would be interested in this article because it is relevant to real world where depositors rush to withdraw their deposits from a bank if there is negative information about future prospect of the bank asset portfolio and bank investment. Economists and financial analysts need to determine the suitable mechanism to improve the stability of the bank and the depositor welfare.

Combining Conventional Investing with a Lifetime Income Guarantee: A Blueprint for Retirement Security

Both retirees and their employers can benefit from combining conventional DC-type savings plans, designed to be spent down in the early part (say, the first 20 years) of retirement, with a DB-like or deferred life annuity component guaranteeing income for the rest of the retiree’s life in order to hedge the risk of living too long. Earlier authors proposed to do this using a riskless investment strategy, and we build on their work by asserting that the DC-type investment will (and should) include equities. Through simulation, we show that either a high-risk (equity-heavy) or low-risk (fixed-income-heavy) DC component plus a deferred annuity component dominates a conventional DC spend down, from the standpoint of generating sustainable retirement income in most states of the world. TOPICS:Retirement, portfolio construction, legal/regulatory/public policy

Turning-on Dimensional Prominence in Decision Making: Experiments and a Model

Could introducing a tiny interest rate on positive balances of checking accounts affect investment decisions? We suggest, counterintuitively, that it might decrease allocations to checking accounts while increasing riskless investments with higher returns. This violation of monotonicity is a potential outcome of a novel behavioral phenomenon that we formalize and investigate experimentally in different environments. It posits that even a small interest rate highlights or turns-on the safe gains dimension, bumping up its decision weight while shrouding other considerations, such as liquidity. Consequently, choices may shift from the most liquid option, the checking account, to safe investments with superior returns.

The Optimal Interaction between a Hedge Fund Manager and Investor

ABSTRACTThis study explores hedge funds from the perspective of investors and the motivation behind their investments. We model a typical hedge fund contract between an investor and a manager, which includes the manager’s special reward scheme, i.e., partial ownership, incentives and early closure conditions. We present a continuous stochastic control problem for the manager’s wealth on a hedge fund comprising one risky asset and one riskless bond as a basis to calculate the investors’ wealth. Then we derive partial differential equations (PDEs) for each agent and numerically obtain the unique viscosity solution for these problems. Our model shows that the manager’s incentives are very high and therefore investors are not receiving profit compared to a riskless investment. We investigate a new type of hedge fund contract where the investor has the option to deposit additional money to the fund at half maturity time. Results show that investors’ inflow increases proportionally with the expected rate of return of the risky asset, but even in low rates of return, investors inflow money to keep the fund open. Finally, comparing the contracts with and without the option, we spot that investors are sometimes better off without the option to inflow money, thus creating a negative value of the option.

An anatomy of global risk premiums

Long-term investors are attuned to the thought that risk is rewarded. By making an investment with more potential variation in returns, investors demand a risk premium – the expected return in excess of a comparatively risk-less investment. This is particularly espoused in the long-term investments of pension funds, yet is a reductive view of financial markets. We investigate the realized risk premiums in a global, multi-asset portfolio of a typical pension fund between 1999–2015, and relate the variation of the realized risk premiums to macroeconomic fluctuations. Owing to the coincident relation between the realized risk premiums and the economic cycle, under the prevailing economic condition, the Sharpe ratios of portfolios constructed ex post to capitalize on risk premiums are appallingly low (between −1 and 0.2). Therefore, despite the heartening corroboration of risk premiums’ existence, investors are susceptible to their time variation.

Islamic Banks

Islamic banks has development in many aspects in practical performance of banks function, this was a limited activity in service Banks and commercial processes. Later, it came to They possess financial power and ability to create Islamic loans. They possess financial power and ability to create Islamic loans. Economical union supported by banks is not restricted to a domestic sphere, but has expanded internationally as its operations enjoy fidelity and fulfillment between banking organizations in different countries. As banking systems Islamic banks had developed, they are no longer restricted to role of being financial and service organizations, but have become money market within public sector. Furthermore, they follow up monetary flows and banking securities, by playing positive role of providing the organized money market with enough information about commercial activities. In addition, as a financial mediator who has adequate statistics about other economical units, besides its main role in creating successful development plans and riskless investment.

Minimizing the lifetime ruin under borrowing and short-selling constraints

In this paper, the optimal investment strategies for minimizing the probability of lifetime ruin under borrowing and short-selling constraints are found. The investment portfolio consists of multiple risky investments and a riskless investment. The investor withdraws money from the portfolio at a constant rate proportional to the portfolio value. In order to find the results, an auxiliary market is constructed, and the techniques of stochastic optimal control are used. Via this method, we show how the application of stochastic optimal control is possible for minimizing the probability of lifetime ruin problem defined under an auxiliary market.

Alternative Overlay for a Traditional Managed Equity Portfolio

The impetus of this paper is to present an investment strategy that is both easy to implement and has a value-added performance component. The core of the investment approach is based on the concept of “alternative” asset classes, and their historical lack of correlation to more traditional asset classes such as domestic and foreign equities, sector funds, domestic and foreign bonds, and cash equivalent instruments. Several trading systems are explored, and are shown to not necessarily accomplish their goal of reducing risk or enhancing return. These approaches are often labeled as being a type of “active” investing, but since most stay fully invested, they often do not achieve the result they are designed for: reducing market risk. It is demonstrated that using actively managed systems, which have the ability to move out of the market at critical points, can indeed add value. The discussion turns to the importance of choosing which investments are used when the system signals a move to the “sidelines”. Traditionally, riskless investments (or as close to riskless as can be expected) are used, such as short-term bonds and cash and cash-like investments. Recently, with the introduction of numerous ETFs and mutual funds in the “alternative” investment space, practitioners have turned to using a portfolio of these assets in lieu of moving to bonds or cash. It is believed that the historically low correlation of these assets to stocks and bonds will result in value-added performance above that of using bonds or cash when moving out of the market. Since the “sideline” investments in this case are not riskless, the success of the method is largely dependent on the stability of the correlation between them and traditional equities. This paper will show that this reliance is a significant flaw, especially during market shocks and increased volatility. As a way of overcoming this flaw, it is shown that the use of “active alternative investments has the ability to insulate a portfolio against market shocks, and at the same time, deliver enhanced risk-adjusted performance.

Life-cycle asset allocation with annuity markets

This paper derives the optimal consumption and portfolio choice pattern over the life-cycle for households facing uninsurable labor income risk, ruin risk, stochastic capital markets, and uncertain lifetime. Our model posits a dynamic utility maximizer with CRRA and Epstein/Zin preferences who has access to liquid stocks, bonds, and illiquid life annuities. We show that a considerable fraction of wealth is gradually annuitized until retirement and beyond to skim the mortality credit. The remaining liquid wealth is mainly invested in stocks to compensate for riskless investment in life annuities. The model allows us to assess the economic importance of common explanations for the empirically low annuity demand by analyzing participations rates, annuitization fractions, and welfare effects.

Hedging, Financing, and Investment Decisions: A Theory and Empirical Tests

In this paper we theoretically and empirically examine the interaction between hedging, financing, and investment decisions. A simple equilibrium model with costly financial distress suggests that as firms become more efficient at risky investments vis a vis riskless investments, they will borrow less, invest more in risky assets, and hedge more. The model also predicts a positive relationship between hedging and leverage, which is consistent with debt capacity arguments. Using Probit, OLS and simultaneous equations, we find that the empirical findings are for the most part consistent with the model predictions.

Symmetry-based solution of a model for a combination of a risky investment and a riskless investment

Benth and Karlsen [F.E. Benth, K.H. Karlsen, A note on Merton's portfolio selection problem for the Schwartz mean-reversion model, Stoch. Anal. Appl. 23 (2005) 687–704] treated a problem of the optimisation of the selection of a portfolio based upon the Schwartz mean-reversion model. The resulting Hamilton–Jacobi–Bellman equation in 1 + 2 dimensions is quite nonlinear. The solution obtained by Benth and Karlsen was very ingenious. We provide a solution of the problem based on the application of the Lie theory of continuous groups to the partial differential equation and its associated boundary and terminal conditions.

Solution to a Problem of Infinitely Many Time Conversions

This paper considers an investment decision problem in continuous-time frame work, in which a firm can switch between a risky investment and a riskless investment. In this paper, I proposes a method to derive a closed-form solution to this (S, s) control problem. As a result, I derive the values of the conversion options and the critical thresholds analytically. The values of the conversion options are very helpful for us to interpret conversions between operations as exercises of the options. OR Subject Classification: Applications (Dynamic Programing), Investment (Financial Institutions), Maintenance/Replacement (Inventory/Production)

The Investment Choices of Low-Income Households and the Aggregation of Information by Asset Prices

Recent research has suggested that we may better explain the equity premium puzzle and similar anomalies by considering marginal equity investors separately from other households. Using Survey of Consumer Finances data, I test whether the effect of risk aversion on the choices of households with limited financial resources is consistent with a mathematical identity that is necessarily true if the underlying equilibrium is a revealing one. The results imply that revealing equilibrium models generate biased risk measures which significantly understate the riskiness of equity investments for families in the United States and overstate their attractiveness relative to riskless investments.

U.S. Dollar Risk Premiums and Capital Flows

This paper sheds light on the attractiveness of U.S. assets by studying dollar risk premiums, calculated using Consensus exchange rate forecasts, and linking them to bilateral capital flows. The paper finds that the presence of negative dollar risk premiums (i.e. expectations of a dollar depreciation net of interest rate effects) amid record capital inflows could suggest that investors may favor U.S. assets for structural reasons. One possible explanation could be that the Asian crisis created a large pool of savings searching for relatively riskless investment opportunities, which were provided by deep, liquid, and innovative U.S. financial markets with robust investor protection. Moreover, the continued attractiveness of U.S. financial markets to European investors suggests that they offer a large array of assets, with different risk/return characteristics, that facilitate the structuring of diversified investment portfolios. Looking forward, this suggests that the allocative efficiency of U.S. financial markets could mitigate risks of a disorderly unwinding of global current account imbalances.

Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications

Most businesses hold cash, often in the form of low-risk or riskless investments that can be converted into cash at short notice. The motivations for holding cash vary across firms. Some hold cash to meet operating needs whereas others keep cash on hand to weather financial crises or take advantage of investment opportunities. In the first part of this paper, we will begin by looking at the extent of cash holdings at publicly traded firms and some of the motives for the cash accumulation. We will also look at how best to value these cash holdings in both discounted cash flow and relative valuation models. In the second part of the paper, we will turn to a trickier component - cross holdings in other companies. We will begin by looking at the way accountants record these holdings and the implications for valuation. We will then consider how to incorporate the value of these cross holdings in a full information environment, followed by approximations that work when information about cross holdings is partial or missing.

Dynamic Control of the Investment Portfolio in the Jump-Diffusion Financial Market with Regime Switching

A problem for control of the portfolio of securities consisting of risky and riskless investments is stated as a dynamic problem of tracking of the standard (hypothetical) portfolio displaying the prescribed desired effectiveness. It is assume that the dynamics of prices of risky financial assets is described by stochastic equations with regular and pulse disturbances and a step (jump-like) change of parameters that corresponds to the switching of the operating regimes a financial market. An approach to the evaluation of an optimal strategy of feedback control over a quadratic criterion is suggested.

Optimal and near-optimal advection—diffusion finite-difference schemes III. Black—Scholes equation

Optimal and near–optimal compact finite–difference schemes are presented and tested for the numerical solution of an extended Black–Scholes equation: ∂ t c - r c + r s ∂ s c + 1 2 σ 2 s 2 ∂ s 2 c = - q - s ∂ s ( s ∂ s g ) . Here c(s,t) is the expected value of the right to buy or sell an asset at some future date, s is the asset price, r(t) is the rate of increase available from alternative riskless investments, and σ (t) is the asset volatility. The terms on the right–hand side allow the applicability to be extended beyond the basic European options model. The compactness of the numerical scheme keeps any computer programming elementary. The required computational resources can be as small as 0.001 of conventional schemes.

A discrete stochastic model for investment with an application to the transaction costs case

This work consists of two parts. In the first one, we study a model where the assets are investment opportunities, which are completely described by their cash-flows. Those cash-flows follow some binomial processes and have the following property called stationarity: it is possible to initiate them at any time and in any state of the world at the same condition. In such a model, we prove that the absence of arbitrage condition implies the existence of a discount rate and a particular probability measure such that the expected value of the net present value of each investment is non-positive if there are short-sales constraints and equal to zero otherwise. This extends the works of Cantor–Lippman [Cantor, D.G., Lippman, S.A., 1983. Investment selection with imperfect capital markets. Econometrica 51, 1121–1144; Cantor, D.G., Lippman, S.A., 1995. Optimal investment selection with a multitude of projects. Econometrica 63 (5) 1231–1241.], Adler–Gale [Alder, I., Gale, D., 1997. Arbitrage and growth rate for riskless investments in a stationary economy. Mathematical Finance 2, 73–81.] and Carassus–Jouini [Carassus, L., Jouini, E., 1998. Arbitrage and investment opportunities with short sales constraints. Mathematical Finance 8 (3) 169–178.], who studied a deterministic setup. In the second part, we apply this result to a financial model in the spirit of Cox–Ross–Rubinstein [Cox, J.C., Ross, S.A., Rubinstein, M., 1979. Option pricing: a simplified approach. Journal of Financial Economics 7, 229–264.] but where there are transaction costs on the assets. This model appears to be stationary. At the equilibrium, the Cox–Ross–Rubinstein's price of a European option is always included between its buying and its selling price. Moreover, if there is transaction cost only on the underlying asset, the option price will be equal to the Cox–Ross–Rubinstein's price. Those results give more information than the results of Jouini–Kallal [Jouini, E., Kallal, H., 1995. Martingales and arbitrage in securities markets with transaction costs. Journal of Economic Theory 66 (1) 178–197.], which where working in a finite horizon model.