Domingo Castelo Joaquin

Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets

The fundamental rationale for international portfolio diversification is that it expands the opportunities for gains from portfolio diversification beyond those that are available through domestic securities. However, if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yie ld the promised gains just when they are needed most. We evaluate the extent to which observed correlations to monthly returns in bear, calm and bull markets are captured by three popular bivariate distributions: (1) the normal, (2) the restricted GARCH(1,1) of J. P. Morgans RiskMetrics, and (3) the Student-t with four degrees of freedom. Observed correlations during calm and bull markets are unexceptional compared to these models. In contrast, observed correlations during bear markets are significantly higher than predicted. Higher-than-normal correlations during extreme market downturns result in monthly returns to equal-weighted portfolios of domestic and international stocks that are, on average, more than two percent lower than those predicted by the normal distribution. If the extent of non-normality during bear markets persists over time, then a U.S. investor allocating assets into foreign markets might want to allocate more assets into foreign markets with near-normal correlation profiles and avoid markets with higher-than-normal bear market co-movements.

Investment timing decisions under threat of potential competition: Why firm size matters1

Abstract We study the value of the option to wait when other firms are looking at similar opportunities and may enter while one firm is waiting for uncertainty resolution. There are two important results. First the value of an investment project is affected by a firm’s assets-in-place, giving some firms a comparative advantage in competitive situations. Second, when two firms with different sized assets-in-place are looking at similar investment decisions, in the unique sub-game perfect equilibrium, the smaller firm invests earlier and also exits before a competing firm with larger assets-in-place. This makes an otherwise identical investment more valuable for the smaller firm. The larger firm optimally foregoes first-mover advantage because of higher expected exit costs.

Loss Modeling Using Spreadsheet-Based Simulation

With the dramatic increase in the speed of personal computers and steep decline in the cost of computing, simulation has become one of the standard tools in the risk managers toolbox and should now become one of the standard tools in the risk management and insurance students toolbox. This teaching note aims to facilitate this process by showing how to create and run a simulation in a spreadsheet environment, and interpret simulation results to gain insight and understanding about a real‐world problem. Specifically, this teaching note provides step‐by‐step instruction for simulating the present value of payments for losses occurring within a 1‐year policy period. Losses are covered by an aggregate excess of loss treaty. The uncertainty lies in the frequency and severity of losses as well as in claim processing time, and also in the discount rate for calculating the present value of loss payments.

Anomalies in net present value calculations

Abstract In a recent issue of Economics Letters (67 (2000) 349–351), Oehmke notes that in exactly the cases that may give rise to either none or more than one internal rate of returns, it is possible for the net present value to increase as the discount rate increases, or to decrease as the discount rate decreases. Oehmke characterizes this behavior as an anomaly which ‘may make the net present value unsuitable for certain types of project-selection decisions.’ This note shows how the NPV criterion can be applied in a specified subset of cases where there is no monotonic relationship between the NPV and the discount rate and only the interval of plausible discount rates is known.

On Animal Spirits and Economic Decisions: Value-at-Risk and Value-within-Reach as Measures of Risk and Return

Let us suppose that presently unimagined is possible, that “the unexpected may happen” (Marshall (1920). Principles of economics, McMillan, London, p. 347). Then “human decisions affecting the future, whether personal, political or economic, cannot depend on strict mathematical expectation since the basis for making such calculations does not exist” (Keynes (1936). The general theory of employment, interest and money, Harcourt Brace, New York, NY, pp. 162–163) and “individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits” (Keynes (1936). The general theory of employment, interest and money, Harcourt Brace, New York, NY, p. 162)—by “a spontaneous urge to action rather than inaction” (Keynes (1936). The general theory of employment, interest and money, Harcourt Brace, New York, NY, p. 161). It is intended here to examine an investments Value-at-Risk as a reasonable calculation of the worst threat an action appears to make possible, and its return counterpart, referred to as the investments Value-within-Reach, as a reasonable calculation of the best hope an action appears to offer. In exploring the extension of the Value-at-Risk approach from applications to investments in financial assets to applications to investments in real assets, the properties of Value-at-Risk as a risk measure are reviewed. Recognizing that Value-at-Risk focuses exclusively on downside risk, a complementary set of properties is specified which is shown to be necessary and sufficient for the acceptance of Value-within-Reach as a measure of return. This note concludes with remarks on a distributions focus-values, consisting of the distributions Value-at-Risk and Value-within-Reach, as reasonable calculation of a course of actions risk and return.

Using Simulation to Support the R&D Decision of a Pharmaceutical Firm

This paper illustrates how simulation modeling can be employed to support the R&D decision of a pharmaceutical firm. We do this in the context of a simplified but realistic example, where a drug company has just successfully completed the second phase of a three-phase process for assessing the effectiveness of a proposed drug in treating a targeted ailment with acceptable levels of side-effects. We provide step-by-step instruction for simulating the net present value and the internal rate of return of a ten-year pharmaceutical R&D project. The uncertainty lies in the efficacy of proposed drug and that of an alternative drug. Random too, are the initial size of the total market, and its subsequent exponential growth rate. Market share depends on the efficacy of proposed drug relative to that of the alternative drug, as well as, the subsequent introduction of new, alternative drugs in the market, which arrive in a random fashion. Finally, the ratio of cost of goods sold to sales and the terminal EBITDA multiple are also random. The problem is a variation of the Newdrug examples in chapters 19-21 of Andrew Metrick and Ayako Yasuda’s (2010) venture capital finance text.