Andrianos E. Tsekrekos

Evaluating Natural Resource Investments under Different Model Dynamics: Managerial Insights

We focus on factors that drive the dynamics of commodity prices. We highlight the capital budgeting implications of three highly-cited, nested, multi-factor models for commodity prices that have been successful in empirical investigations. Competing assumptions regarding commodity prices and their convenience yields can account for differences close to 40% on average, and in excess of 60% in cases, in the valuation of typical natural resource investments. These value differences are found to increase with the maturity and the intrinsic value of the investment, and also with the level and the volatility of the resources convenience yield. Resources such as oil or copper, that are used for production purposes, usually exhibit high and volatile convenience yields; thus our findings should be more relevant for decision-makers in such sectors.

Optimal switching decisions under stochastic volatility with fast mean reversion

We study infinite-horizon, optimal switching problems for underlying processes that exhibiting “fast” mean-reverting stochastic volatility. We obtain closed-form analytic approximations of the solution for the resulting quasi-variational inequalities, that provide quantitative and qualitative results for the effects of multi-scale variability of the underlying process on the optimal switching rule. The proposed methodology is applicable to a number of operations research problems involving switching flexibility.

The Correlation Structure of FX Option Markets Before and Since the Financial Crisis

The liquidity crunch and the ensuing financial crisis have unambiguously affected all national economies and global currency exchange rates. In this article we ask whether the cross-currency correlation structure has changed since 2007. Using an extensive set of volatility surfaces implied from over-the-counter options on 11 different exchange rates, as well as recent advances in static and dynamic factor models, we are able to show that the number of factors that innovate the correlation structure has not changed in the last two and a half years. It is the volatility, the persistence and the significance of global systematic factors, vis-à-vis regional or economy-specific ones, that appear to have changed dramatically. The implications for the risk management of currency exposures and for the predictability of exchange rate volatility are also outlined.

Real Options in Operations Research: A Review

The Real Options approach to decision-making has been useful in capturing and valuing the flexibility inherent in many operating decisions that decision makers are faced with. In Operations Research (OR), a field that encompasses a plethora of problem-solving techniques for improving decision-making, we note an observable steady increase in contributions that apply the Real Options approach to model, analyze and evaluate flexible operating alternatives available to decision-makers or to optimize the operational efficiency of decision timing. We review 164 papers that appeared in five internationally-renowned OR journals in the last twelve years, cataloguing the main subject themes and contributions where the Real Options approach has been most valuable to Operations Research. We classify the reviewed papers into six main subject themes, and identify their main characteristics, the modeling approaches used, key issues and sub-categories. We further document current trends and suggest promising opportunities for future research.

The effect of financial leverage on real and accrual-based earnings management

Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirically documented trade-off. We hypothesise that in the presence of high leverage, firms that engage in earnings manipulation tactics will exhibit a preference for RM due to a lower possibility – and subsequent costs – of getting caught. We show that leverage levels and increases positively and significantly affect upward RM, with no significant effect on income-increasing AM, while our findings point towards a complementarity effect between unexpected levels of RM and AM for firms with very high leverage levels and changes. This is interpreted as an indication that high leverage could attract heavy outsider scrutiny, making it necessary for firms to use both forms of earnings management in order to achieve earnings targets. Furthermore, we document that equity investors exhibit a significantly stronger penalising reaction to AM vs. RM, indicating that leverage-induced RM is not as easily detectable by market participants as debt-induced AM, despite the fact that the former could imply deviation from optimal business practices.

Latent semantic analysis of the FOMC statements

Purpose - The purpose of this paper is to analyze the content of the statements that are released by the Federal Open Market Committee (FOMC) after its meetings, identify the main textual associative patterns in the statements and examine their impact on the US treasury market. Design/methodology/approach - Latent semantic analysis (LSA), a language processing technique that allows recognition of the textual associative patterns in documents, is applied to all the statements released by the FOMC between 2003 and 2014, so as to identify the main textual “themes” used by the Committee in its communication to the public. The importance of the main identified “themes” is tracked over time, before examining their (collective and individual) effect on treasury market yield volatility via time-series regression analysis. Findings - We find that FOMC statements incorporate multiple, multifaceted and recurring textual themes, with six of them being able to characterize most of the communicated monetary policy in the authors’ sample period. The themes are statistically significant in explaining the variation in three-month, two-year, five-year and ten-year treasury yields, even after controlling for monetary policy uncertainty and the concurrent economic outlook. Research limitations/implications - The main research implication of the authors’ study is that the LSA can successfully identify the most economically significant themes underlying the Fed’s communication, as the latter is expressed in monetary policy statements. The authors feel that the findings of the study would be strengthened if the analysis was repeated using intra-day (tick-by-tick or five-minute) data on treasury yields. Social implications - The authors’ findings are consistent with the notion that the move to “increased transparency” by the Fed is important and meaningful for financial and capital markets, as suggested by the significant effect that the most important identified textual themes have on treasury yield volatility. Originality/value - This paper makes a timely contribution to a fairly recent stream of research that combines specific textual and statistical techniques so as to conduct content analysis. To the best of their knowledge, the authors’ study is the first that applies the LSA to the statements released by the FOMC.

Predictability in Implied Volatility Surfaces: Evidence from the Euro OTC FX Market

Recent general equilibrium models prescribe predictable dynamics in the volatility surfaces that are implied by observed option prices. In this paper, we investigate the predictability of surfaces, using extensive time series of implied volatilities from over-the-counter options on eight different currencies, quoted against the Euro. We examine implied volatility surfaces in the context of predictability through three different models, two that employ parametric specifications to describe the surface and one that decomposes it into latent statistical factors. All examined models are shown to (a) accurately describe the surfaces in-sample, and (b) produce forecasts that are superior to hard-to-beat benchmarks that ignore information about the shape of the surface, in medium- to long-term horizons. We show that these forecasts can support profitable volatility trading strategies in the absence of transaction costs. Comparing across competing models, our results suggest that parametric models, that allow for a more structured description of the surface, are more successful in terms of forecasts’ accuracy and significance of trading profits.

Approximation of Optimal Stopping Problems and Variational Inequalities Involving Multiple Scales in Economics and Finance

Many interesting decision-making problems in economics and finance can be expressed in terms of variational inequalities, whose well-developed theory provides valuable answers and insights concerning optimal policies. In this chapter, we first provide a brief introduction to the theory of variational inequalities as applied to economic decision-making, before focusing on a particular class (optimal stopping problems) where the underlying Markov process that introduces the uncertainty in the setting presents evolution of multiple time scales. Such problems lead to variational inequalities with fast-varying coefficients which require techniques related to homogenisation theory. Our results establish how, for such problems, approximate solutions to any order and (importantly) in almost closed form can be obtained by a singular perturbation approach. Our example from the waiting-to-invest literature in the last section demonstrates the applicability of the results.