Rainer Baule

Optimal portfolio selection for the small investor considering risk and transaction costs

A direct application of classical portfolio selection theory is problematic for the small investor because of transaction costs in the form of bank and broker fees. In particular, minimum fees force the investor to choose a comparatively rather small selection of assets. The existence of transaction costs leads to an optimization problem that juxtaposes those costs against the risk costs that arise with portfolios consisting of only a few assets. Despite the non-convex and, thus, complex optimization, an algorithmic solution turns out to be very fast and precise. An empirical study shows that, for smaller investment volumes, transaction costs dominate risk costs so that optimal portfolios contain only a very small number of assets. Based upon these results, the cost-effectiveness of direct investments is compared to alternative vehicles, particularly index certificates and exchange-traded funds, depending on the level of invested wealth.

The Pricing of Path-Dependent Structured Financial Retail Products: The Case of Bonus Certificates

For no clear reason, many retail investors seem to have an unnatural taste for exotic structured products with payoffs that depend on complex and hard-to-value contingencies. Examples include barrier reverse convertibles, turbo certificates, and the object of this article, the bonus certificate. The payoff on a bonus certificate is tied to the level at expiration of an underlying variable, such as a stock index, and the path it has followed over its lifetime. At maturity, the return is the terminal value of the underlying, plus a bonus equal to the greater of a fixed exercise price less the terminal price, which is paid only if the underlying has not penetrated a prespecified barrier level during the contract’s lifetime. Valuing such a pathdependent instrument depends heavily on the nature of the return process. Baule and Tallau investigate the pricing and performance of bonus certificates in the German market, under several alternative models, with different assumptions about volatility behavior. The general conclusion, in rough terms, is that the issuers make an excess return while the buyers pay too much.

The Demand for Warrants and Issuer Pricing Strategies

We develop a model for the demand of warrants by individual investors with regard to their sensitivity to issuer margins, defined as the relative overpricing with respect to the theoretical value. Based on an empirical data set we show that investors are relatively margin‐sensitive; that is, given similar warrants from different issuers or warrants with similar characteristics, investors tend to buy those with the lowest margin. Investors are, however, not absolutely margin‐sensitive; that is, demand is not influenced by the overall margin level. Our model suggests an equilibrium with different issuer pricing strategies for different warrants in such a situation. Consistent with the models predictions, we find that issuers vary their pricing with the moneyness of a warrant. We thus give an explanation for the dependence of issuer margins on a products moneyness, which has been documented in the literature for several retail derivative products.

Measuring Idiosyncratic Risks in Leveraged Buyout Transactions

We use a contingent claims analysis model to calculate the idiosyncratic risks in Leveraged Buyout transactions. A decisive feature of the model is the consideration of amortization. From the model, asset value volatility and equity value volatility can be derived via a numerical procedure. For a sample of 40 Leveraged Buyout transactions we determine the necessary model parameters and calculate the implied idiosyncratic risks. We verify the expected model sensitivities by varying the input parameters. For the first time, we are able to calculate Sharpe Ratios for individual Leveraged Buyouts, thereby fully incorporating the leverage risks.

Which Beta is Best?On the Information Content of Option-Implied Betas

Option-implied betas are a promising alternative to historical beta estimators, because they are inherently forward-looking and can incorporate new information immediately and fully. Recently, different implied beta estimators have been developed in previous literature, but very little is known about their properties and information content. This paper presents a first systematic comparison between six different implied beta estimators, which provides some guidance for applications and identifies directions for further improvements. The main results of the empirical study reveal that betas derived from implied variances are better predictors of realized betas than betas obtained from implied skewness, and that cross-sectional information from all stocks in the market improves beta estimation significantly. We also find that option-implied betas generally have a higher information content in periods of relatively high trading activity in options markets.

Market Response to Mandatory Pre-Earnings-Announcements - Evidence from Ad-Hoc Disclosures in Germany

In this study, we examine the market reaction to ad hoc disclosures, a form of early disclosure unique to Germany, associated with periodic financial reports using data from the German stock market for the period 2003--2009. Although the immediate release of ad hoc disclosures is mandatory if subsequent periodic reports contain significant surprises, a considerable number of these disclosures is published on the same date as the corresponding report. While ad hoc disclosures, in general, lead to larger market reactions than periodic reports, results indicate that the majority of contemporaneous ad hoc disclosures are less important. An analysis of earnings surprises shows that market reaction to a similar earnings surprise is larger when the information is communicated through an ad hoc disclosure than when through a regular periodic report. We interpret a stronger market reaction as perceived higher persistence of the earnings surprise. Investigating the announcement timing, our analysis suggests that positive news that has persistent impact on future earnings is more likely to be announced early via ad hoc disclosure, while permanent disappointments tend to be announced with a delay.

Information Shares in Stationary Time Series and Global Volatility Discovery

Standard price discovery measures, particularly information shares, rely on the concept of co-integration for non-stationary time series. For the definition of information shares, the existence of a permanent impact of innovations is crucial, as these shares measure the relative contribution of different markets to this permanent impact. For stationary time series such as interest rates, CDS prices, or volatilities, a permanent impact however does not occur and thus the concept fails and lacks an interpretation. In this paper we extend the concept of information shares to the case of stationary time series. We suggest a price discovery measure based on the well-known variance decomposition for stationary time series, aiming to be equivalent to Hasbroucks information share. We show that this new price discovery measure converges to the standard information share in the border case of non-stationarity.

Revisiting Basel risk weights: cross-sectional risk sensitivity and cyclicality

We empirically assess the sensitivity of Basel risk weights to bank portfolio risk and the business cycle. With our econometric model, we distinguish between cross-sectional risk sensitivity and longitudinal risk sensitivity (cyclicality) of the regulatory standard. Employing a comprehensive data set covering 200 large banks from 28 countries, we find that actual risk weights are fairly insensitive to the business cycle. There is no evidence that Basel II has significantly increased cyclicality. Furthermore, cross-sectional risk sensitivity of regulatory risk weights to a market measure of bank portfolio risk is low. We further assess the adequacy of the capital standard’s risk sensitivity based on a Merton-style model of bank risk and bank default. Judged upon the Basel Committee’s self-established goal of maintaining bank default rates below 0.1 %, our results suggest that risk weights and minimum capital requirements are ill-calibrated, even under the stricter Basel III rules.

Zum Wertbeitrag des finanziellen Risikomanagements

Der Beitrag untersucht die Auswirkung finanziellen Risikomanagements auf den Wert einer Unternehmung. Ausgehend von der Irrelevanz finanziellen Risikomanagements bei Existenz eines vollkommenen Kapitalmarktes wird dessen Wertbeitrag auf der Grundlage von Marktunvollkommenheiten hergeleitet. Die Ausführungen konzentrieren sich auf Kosten finanzieller Anspannung als eine konkrete Abweichung zur neoklassischen Modellwelt.

Model Risk and Model Choice in the Case of Barrier Options

We analyze model risk for the pricing of barrier options. In contrast to existing literature, this paper is based on an empirical data set of over 40,000 bonus certificates to analyze the real market extent of model risk for traded barrier options instead of purely synthetic options. For this purpose a local volatility model, the Heston model and the Bates model are applied. Furthermore, we add to the literature on the behavior of issuers of retail derivatives in terms of model choice. We find evidence that the majority of the issuers prefer stochastic volatility over local volatility models, while they do not use the even more realistic Bates model which incorporates jumps in the underlying.