Joseph Cherian

Options Markets, Self-Fulfilling Prophecies, and Implied Volatilities

This paper answers the following often asked question in option pricing theory: if the underlying assets price does not satisfy a lognormal distribution, can market prices satisfy the Black-Scholes formula just because market participants believe it should?In complete markets, if the underlying assets objective distribution is not lognormal, then the answer is no. But, in an incomplete market, if the underlying assets objective distribution is not lognormal and all traders believe it is, then the answer is yes! The Black-Scholes formula can be a self-fulfilling prophecy.The proof of this second assertion consists of generating an economy where self-confirming beliefs sustain the Black-Scholes formula as an equilibrium. An asymmetric information model is provided, where the underlying assets price has stochastic volatility and drift. This model is distinct from the existing pricing models in the literature, and it provides new empirical implications concerning Black-Scholes implied volatilities and the bid/ask spread. Similar to stochastic volatility models, this model is consistent with the implied volatility “smile” pattern in strike prices. In addition, it is consistent with implied volatilities being biased predictors of future volatilities.

A Model of the Convenience Yields in On-the-Run Treasuries

The convenience yield differential between on- and off-the-run Treasury securities with identical maturities has two components. A non-cyclical component may arise due to the higher illiquidity of off-the-run bonds. Also, trading in the market for the next issue often causes cyclical shortages of the on-the-runs. When this occurs, owners of the on-the-run bond can earn riskless profits by borrowing at a special repo rate while lending at the prevailing risk free market rate. This second component of the convenience yield, induced by the auction, is cyclical. We first show that special repo rates and the convenience yield are jointly cyclical over the auction cycle. The patterns are statistically significant and pervasive. Repo specials are highest around the announcement day and disappear by the issue day. The off- minus on-the-run yield spread is highest at the beginning of the cycle and collapses near its end, consistent with a decreasing present value of profits over a decreasing horizon. Second, we develop a first no-arbitrage continuous-time model, with both interest and special repo rates stochastic, that prices the on-the-run bonds that command this convenience yield. A simple implementation of the model can generate yields consistent with the evidence.

An Emprical Analysis of Directional and Volatility Trading in Options Markets

Considerable research in the area of “market micro structure” focuses on the problem faced by market makers who are obliged to quote firm prices and trade with all comers, even when some of the traders they face will have access to valuable information that they do not know. For an optional stock, there are two classes of information about which way the stock price is likely to move next, and volatility information, relating to the likely size of the price move, which is most important for options trading. The two types of information have different implications for market makers in the stock and the options. In this article, Cherian and Weng investigate the extent to which trading activity in a stock and its options can provide insight into which type of information traders are currently active, and, then, how prices and bid-ask spreads respond in the different situations.

Optimal Extraction of Nonrenewable Resources When Prices are Uncertain and Costs Cumulate

Advances in economic theory and optimal control methods have considerably improved the prescriptions for the extraction of renewable and nonrenewable resources. While the classic analyses, going back to Hotelling (1931), proceeded under assumptions of price certainty, recent work addresses the considerable uncertainty in resource prices (which is of the same order as that of stock prices). For tractability, this newer literature assumes a constant marginal cost of extraction which ignores the considerable emphasis in the older literature on increasing marginal costs. We frame and solve the nonrenewable resource extraction problem (in the context of a typical mine) that jointly accounts for the significant price uncertainties as well as the dependence of extraction costs on the extraction rate and on the cumulative amount extracted. We find that ignoring cumulating cost when determining extraction strategy can lead to significant loss of value. Our analysis also establishes the general tools to pursue, for instance, the optimal taxation of natural resource sector that is of significant policy interest to many developing countries.

Chapter 20 Market manipulation

Publisher Summary This chapter presents an analytical classification scheme for surveying the recent papers on market manipulations in primary markets, specifically equity markets. The focus is to illustrate the types of market manipulation trading strategies possible, with examples similar in spirit to equilibrium models contained in the literature. A new perspective on firm corporate policy can be obtained by viewing the corporation as an active, strategic manipulator of its shares. The purpose of such corporation behavior is twofold: (i) to maximize its share price and (ii) to prevent its shares from being manipulated by others. The analysis generated within this framework provides insights into a number of frequently occurring phenomena in the corporate world. There are many ways to combat undesirable manipulation of the forms described in this chapter. Allowing manipulators to cover their short positions in the pre-issue market with stock purchased at the offering reduces manipulation around seasoned equity offerings. In the Jarrowas well as Kumar and Seppi models, better information flows between markets would curtail manipulation as prices act as a natural market-based safeguard against it. All models agree that free, unrestricted competition between the manipulators tends to drive their profits to zero.

Worry-Free Inflation-Indexing for Sovereigns - How Governments Can Effectively Deliver Inflation-Indexed Returns to Their Citizens and Retirees

In this paper we explore how small countries such as Malaysia, Singapore, and Taiwan, can offer their aging populations the means to protect their retirement income against inflation without the governments directly issuing inflation-protected bonds. While inflation swaps are a well-known means by which to attain this, we show how an inflation index-replication strategy is also feasible. With this ability to provide inflation-adjusted returns, governments, pension funds, and other institutions can begin to offer a broad suite of inflation-indexed products, ranging from retirement annuities to inflation-linked insurance policies. This will improve the functioning of national pension systems, and hence the welfare of retirees. The added benefit of such structures is that they allow governments to broadly replicate their local Consumer Price Index (CPI) returns without disrupting their traditional financing structures. Given the potential of reinsuring national default risks across borders via currency and credit default swap facilities at the federal level, there is a unique role for the government in this process as the reinsurer of last resort.

A Tail of Two Cities: On the Downside Risk and Loss Profile of Asian and North American Hedge Funds

This paper analyzes the downside risk and loss profiles of hedge funds in North America and Asia to identify any significant differences between the geographic markets and determine how these differences have converged or diverged over time. An attempt is made to understand the performance drivers that differentiate Asian from North American hedge funds. In the downside-risk analysis of 2,631 North American and 994 Asian hedge funds from January 1995 to February 2013, event-driven investment strategies for both geographic regions perform better than the other hedge fund investment strategies in relation to both risk and return, and downside risk. More diversified funds such as multi-strategy hedge funds do not necessarily perform better than single-manager strategies in relation to downside risk, while relative value strategies exhibit the most similar characteristics across the two geographies. Following their lackluster performance during the Asian Financial Crisis, Asian hedge funds improved their risk-adjusted performance, particularly during the recent Global Financial Crisis when their loss profile reached a level similar to that of their North American peers. Lastly, “nearby” funds, i.e., funds whose managers are located in the same investment geography, have slightly worse loss profiles than “distant” funds in both geographic markets, which result is slightly contrary to extant empirical evidence.

Panel: Asian financial integration

Asian intraregional trade far exceeds intraregional financial flows. Regional financial integration requires further market development with supportive institutions and common standards. Internal growth generation is important for the region to sustain global growth in the face of continued problems in Europe. Asian savings are large and it is an originator, not just a recipient, of financial flows. Given its population density, acute need for better retirement savings products, and genuine demand for infrastructure, institutional and product innovations that help retain its high savings in the region could meet real needs, while promoting more diverse and stable capital flows.