James J. Kung

Efficiency Of The Taiwan Stock Market

This study uses two popular technical trading rules to assess whether the gradual liberalization of Taiwans securities markets has improved the efficiency of its stock market. The results show that the two rules have considerable predictive power for 1983–1990, they become less predictive for 1991–1997, and they cannot predict the market for 1998–2005. These results indicate that the efficiency of Taiwan stock market has been greatly enhanced by the liberalization measures implemented over the last 20 years.

Option pricing under the Merton model of the short rate

Previous option pricing research typically assumes that the risk-free rate or the short rate is constant during the life of the option. In this study, we incorporate the stochastic nature of the short rate in our option valuation model and derive explicit formulas for European call and put options on a stock when the short rate follows the Merton model. Using our option model as a benchmark, our numerical analysis indicates that, in general, the Black-Scholes model overvalues out-of-the-money calls, moderately overvalues at-the-money calls, and slightly overvalues in-the-money calls. Our analysis is directly extensible to American calls on non-dividend-paying stocks and to European puts by virtue of put-call parity.

A cointegration study of the efficiency of the US Treasury STRIPS market

One theoretical implication of cointegration, according to Granger (1986), is that asset prices in an efficient market cannot be cointegrated. Using price data on US Treasury STRIPS with maturities from 2/15/1997 to 8/15/2015, it is found that a set of three STRIPS series is often cointegrated. In addition, by setting up a costless hedge portfolio from three STRIPS with three different maturities, it is found that the hedge portfolio is often stationary and thus arbitrage opportunities are likely to occur. That is, because the hedge portfolio is costless and stationary, cash in can be done when the value of the hedge portfolio is either positive or negative. However, when taking liquidity, tax effects, and transaction costs into consideration, these arbitrage profits would be unlikely. Hence, it is concluded that the US Treasury STRIPS market is efficient.

Multi-period asset allocation by stochastic dynamic programming

This study makes use of stochastic dynamic programming to set up a multi-period asset allocation model and derives an analytic formula for the optimal proportions invested in short and long bonds. Then maximum likelihood method is employed to estimate the relevant parameters. Finally, we implement the model through backward recursion algorithm to find numerically the optimal allocation of funds between short and long bonds for an investor with power utility and an investment horizon of ten years. Our results show that an investor will hold a larger proportion of short bond if his/her investment horizon gets shorter and/or if he/she is more risk averse.

An evaluation of some popular investment strategies under stochastic interest rates

The payoff distribution pricing model (PDPM) of Dybvig [13] is a powerful tool for measuring the inefficiency of any investment strategy in a multiperiod setting. In this study, we extend the PDPM in three major ways. Firstly, we develop an operational formula for computing the inefficiency amount of a strategy. Secondly, we use six different investment horizons spanning from one month to five years to cater to short-term and long-term investors. Thirdly, and most importantly, we incorporate the stochastic nature of the short interest rate into the PDPM using two well-known interest rate models. Under such formulation, we investigate the inefficiency of three popular investment strategies. Our simulation results show that their inefficiency amounts increase considerably when the investment horizon lengthens and/or when the short interest rate is stochastic. In general, the stop-loss strategy performs better than the other two strategies in terms of inefficiency amount.

Indonesia's stock market: evolving role, growing efficiency

Abstract The banking sector traditionally dominated Indonesias financial system, and until the 1990s the stock market remained of little significance. Re-opened in 1977 after two decades of inactivity, the stock exchange made little contribution to Indonesias development until a series of reform and deregulation measures were implemented from December 1987. This study examines the evolving role of the stock market in the financial system, and analyses changes in its efficiency over time. We find that stock market activity grew markedly in importance relative to banking after the reforms began to take effect, gaining the ascendancy in 2004 and moving well ahead subsequently. One contributor to this success is improvement in efficiency. Using two simple technical trading rules, we demonstrate that the stock exchange secondary market has indeed become significantly more efficient over time.

A two-asset stochastic model for long-term portfolio selection

In mean-variance (M-V) analysis, an investor with a holding period [0,T] operates in a two-dimensional space-one is the mean and the other is the variance. At time 0, he/she evaluates alternative portfolios based on their means and variances, and holds a combination of the market portfolio (e.g., an index fund) and the risk-free asset to maximize his/her expected utility at time T. In our continuous-time model, we operate in a three-dimensional space-the first is the spot rate, the second is the expected return on the risky asset (e.g., an index fund), and the third is time. At various times over [0,T], we determine, for each combination of the spot rate and expected return, the optimum fractions invested in the risky and risk-free assets to maximize our expected utility at time T. Hence, unlike those static M-V models, our dynamic model allows investors to trade at any time in response to changes in the market conditions and the length of their holding period. Our results show that (1) the optimum fraction y*(t) in the risky asset increases as the expected return increases but decreases as the spot rate increases; (2) y*(t) decreases as the holding period shortens; and (3) y*(t) decreases as the risk aversion parameter-@c is larger.

A nonparametric kernel regression approach for pricing options on stock market index

ABSTRACT Previous options studies typically assume that the dynamics of the underlying asset price follow a geometric Brownian motion (GBM) when pricing options on stocks, stock indices, currencies or futures. However, there is mounting empirical evidence that the volatility of asset price or return is far from constant. This article, in contrast to studies that use parametric approach for option pricing, employs nonparametric kernel regression to deal with changing volatility and, accordingly, prices options on stock index. Specifically, we first estimate nonparametrically the volatility of asset return in the GBM based on the Nadaraya–Watson (N–W) kernel estimator. Then, based on the N–W estimates for the volatility, we use Monte Carlo simulation to compute option prices under different settings. Finally, we compare the index option prices under our nonparametric model with those under the Black–Scholes model and the Stein–Stein model.

A Continuous-Time Model for Valuing Foreign Exchange Options

This paper makes use of stochastic calculus to develop a continuous-time model for valuing European options on foreign exchange (FX) when both domestic and foreign spot rates follow a generalized Wiener process. Using the dollar/euro exchange rate as input for parameter estimation and employing our FX option model as a yardstick, we find that the traditional Garman-Kohlhagen FX option model, which assumes constant spot rates, values incorrectly calls and puts for different values of the ratio of exchange rate to exercise price. Specifically, it undervalues calls when the ratio is between 0.70 and 1.08, and it overvalues calls when the ratio is between 1.18 and 1.30, whereas it overvalues puts when the ratio is between 0.70 and 0.82, and it undervalues puts when the ratio is between 0.86 and 1.30.

An efficient ex-ante criterion for ranking investment strategies

Fisher separation theorem [T.E. Copeland, J.F. Weston, K. Shastri, Financial Theory and Corporate Policy, fourth ed., Addison Wesley, New York, 2005] states that, in a perfect and complete capital market, the investment decisions of a firm are to maximize the wealth of its current shareholders regardless of their preferences. In this study, we integrate Dybvigs [P.H. Dybvig, Inefficient dynamic portfolio strategies or how to throw away a million dollars in the stock market, Review of Financial Studies 1 (1988) 67-88; P.H. Dybvig, Distributional analysis of portfolio choice, Journal of Business 61 (1988) 369-393] payoff distribution pricing model (PDPM) into the framework of this separation theorem and propose that an investment firm with numerous shareholders can use the inefficiency amount of the PDPM as a decision criterion for ranking ex-ante investment strategies in order of their value to the firm. For implementation, we formulate the PDPM in a multiperiod setting and develop an operational formula for computing the inefficiency amount of any strategy. Finally, using simulation, we compare four commonly used fixed-income strategies based on their inefficiency amounts.