Arjen Siegmann

Discrete-Time Financial Planning Models Under Loss-Averse Preferences

We consider a dynamic asset allocation problem formulated as a mean-shortfall model in discrete time. A characterization of the solution is derived analytically under general distributional assumptions for serially independent risky returns. The solution displays risk taking under shortfall, as well as a specific form of time diversification. Also, for a representative stock-return distribution, risk taking increases monotonically with the number of decision moments given a fixed horizon. This is related to the well-known casino effect arising in a downside-risk and expected return framework. As a robustness check, we provide results for a modified objective with a quadratic penalty on shortfall. An analytical solution for a single-stage setup is derived, and numerical results for the two-period model and time diversification are provided.

PALMNET: A Pension Asset and Liability Model for the Netherlands

This study presents a pension model geared to the typical pension contract in the Netherlands. It is based on a defined benefit/average earnings pension system. Nominal benefits are guaranteed and indexation is intended. The model provides a framework for analysing adjustments to such factors as the asset mix, retirement age, returns and the method of discounting, premium setting and indexation. The importance of uncertainty over interest rate movements and returns on shares is made explicit by means of stochastic and historical simulations. In this, PALMNET differs from existing, often deterministic pension models. The main findings are, first, a wage -indexed defined benefit pension is still affordable despite the current shortfall of wealth of pension funds. Second, fair value accounting considerably increases the volatility of pension premiums. Third, reducing risks by adjusting the asset mix towards more bonds is costly in terms of average premiums, but reduces the volatility. These conclusions are based on realistic to conservative assumptions regarding returns and risks.

Minimum funding ratios for defined-benefit pension funds

We compute minimum nominal funding ratios for defined-benefit (DB) plans based on the expected utility that can be achieved in a defined-contribution (DC) pension scheme. Using Monte Carlo simulation, expected utility is computed for three different specifications of utility: power utility, mean-shortfall, and mean-downside deviation. Depending on risk aversion and the level of sophistication assumed for the DC scheme, minimum acceptable funding ratios are between 0.87 and 1.20 in nominal terms. For relative risk aversion of 5 and a DC scheme with a fixed-contribution setup, the minimum nominal funding ratio is between 0.87 and 0.98. The attractiveness of the DB plan increases with the expected equity premium and the fraction invested in stocks. We conclude that the expected value of intergenerational solidarity, providing time-diversification to its participants, can be large. Minimum funding ratios in real (inflation-adjusted) terms lie between 0.56 and 0.79. Given a DB pension fund with a funding ratio of 1.30, a participant in a DC plan has to pay a 2.7 to 6.1% point higher contribution on average to achieve equal expected utility.

The Effect of Shortfall as a Risk Measure for Portfolios with Hedge Funds

Current research suggests that the large downside risk in hedge fund returns disqualifies the variance as an appropriate risk measure. For example, one can easily construct portfolios with nonlinear pay-offs that have both a high Sharpe ratio and a high downside risk. This paper examines the consequences of shortfall-based risk measures in the context of portfolio optimization. In contrast to popular belief, we show that negative skewness for optimal mean-shortfall portfolios can be much greater than for mean-variance portfolios. Using empirical hedge fund return data we show that the optimal mean-shortfall portfolio substantially reduces the probability of small shortfalls at the expense of an increased extreme crash probability. We explain this by proving analytically under what conditions short-put payoffs are optimal for a mean-shortfall investor. Finally, we show that quadratic shortfall or semivariance is less prone to these problems. This suggests that the precise choice of the downside risk measure is highly relevant for optimal portfolio construction under loss averse preferences. Copyright 2007 The Authors Journal compilation (c) 2007 Blackwell Publishing Ltd.

Efficiency Gains of a European Banking Union

An anticipated benefit of the prospective European Banking Union is stronger supervision of European banks. Another benefit would be enhanced resolution of banks in distress. While national governments confine themselves to the domestic effects of a banking failure, a European Resolution Authority would follow a supranational approach, under which domestic and cross-border effects within Europe are incorporated. Using a model of recapitalising banks, this paper develops indicators to measure the efficiency improvement of resolution. Next, these efficiency indicators are applied to the hypothetical resolution of the top 25 European banks, which count for the vast majority of cross-border banking in Europe. Our cost-benefit analysis indicates that the UK, Spain, Sweden, and the Netherlands are the main beneficiaries and thus have the largest economic incentives to join Europe’s Banking Union.

Optimal saving rules for loss-averse agents under uncertainty

Most empirical studies assume only monotonic preferences for households. Behavioral research however providessubstantial evidence that preferences for wealth are measured relative to a reference point. In this paper weintroduce and solve a two-period consumption and savings model for a loss-averse agent who measures utilityfrom consumption relative to a benchmark level. The solution is given as a parametric decision rule with oneunknown parameter that depends on the distribution of the return on saving. We find non-linearity in the fractionof wealth saved, where the specific saving pattern depends on the sign of the real return on savings. The amount of saving is nondecreasing in initial wealth and the riskiness of the return distribution.

Hedge Fund Innovation

We study first-mover advantages in the hedge fund industry by clustering hedge funds based on the type of assets and instruments they trade in, sector and investment focus, and fund details. We find that early entry in a cluster is associated with higher excess returns, longer survival, higher incentive fees and lower management fees compared to funds that arrive later. Moreover, the latest entrants have a high loading on the returns of the innovators, but with lower incentive fees, and higher management fees. Cross-sectional regressions show that the outperformance of innovating funds are declining with age. The results are robust to different parameters of clustering and backfill-bias, and are not driven by the possible existence of flagship and follow-on funds. Our results show that the reported characteristics of hedge funds can be used to infer strategy-related information and suggest that specific first-mover advantages exist in the hedge fund industry.

Short-put exposures in hedge fund returns: Are they really there?

Previous studies have shown that systematic risk in hedge fund returns is partly captured by short positions in put option returns. This is suggestive of a potential ‘peso problem’ in hedge fund returns: a series of steady returns may alternate with an occasional crash. In this paper, we analyze whether equity option-exposures are actually there, and find they are not. Although some hedge fund indices show some exposure to put or call-returns, several robustness analysis as well as an analysis of individual hedge fund returns show that exposures are not consistent with fundamental characteristics of options, such as put-call parity and the positive relation between option prices and volatility.

From Chaining Blocks to Breaking Even: A Study on the Profitability of Bitcoin Mining from 2012 to 2016

Bitcoin is a widely-spread payment instrument, but it is doubtful whether the proof-of-work (PoW) nature of the system is sustainable on the long term. To assess sustainability, we focus on the bitcoin miners as they play an important role in the proof-of-work consensus mechanism of bitcoin to create trust in the currency. Miners offer their services against a reward while recurring costs. Our results show that bitcoin mining has become less profitable over time to the extent that profits seem to converge to zero. This is what economic theory predicts for a competitive market that has a single homogenous good. We analyze the actors involved in the bitcoin system as well as the value flows between these actors using the e3value methodology. Then we quantify these value flows for the period January 2012 – December 2016. Since definitive figures about the size of the bitcoin mining industry are lacking, we reverse-engineer the expenses and revenues of the participating actors by deducting these from the bitcoin value, computing power of the network and available mining hardware specifications. At the end of our analysis period, the marginal profit of mining a bitcoin becomes negative, i.e., to a loss for the miners. This is caused by the consensus mechanism of the bitcoin protocol, which requires a substantial investment in hardware and significant recurring daily expenses for energy. Therefore, a sustainable crypto currency needs more computationally efficient algorithms to achieve consensus in a network about the truth of the distributed ledger.

Policy Lessons from Systemic Risk Modeling and Measurement

Abstract: The financial crisis changed the consensus on the adequacy of traditional bank regulation, which focused on the solvency of a single institution. The basic insight is that the banking system can “run on itself”, because of a lack of trust between financial institutions. The old system assumed that the health of banks was adequately captured with risk-based regulation, which turned out to be false. When the losses mounted, it turned out that potential losses were severely underestimated. Moreover, it became quite hard to assess which bank was solvent and which was not. The financial position of multiple banks was threatened at the same time: a systemic crisis.