Raman Uppal

Optimal Replication of Options with Transactions Costs and Trading Restrictions

This paper analyzes the strategy that minimizes the initial cost of replicating a contingent claim in a market with transactions costs and trading constraints. The linear programming and two-stage backward recursive models developed are applicable to the replication of convex as well as nonconvex payoffs and to a portfolio of options with different maturities. The papers formulation conveniently accounts for fixed and variable transactions costs, lot size constraints, and position limits on trading. The article shows that in the presence of trading frictions, it is no longer optimal to revise ones portfolio in each period. At the optimum, cash flows in excess of the desired ones may be generated. The optimal policy trades off the curvature of the payoff that is generated against the terminal slack.

Improving Portfolio Selection Using Option-Implied Volatility and Skewness

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful for improving their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics. Using option-implied volatility, risk-premium, and skewness to adjust expected returns leads to a substantial improvement in the Sharpe ratio, even after prohibiting shortsales and accounting for transactions costs.

Keynes Meets Markowitz: The Trade-Off Between Familiarity and Diversification

We develop a model of portfolio choice to nest the views of Keynes, who advocates concentration in a few familiar assets, and Markowitz, who advocates diversification. We use the concepts of ambiguity and ambiguity aversion to formalize the idea of an investors “familiarity” toward assets. The model shows that for any given level of expected returns, the optimal portfolio depends on two quantities: relative ambiguity across assets and the standard deviation of the expected return estimate for each asset. If both quantities are low, then the optimal portfolio consists of a mix of familiar and unfamiliar assets; moreover, an increase in correlation between assets causes an investor to increase concentration in familiar assets (flight to familiarity). Alternatively, if both quantities are high, then the optimal portfolio contains only the familiar asset(s), as Keynes would have advocated. In the extreme case in which both quantities are very high, no risky asset is held (nonparticipation). This paper was accepted by Brad Barber, Teck Ho, and Terrance Odean, special issue editors.

Efficient Intertemporal Allocations with Recursive Utility

In this article, our objective is to determine efficient allocations in economies with multiple agents having recursive utility functions. Our main result is to show that in a multiagent economy, the problem of determining efficient allocations can be characterized in terms of a single value function (that of a social planner), rather than multiple functions (one for each investor), as has been proposed thus far (Duffie, Geoffard and Skiadas (1994)). We then show how the single value function can be identified using the familiar technique of stochastic dynamic programming. We achieve these goals by first extending to a stochastic environment Geoffards (1996) concept of variational utility and his result that variational utility is equivalent to recursive utility, and then using these results to characterize allocations in a multiagent setting.

Valuing risk and flexibility: A comparison of methods

Discounted-cash-flow (DCF) techniques form the basis of most corporate-investment decisions. Many practitioners, however, claim to be dissatisfied with traditional methods of appraisal. In this paper, we survey DCF and more recent methods of evaluating cyclical projects.

Asset Prices with Heterogeneity in Preferences and Beliefs

In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have “catching up with the Joneses” utility functions and differ with respect to their beliefs (because of differences in priors) and their preference parameters for time discount, risk aversion, and sensitivity to habit. A key contribution of our paper is to demonstrate how one can obtain a closed-form solution to the consumption-sharing rule for agents who have both heterogeneous priors and heterogeneous preferences without restricting the risk aversion of the two agents to special values. We solve in closed form also for the the state-price density, the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; the term structure of interest rates; and the conditions necessary to obtain a stationary equilibrium in which both agents survive in the long run. The methodology we develop is sufficiently general that, as long as markets are complete, it can be used to obtain the sharing rule and state prices for models set in discrete or continuous time and for arbitrary endowment and belief updating processes.

Leverage Constraints and the Optimal Hedging of Stock and Bond Options

This paper considers the problem of a financial institution that needs to hedge a stream of state-contingent cash flows while facing borrowing and short-sales restrictions. The study determines analytically the strategy that minimizes the initial cost of hedging the desired cash flow, which is also the upper bound on its market price, and shows that the impact of leverage constraints on the cost of hedging call and put options is significant and, therefore, the biases detected by tests of option pricing models may not represent arbitrage opportunities. The paper also shows that with credit limits, it is optimal to reduce the rate of trading; thus, these constraints need to be recognized when estimating the trading volume generated in replicating contingent payoffs such as portfolio insurance.

Deviations from purchasing power parity and capital flows

Abstract This article examines the implications of deviations from purchasing power parity (PPP) for an investors portfolio decision and the consequent capital flows, in a two-country, intertemporal model with complete financial markets. In the presence of deviations form PPP, investors from different nations hold disparate portfolios and the equilibrium that results is not a pooling one. We solve eplicitly for asset demands and derive the relationship between the direction of capital flows and deviations from PPP. In contrast to the small country assumption in the existing literature, the world interest rate in this model is determined endogenously.

Asset Prices in General Equilibrium with Recursive Utility and Illiquidity Induced by Transactions Costs

In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium.

The intended and unintended consequences of financial-market regulations: A general equilibrium analysis

In a production economy with trade in financial markets motivated by the desire to share labor-income risk and to speculate, we show that speculation increases volatility of asset returns and investment growth, increases the equity risk premium, and reduces welfare. Regulatory measures, such as constraints on stock positions, borrowing constraints, and the Tobin tax have similar effects on financial and macroeconomic variables. Borrowing limits and a financial transaction tax improve welfare because they substantially reduce speculative trading without impairing excessively risk-sharing trades.