Portfolio Trading Research Articles

THE ESTIMATION AND DECOMPOSITION OF VALUE-AT-RISK FOR NON-NORMAL PORTFOLIO RETURNS

Value-at-risk (VaR) is a widely used measure for evaluating the market risk of a trading portfolio. This article presents the g-and-h method for estimating the VaR of a portfolio with non-normal returns, and adds to the usefulness of VaR as a risk management tool by decomposing the portfolio into individual VaRs to estimate the contribution of the individual components toward the overall VaR. While the VaR decomposition is algebraically simple under the assumption of normality, that is not the case under non-normality which is the property exhibited by most financial returns. We show that, by using the g-and-h VaR method, the decomposition analysis under non-normality can be performed with the same degree of intuitiveness and ease as for the analytical methods based on the assumption of normality.

Market-Based Structural Top-Down Stress Tests of the Banking System

Despite increased need for top-down stress tests of financial institutions, performing them is challenging owing to the absence of granular information on banks’ trading and loan portfolios. To deal with these data shortcomings, this paper presents a market-based structural top-down stress testing methodology that relies in market-based measures of a bank's probability of default and structural models of default risk to infer the capital losses they could experience in stress scenarios. As an illustration, the methodology is applied to a set of banks in an advanced emerging market economy.

On the appraisal of LVaR throughout the close-out period: an investment management outlook from recent global financial crisis

In this paper, we launch a practical modus-operandi for the assessment of potential market risk exposures for financial trading portfolios by providing an investment management perspective from recent global financial crisis. This proposed tactic is based on the renowned concept of Liquidity-Adjusted Value-at-Risk (LVaR) along with the innovation of a risk-engine algorithm that can estimate LVaR for both long and short-sales positions. Our wide-ranging risk model can conduct LVaR analysis under normal and severe market conditions besides it takes into account the effects of illiquidity of equity securities, under crisis-driven circumstances, throughout the close-out period. In order to clarify the accurate use of LVaR and stress-testing methods, real-world simulation scenarios of trading risk management are presented for the Gulf Cooperation Council (GCC) financial markets. The developed methodology and risk assessment algorithms can aid in advancing risk management practices in emerging markets and particularly in the wake of recent credit crunch.

Strategic Allocation, Asset Pricing and Prior Return Patterns: Evidence from Indian Commodity Market

In this article we employ data for 12 commodities, four commodity indices and one stock market proxy from July 2006 to February 2011 for India. We find that commodities that provide higher average returns also exhibit higher price volatility. The return distributions for commodities as well as for indices do not seem to follow a random walk. Combining gold with stock market index provides large portfolio diversification benefits. Capital Asset Pricing Model (CAPM) seems to be a better descriptor of asset pricing in commodity markets when one uses commodity index instead of stock market index to represent market portfolio. It is further observed that there are no discernible prior return patterns in very short term and short term commodity returns that can be used by investors to develop portfolio trading strategies, as is the case in equity markets. Our findings are relevant for policymakers as well as for market traders. This study contributes to the alternative investment literature for emerging markets.

The Speed of Stock Price Discovery

We develop closed-form expressions for the path and speed of stock price ‎discovery in a utility-based CAPM with wealth effects. Two investors with ‎uniquely bounded risk-preferences always apply opposite portfolio rebalancing ‎trades. These trades determine the intra-period path and speed of price discovery ‎in a Walrasian, tâtonnement setup. While conditions for maximum speed exist, ‎convergence is rapid over a wide range of endowments and preferences. ‎Convergence to equilibrium is exponential, and its speed depends on ‎endowments, risk-preferences, firm size, and market price for risk. Convergence is ‎not guaranteed, and the conditions for divergence are specified. ‎

Risk Management in Trading and Investment Portfolios

The aim of this article is to bridge the gap in equity trading risk management literatures and particularly from the perspective of emerging and illiquid markets, such as in the context of the Gulf Cooperation Council (GCC) financial markets. In this article, we demonstrate a practical approach for the measurement and control of market risk exposure for financial trading portfolios that contain several illiquid equity securities during the unwinding (close-out) period. This approach is based on the renowned concept of Value-at-Risk (VaR) along with the development of an optimisation risk algorithm utilising matrix-algebra technique. Our thorough asset market risk modelling-algorithm can simultaneously handle VaR analysis under normal and severe market conditions, besides it takes into account the effects of illiquidity and short-sales of traded equity securities. In order to illustrate the proper use of VaR and stress-testing methods, real-world structured modelling techniques of trading risk management are presented for the GCC financial markets. To this end, comprehensive simulation case studies are accomplished with the objective of constructing a realistic framework for trading risk measurement and control in addition to the instigation of a risk optimisation algorithm-process for the computation of maximum authorised VaR risk-budgeting limits. JEL Classification: C10, C13, G20, G28

Profitability of pairs trading strategy in an illiquid market with multiple share classes

We investigate the practical issues of implementing the self-financing pairs portfolio trading strategy presented by Gatev et al. (2006). We also provide new evidence on the profitability of pairs trading under different weighting structures and trade initiation conditions. Using data from the Finnish stock market over the period 1987–2008, we find pairs trading to be profitable even after allowing for a one day delay in the trade initiation after the signal. On average, the annualized return can be as high as 12.5%, though requiring trading on days a pair is traded lowers the return approximately by three percentage points. On the other hand, lowering the threshold for opening a pair is found to increase returns even after accounting for trading costs, indicating that there might be a more optimal trade initiation threshold available than that presented in earlier literature. The profits are not related to market risk. Pairs trading strategy is found to produce positive alpha during the sample period.

Optimal commodity asset allocation with a coherent market risk modeling

This paper fills a fundamental gap in commodity price risk management and optimal portfolio selection literatures by contributing a thorough reflection on trading risk modeling with a dynamic asset allocation process and under the supposition of illiquid and adverse market settings. This paper analyzes, from a portfolio managers' perspective, the performance of liquidity adjusted risk modeling in obtaining efficient and coherent investable commodity portfolios under normal and adverse market conditions. As such, the author argues that liquidity risk associated with the uncertainty of liquidating multiple commodity assets over given holding periods is a key factor in formalizing and measuring overall trading risk and is thus an important component to model, particularly in the wake of the repercussions of the recent 2008 financial crisis. To this end, this article proposes a practical technique for the quantification of liquidity trading risk for large portfolios that consist of multiple commodity assets and whereby the holding periods are adjusted according to the specific needs of each trading portfolio. Specifically, the paper proposes a robust technique to commodity optimal portfolio selection, in a liquidity-adjusted value-at-risk (L-VaR) framework, and particularly from the perspective of large portfolios that have both long and short positions or portfolios that consist of merely pure long trading positions. Moreover, in this paper, the author develops a portfolio selection model and an optimization-algorithm which allocates commodity assets by minimizing the L-VaR subject to applying credible operational and financial constraints based on fundamental asset management considerations. The empirical optimization results indicate that this alternate L-VaR technique can be regarded as a robust portfolio management tool and can have many uses and applications in real-world asset management practices and predominantly for fund managers with large commodity portfolios.

An Effective Stock Portfolio Trading Strategy using Genetic Algorithms and Weighted Fuzzy Time Series

Investments in a stock market may incur risk. To reduce the risk of an investment, many portfolio selection methods have been proposed. By buying several stocks together, a portfolio selection method aims at maximizing the return of an investment given a predefined risk level. To build an optimal stock portfolio, one needs to select stocks and decide the proportion of the capital on each stock. Also, it is very important to decide when to buy or sell a stock portfolio. In this paper, we present a genetic algorithm to build stock portfolios. The proposed method comprises a genetic algorithm and a weighted fuzzy time series. The genetic algorithm is used to construct an optimal portfolio while the weighted fuzzy time series is used to predict the return of the portfolio which in turn is used to formulate the fitness function of the genetic algorithm. Furthermore, we propose the periodically checking and stop-loss point policies to decide selling and buying time points of the stock portfolio. The experiments on the stocks of Taiwan 50 show that the proposed method outperforms the Taiwan 50 index and the TAIEX index in terms of the 7-year average return rate.

Do trading and power operations mix? The case of Constellation Energy Group in 2008

For the first seven years following its creation in 2000, Constellation Energy Group was a leader in the merchant power business, and its stock significantly outperformed the industry. Then, in 2008, in the space of less than two months, the company found itself in a liquidity crisis in which its stock lost more than 70% of its value, leading to a forced sale at a low price. What happened? Constellation’s crisis illustrates the hidden dangers that arise when a power company’s trading operation stops playing a subordinate function and becomes the strategic focus of the business. The case highlights the illiquidity of many commodity trading portfolios, which increases the danger of potentially large contingent capital requirements. These are often overlooked in traditional value-at-risk calculations. It is therefore easy to underestimate exposure and the capital implicitly dedicated to the trading operation, exaggerating its profitability. When the trading unit shares a balance sheet with other operations, such as generation and customer supply, the capital required for trading is often borrowed from these other units at zero cost. Trading can improve the profitability of generation and customer supply if it is organized as a support function. If it is to be a profit center of its own, it should be organized on its own balance sheet, separate from the other operations.

Heuristic Portfolio Trading Rules with Capital Gain Taxes

We study the out-of-sample performance of portfolio trading strategies when an investor faces capital gain taxation and proportional transaction costs. Under no capital gain taxation and no transaction costs, we show that, consistent with DeMiguel, Garlappi, and Uppal (2009), a simple 1/N trading strategy is not dominated out-of-sample by a variety of optimizing trading strategies, except the parametric portfolios of Brandt, Santa-Clara, and Valkanov (2009). With dividend and realization-based capital gain taxes, the welfare costs of the taxes are large with the cost being as large as 30% of wealth in some cases. Overlaying simple tax trading heuristics on these trading strategies improves out-of-sample performance. In particular, the 1/N trading strategy's welfare gains improve when a variety of tax trading heuristics are also imposed. For medium to large transaction costs, no trading strategy can outperform a 1/N trading strategy augmented with a tax heuristic, not even the most tax- and transaction-cost efficient buy-and-hold strategy. Overall, the best strategy is 1/N augmented with a heuristic that allows for a fixed deviation in absolute portfolio weights. Our results show that the best trading strategies trade diversification considerations off against tax considerations without solely focusing on one or the other.

The Impact of Financial Advisors on the Stock Portfolios of Retail Investors

This study investigates the impact of financial advisors on portfolio returns, risk, trading, and diversification using a large data set of individual Dutch equity investors, with random assignment to specific advisors. We confirm recent experimental results on the benefits of advisory interventions that control for moral hazard behavior and endogeneity as a result of self-selection. Advice improves risk-adjusted equity returns and reduces risk. In addition, advisors reduce trading activity, as proxied by the frequency of trades. This study is unique in terms of the data set, the focus on individual stocks, and the use of the Hausman-Taylor panel estimation technique.

Heuristic Portfolio Trading Rules with Capital Gain Taxes

Heuristic Portfolio Trading Rules with Capital Gain Taxes

Heuristic Portfolio Trading Rules with Capital Gain Taxes

Heuristic Portfolio Trading Rules with Capital Gain Taxes

Survey of recent developments

There is a growing confidence in policy, business and finance circles about Indonesia's ability to withstand global economic and financial shocks, and a renewed belief in domestic sources of growth. Despite uncertainty in Europe and slower than expected recovery in the US, Indonesia is well placed for moderately high growth in the medium term, and economic stability in the shorter term. At the end of June 2011, foreign reserves were at a record high, inflation was down, annual growth was steady at 6.5%, and investment – especially foreign direct investment (FDI) – was up significantly. Consumer price inflation had fallen to just below 5% by August, from double-digit levels earlier in the year. This was due partly to low food prices and success in sterilising the effects of capital inflows. However, turmoil in international markets led to a sharp fall in the Indonesia stock exchange index and a mild currency depreciation in August– September, prompting central bank intervention in the foreign exchange market. Fiscal policy has remained conservative, aiming for a balanced budget by 2014. However, the government has still not moved to reduce growing fuel and energy subsidies. While the service sectors have continued to record high rates of growth, there has been a revival of manufacturing in 2011. This is partly underpinned by strong inflows of FDI, and is especially evident in the labour-intensive textiles, clothing and footwear industries after a decade of stagnation. Multinationals have announced plans to expand operations in Indonesia in the past six months to take advantage of new tax incentives. Overseas investors have also been attracted by Indonesia's growing middle class – a result partly of higher rural incomes driven by the commodity boom outside Java. Some recent ministerial announcements about initiatives to promote domestic industry have a protectionist flavour. A cabinet reshuffle in October may signal a more dirigiste approach to industrial policy – especially the shifting of internationally respected economist Mari Pangestu from the trade portfolio to that of tourism and creative economy. One important outcome of recent growth has been falling unemployment rates. However, youth unemployment remains a major problem, and efforts to overcome it have been fragmentary. A recent ban on overseas migration of domestic helpers (maids) seems certain to add to labour supply pressures among young people. The government is now considering how to mobilise its large population base, abundant natural resources and strategic location to play a greater role in the world economy. These assets are central to the ambitious ‘Master Plan’ for longer-term development (2011–25), announced in May. It focuses on developing the resource-rich Outer Island regions, with massive investments in energy and ‘connectivity’ to link the major centres and islands with each other, and centres with their hinterlands. Funding (to come mainly from the private sector), implementation and coordination are all major challenges.

Reducing Global Imbalances: Can Fixed Exchange Rates and Current Account Limits Help?

This paper analyzes the stability of foreign trade, currency markets and international portfolio balances with the help of a model of current account balances and internationally held assets. In particular, the paper considers the conditions for simultaneous equilibrium of trade and asset balances, and whether such equilibria are stable or not. The conditions under which those equilibria continue to exist, and are reachable, are then analyzed when the markets are distorted by the common policy prescriptions of fixed exchange rates or defined limits to the size of current account surpluses or deficits. A better approach is derived from the idea of a “trade space” defining the areas in which it is safe to allow trade deficits and net foreign assets or debt to operate. This allows us to investigate and draw conclusions about the best policy options to make the system stable in the long run with respect to current account imbalances and net foreign debt. First, institutional arrangements that ensure stability and maximize “trade space”; second, an exchange rate minimum as a circuit breaker to prevent debt escalation; third, policies to raise trade elasticities and lower portfolio adjustments in order to limit imbalances in size.

Modeling coherent trading risk parameters under illiquid market perspective

PurposeThe purpose of this paper is to originate a proactive approach for the quantification and analysis of liquidity risk for trading portfolios that consist of multiple equity assets.Design/methodology/approachThe paper presents a coherent modeling method whereby the holding periods are adjusted according to the specific needs of each trading portfolio. This adjustment can be attained for the entire portfolio or for any specific asset within the equity trading portfolio. This paper extends previous approaches by explicitly modeling the liquidation of trading portfolios, over the holding period, with the aid of an appropriate scaling of the multiple‐assets' liquidity‐adjusted value‐at‐risk matrix. The key methodological contribution is a different and less conservative liquidity scaling factor than the conventional root‐t multiplier.FindingsThe proposed coherent liquidity multiplier is a function of a predetermined liquidity threshold, defined as the maximum position which can be unwound without disturbing market prices during one trading day, and is quite straightforward to put into practice even by very large financial institutions and institutional portfolio managers. Furthermore, it is designed to accommodate all types of trading assets held and its simplicity stems from the fact that it focuses on the time‐volatility dimension of liquidity risk instead of the cost spread (bid‐ask margin) as most researchers have done heretofore.Practical implicationsUsing more than six years of daily return data, for the period 2004‐2009, of emerging Gulf Cooperation Council (GCC) stock markets, the paper analyzes different structured and optimum trading portfolios and determine coherent risk exposure and liquidity risk premium under different illiquid and adverse market conditions and under the notion of different correlation factors.Originality/valueThis paper fills a main gap in market and liquidity risk management literatures by putting forward a thorough modeling of liquidity risk under the supposition of illiquid and adverse market settings. The empirical results are interesting in terms of theory as well as practical applications to trading units, asset management service entities and other financial institutions. This coherent modeling technique and empirical tests can aid the GCC financial markets and other emerging economies in devising contemporary internal risk models, particularly in light of the aftermaths of the recent sub‐prime financial crisis.

An Algorithm for Portfolio Trades with Transaction Costs

Optimal portfolio weights must be computed against the total committed wealth net of all transaction costs. Consequently, portfolio weights normally computed without regard to transaction costs may not be optimal and result in wrong trade recommendations. In particular, when portfolios are rebalanced, an increase (decrease) in portfolio weights may not necessarily mean that a security ought to be bought or sold. This would be so, especially if one considers the investors’ desire to hold a certain amount of cash in their portfolio. This article considers explicitly the trading costs of the portfolio and develops a simple trading rule consistent with the investors’ desired cash requirement.

On the choice of liquidity horizon for incremental risk charges: are the incentives of banks and regulators aligned?

The recent incremental risk to the Basel market risk requires banks to estimate, separately, the default and migration risk of their trading portfolios that are exposed to credit risk. The regulation requires the total regulatory charges for trading books to be computed as the sum of the market risk capital and the incremental risk charge for credit risk. In the calculation of incremental risk charges a key component is the choice of the liquidity horizon for traded credits. In this paper we explore the effect of the liquidity horizon on the incremental risk charge and in particular validate that the framework for assigning liquidity horizons proposed by regulation is consistent with bank's motivation to conserve the regulatory capital requirement. We consider a stylized portfolio of 28 bonds with different ratings and liquidity horizons to evaluate the impact of the choice of the liquidity horizon for a certain rating class of credits. We find that choosing the liquidity horizon for a particular credit there are two important effects that need to be considered. The first effect is the bonds with short liquidity horizons can avoid further downgrading by frequently trading to a bond of the same initial quality. The second effect is the possibility of multiple defaults. Our findings are also supported by empirical result of credit spread term structure. Therefore, the liquidity horizon specification in the incremental risk charge requirement from Basel committee is consistent with the market reality, banks' incentive in capital requirement conservation and consequently alleviates the concerns in IRC model validation.

Why Financial Institutions Matter: The Case of Energy Infrastructure MLPs

Institutional investors entered the Master Limited Partnership (MLP) space in 2001 with the Kinder Morgan offering of I‐share units. In the ten years that have passed since then, the number of MLPs has quadrupled, and their total market capitalization has increased tenfold. When compared to the MLPs of the 1980s, today's MLP are more focused both in terms of operations and distribution policy. After its birth in 1981, the MLP spread to over 30 different industries. But thanks in large part to tax law changes in 1987 that have helped limit MLPs to natural resource sectors, companies adopting the MLP structure since then have been concentrated in energy, and especially in energy infrastructure. And whereas distribution policy varied considerably among the early MLPs, today's MLPs uniformly pay out a large majority of their distributable cash flow.But to maintain or expand existing energy infrastructure while paying out most of their cash from operations, many MLPs require significant amounts of new capital. To help meet this ongoing funding requirement, new kinds of institutional intermediaries such as closed‐end C‐Corporation investment companies have emerged to provide capital to MLPs in the form of direct placements that offer flexibility with regard to offer sizing and timing. Since 2004, the total value of such direct placements of MLP units has exceeded $15 billion.What's more, the rise of this MLP operating/C‐corporation investment company structure has resulted in a novel realignment of incentives and functions. In this innovative arrangement, the pass‐through operating vehicle (i.e., the MLP) avoids double taxation of dividends while effectively committing managers to distribute cash. At the same time, for those MLPs with large maintenance and other requirements for capital, the commitment to pay out cash effectively forces the operating companies to raise capital continuously and stay “close to the capital marketplace.” This unusual combination of operating and investment vehicles also means that C‐Corporation investment companies, unlike their pass‐through counterparts, must manage tax on their own books and disclose to their investors the after‐tax results of their portfolio trading as well as their capital gains “overhang.”