combining valuable inventions exploring the impact of prior invention value on the performance of subsequent inventions innovation research widely acknowledges that most inventions are recombinations of existing ideas and technologies following this stream of research this study analyses how the values of prior inventions used to develop a subsequent invention influence the value of the new invention building on evolutionary theory and research on technological search and technological paradigms this article proposes a positive relationship between prior inventions value and subsequent invention value the analysis of a large scale patent data set of pharmaceutical and semiconductor firms largely confirms this notion however it also shows that the effect weakens when prior inventions are of higher value valuable prior inventions are also positively related to the likelihood that subsequent inventions are breakthroughs however while this effect also decreases when prior inventions hold higher values the decreasing effect occurs only at particularly high levels of prior invention value in contrast combining valuable inventions limits the likelihood of generating poor invention outcomes value in summary while the results lend support to theories of evolutionary and cumulative technological progress they also show that despite the recombination potential of technical knowledge there are practical limits to the benefits of valuable inputs

u s federal budget deficits and gramm rudman hollings the u s federal budget deficits averaged about 1 percent of gnp in the 1960s about 2 percent of gnp in the 1970s and then rose to a peak of 5 5 percent of gnp in the four bad years of fiscal 1983 to fiscal 1986 by fiscal 1989 they had fallen back to 2 9 percent of gnp and under present legislation they are now projected to drop to about 1 5 percent of gnp by 1994 when deficits were at their peak before the start of the budget bargain for fiscal 1987 the first budget to show any sizeable deficit reduction the country passed the grammrudman hollings grh deficit control law this law has been revised and amended over time but it is still operating in roughly its initial form superficially the numbers given above suggest that it must be working pretty well moreover in many ways grh was written to respond to the standard criticisms of deficit constraint legislation it did not call for abrupt cuts in deficits but rather gradual declines it was legislative and flexible rather than constitutional and rigid yet just as the country is on the verge of finally getting its deficits under control the legislation is coming under vicious attack including even that of one of its sponsors senator hollings why should such an apparently successful piece of legislation be so widely scorned in this paper i take on this question i first illustrate how grh was intended to operate with a simple indifference curve model and use this model to see what kinds of changes should have occurred in budget bargains and spending patterns then i look for these changes by comparing numbers from the pre grh era 1983 86 with those from the post grh era 1987 89 i also identify other sources of improvement in budgetary position from the earlier to the later period this numerical comparison suggests that the direct effects of grh played a very minor role in the improvement in the u s budgetary position though it seems likely that difficult to evaluate indirect effects were much more significant

variance risk premium dynamics the role of jumps using high frequency stock market data and synthetic variance swap rates this paper identifles and investigates the temporal variation in the market variance risk premium the variance risk is manifest in two salient features of flnancial returns stochastic volatility and jumps the pricing of these two separate components is analyzed in a general semiparametric framework the key empirical results imply that investors fears of future jumps are especially sensitive to recent jump activity and that their willingness to pay for protection against jumps increase signiflcantly immediately after the occurrence of jumps this in turn suggests that time varying risk aversion as previously documented in the literature is primarily driven by large or extreme market moves the dynamics of risk neutral jump intensity extracted from deep out of the money put options conflrms these flndings jel c51 c52 g12 g13

performance evaluation of optimized portfolio insurance strategies abstract we use s p 500 index return data for the time period 1985 2013 to evaluate the performance of portfolio insurance strategies we shed light on the question if the performance of a constant proportion portfolio insurance cppi strategy can be improved by means of a time varying multiplier which depends on the estimated future volatility neglecting any inter temporal hedging demand the theoretical foundation of the strategies is given by maximizing the expected utility of a hara investor in a diffusion model setup if the risk premium is assumed to be proportional to the variance the optimal strategy is a cppi strategy otherwise the multiple is time varying ppi it turns out that even time varying multiple strategies based on a rolling window of historical volatility estimates give a significant improvement of cppi strategies the out performance is robust w r t alternative performance measures and is also true for proportional transaction costs and adequate trigger trading

dynamic asset allocation with event risk major events often trigger abrupt changes in stock prices and volatility we study the implications of jumps in prices and volatility on investment strategies using the event risk framework of duffie pan and singleton 2000 we provide analytical solutions to the optimal portfolio problem event risk dramatically affects the optimal strategy an investor facing event risk is less willing to take leveraged or short positions the investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends both dynamic and buy and hold strategies jumps in prices and volatility both have important effects

preference heterogeneity and asset prices an exact solution abstract we introduce a general equilibrium model of a multi agent pure exchange economy and find a set of conditions that enable us to obtain explicit closed form solutions to the equilibrium interest rate stock price risk premium and stock market volatility when investors have heterogenous risk aversions because the market is dynamically complete full risk sharing obtains and a representative agent can be constructed though the risk aversion of this agent fluctuates over time with the state of the economy as the relative wealth distribution of the individual investors changes we show that preference heterogeneity can cause asset prices to be significantly more volatile than the underlying dividends and that it can lead to leverage like effects in volatility in the sense that volatility increases after stock market declines

the skew risk premium in the equity index market we develop a new method for measuring moment risk premiums we find that the skew premium accounts for over 40 of the slope in the implied volatility curve in the s p 500 market skew risk is tightly related to variance risk in the sense that strategies designed to capture the one and hedge out exposure to the other earn an insignificant risk premium this provides a new testable restriction for asset pricing models trying to capture in particular disaster risk premiums we base our results on a general trading strategy by replicating contracts that swap implied for realized conditional asset moments

riding the swaption curve abstract we conduct an empirical analysis of the term structure in the volatility risk premium in the fixed income market by constructing long short combinations of two at the money straddles for the four major swaption markets usd jpy eur and gbp our findings are consistent with a concave upward sloping maturity structure for all markets with the largest negative premium for the shortest term maturity the fact that both delta vega and delta gamma neutral straddle combinations earn positive returns that seem uncorrelated suggests that the term structure is affected by both jump risk and volatility risk the results seem robust for macroeconomic announcements and the specific model choice to estimate the risk exposures for hedging

the volatility risk premium embedded in currency options this study employs a non parametric approach to investigate the volatility risk premium in the over the counter currency option market using a large database of daily delta neutral straddle quotes in four major currencies the british pound the euro the japanese yen and the swiss franc we find that volatility risk is priced in all four currencies across different option maturities we find that the volatility risk premium is negative with the premium decreasing in maturity finally we also find evidence that jump risk may be priced in the currency option market

dynamic optimal portfolio choice in a jump diffusion model with investment constraints we consider the dynamic portfolio choice problem in a jump diffusion model where an investor may face constraints on her portfolio weights for instance no short selling constraints it is a daunting task to use standard numerical methods to solve a constrained portfolio choice problem especially when there is a large number of state variables by suitably embedding the constrained problem in an appropriate family of unconstrained ones we provide some equivalent optimality conditions for the indirect value function and optimal portfolio weights these results simplify and help to solve the constrained optimal portfolio choice problem in jump diffusion models finally we apply our theoretical results to several examples to examine the impact of no short selling and or no borrowing constraints on the performance of optimal portfolio strategies

dosi s technological paradigms and trajectories insights for economics and management dosi 1982 has provided an eclectic framework which has for some time now been one of the core concepts in innovation studies while it has been very influential in public policy in management it remains underexploited many insights remain to be teased out of the framework which can help managers make better decisions this article reflects on the far reaching impact of dosi s ideas and his role in the founding and development of industrial and corporate change

decomposition of optimal portfolio weight in a jump diffusion model and its applications this article solves the portfolio choice problem in a multi asset jump diffusion model we decompose the optimal portfolio weight into components that correspond to a collection of fictitious economies one of which is a standard diffusion economy and the others of which are pure jump economies we derive a semi closed form solution for the optimal portfolio weight and investigate its properties with or without ambiguity aversion we find that an investor may not reduce her investment in risky assets when facing more frequent jumps as suggested by a single asset jump diffusion model moreover an investor who is extremely cautious about her estimates of higher moments of asset returns may still hold risky assets contrary to the prediction of a pure diffusion model with ambiguity aversion to the first moment

partial information about contagion risk self exciting processes and portfolio optimization abstract this paper compares two classes of models that allow for additional channels of correlation between asset returns regime switching models with jumps and models with contagious jumps both classes of models involve a hidden markov chain that captures good and bad economic states the distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously we show that in this framework the filtered loss intensities have dynamics similar to self exciting processes besides we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering

wage expectations in the labor market survey evidence on rationality using a new set of directly observed wage expectations among firms this paper finds that in general firms forecasts fail the unbiasedness and efficiency requirements of weak form rational expectations these market participants consistently underestimate the wages they actually end up paying and their expectations do not efficiently utilize the information in past realizations the mean absolute forecast error of two percent compares with an error of only five percent if static expectations were held the major source of wage fore cast error seems to be errors in predicting demand rather than in predicting supply or the general price level wage forecast errors are positively correlated across fields with distinct supply patterns and are positively correlated with quantity forecast error the properties of stochastically weighted expectations and the effectiveness of the wage and price controls of the early 1970 s are also discussed this abstract was borrowed from another version of this item

learning and forecasts about option returns through the volatility risk premium we use learning in an equilibrium model to explain the puzzling predictive power of the volatility risk premium vrp for option returns in the model a representative agent follows a rational bayesian learning process in an economy under incomplete information with the objective of pricing options we show that learning induces dynamic differences between probability measuresp and q which produces predictability patterns from the vrp for option returns the forecasting features of the vrp for option returns obtained through our model exhibit the same behaviour as those observed in an empirical analysis with s p 500 index options

who should buy long term bonds according to conventional wisdom long term bonds are appropriate for conservative long term investors this paper develops a model of optimal consumption and portfolio choice for infinite lived investors with recursive utility who face stochastic interest rates solves the model using an approximate analytical method and evaluates conventional wisdom as risk aversion increases the myopic component of risky asset demand disappears but the intertemporal hedging component does not conservative investors hold assets to hedge the risk that real interest rates will decline long term inflation indexed bonds are most suitable for this purpose but nominal bonds may also be used if inflation risk is low

the role of the variance premium in jump garch option pricing models abstract we develop a discrete time option pricing model incorporating a variance dependent pricing kernel of christoffersen et al 2013 under an economic framework allowing for dynamic volatility and jump intensity based on the model we examine the role of the variance premium and jump risk premium in explaining s p 500 index option prices and returns according to the results the variance premium is equally important as the jump risk premium in explaining the empirical option data whereas the incorporation of the jump risk premium improves the model fit on option prices the incorporation of the variance premium improves the fit on option returns in particular the variance premium can explain both 1 month holding period returns of 2 month maturity straddles which are significantly negative and call returns which decrease according to moneyness the model incorporating the jump risk premium only has a limitation in explaining the above two stylized returns the outperformance of the model incorporating the variance premium on option returns stems from its ability to capture the wedge between physical and risk neutral volatilities

the role of risk aversion and intertemporal substitution in dynamic consumption portfolio choice with recursive utility abstract our objective is to understand how risk aversion and elasticity of intertemporal substitution under recursive utility affect dynamic consumption portfolio decisions for a three date model with a stochastic interest rate we obtain an analytic solution for the optimal policies we find that in general consumption and portfolio decisions depend on both risk aversion and elasticity of intertemporal substitution the size of risk aversion relative to unity determines the sign of the intertemporal hedging portfolio while elasticity of intertemporal substitution affects only its magnitude the portfolio weight is independent of elasticity of intertemporal substitution only for the case of a constant investment opportunity set

a theory of volatility spreads this study formalizes the departure between risk neutral and physical index return volatilities termed volatility spreads theoretically the departure between risk neutral and physical index volatility is connected to the higher order physical return moments and the parameters of the pricing kernel process this theory predicts positive volatility spreads when investors are risk averse and when the physical index distribution is negatively skewed and leptokurtic our empirical evidence is supportive of the theoretical implications of risk aversion exposure to tail events and fatter left tails of the physical index distribution in markets where volatility is traded

deficits and inflation an open economy model of the united states the deficit debate is a recurring theme in academic and political circles the controversy is over the effect of deficits on inflation and interest rates the existing body of empirical evidence does not resolve the controversy this paper focuses on the inflationary impact of deficits the model used is derived from a comprehensive is lm analysis which incorporates a foreign trade sector and a general price adoptive expectation adjustment mechanism we test the model using time series data for the united states from our results we conclude that nia deficits have no significant bearing on the rate of inflation

paradigm changing vs paradigm deepening innovation how firm scope influences firm technological response to shocks we examine the direction of firms research efforts as they respond to the shock of a sharp increase in the price of a key input in terms of direction firms can respond to this shock with paradigm changing investments that develop technologies to use substitute inputs or with paradigm deepening investments that develop technologies to improve the utilization efficiency of the existing input we develop a framework that suggests that firms emphasis on paradigm changing versus paradigm deepening investments depends on the degree of input relatedness across their businesses we test our hypotheses by examining the responses of large manufacturing firms in the united states to the oil shock of the early 1980s our framework predicts and our results show that the more related a firm s businesses are the larger its investments into paradigm changing technologies are and the smaller its investments into paradigm deepening technologies in response to the oil shock are we identify the implications of these findings for technological evolution and diversification literatures

volatility uncertainty time decay and option bid ask spreads in an incomplete market this paper documents the fact that in options markets the percentage implied volatility bid ask spread increases at an increasing rate as the option s maturity date approaches to explain this stylized fact this paper provides a market microstructure model for the bid ask spread in options markets we first construct a static equilibrium model to illustrate the aforementioned phenomenon where risk averse and competitive option market makers quote bid and ask prices to minimize their inventory risk in an incomplete market with both directional and volatility risk we extend this model to multiperiods and show that the same phenomenon occurs there as well two new implications are generated a volatility level effect and a volatility variance effect these implications are empirically tested and the empirical results confirm the model s validity finally we document the importance of detrending the maturity effect by showing that the detrended percentage volatility spread explains future jump intensit

bias in omb s economic forecasts and budget proposals the office of management and budget omb annually submits the president s budget for the u s government to the congress the economic forecasts and revenue and outlay proposals contained in the budget have been criticized as biased especially during the 1980s tests for bias in one year ahead proposals for the 1963 89 period show no bias in economic forecasts and revenue estimates but substantial bias in outlay proposals most outlay proposals are consistently less than actual outcomes accounting for underprediction of the federal deficit omb outlay proposals appear to be influenced by politics republican administrations show more significant proposal biases with defense proposals higher and domestic outlay proposals lower than outcomes the office of management and budget consistently understates the deficits by resorting to the most optimistic economic assumptions it can credibly and now sometimes even incredibly employ senator james sasserwall street journal 25 january 1990

explaining cds prices with merton s model before and after the lehman default abstract we examine whether cds prices around the credit crisis can be explained with merton s model first we invert the model with market prices to reveal skewed volatility smiles over the whole 2005 2012 period then we calibrate the model to pre crisis data in two novel ways that allow for skewness one based on equity index options meiv and the other on the sensitivity of cds prices to equity volatility mskew in out of sample forecasts both calibrations match the in crisis peak of prices but the second is better at capturing the systematic component of prices thereafter average cds prices remain at twice their pre crisis level long after that event the mskew calibration demonstrates that this is due to extra idiosyncratic risks which are important for some firms but have negligible impact on others

a characterization of the daily and intraday behavior of returns on options the daily and intraday behavior of returns on chicago board options exchange options is examined option returns contain systematic patterns even after adjusting for patterns in the means and variances of the underlying assets this is consistent with the hypothesis that informed trading in options can make the order flow in the options market informative about the value of the underlying asset making options nonredundant the intraday patterns in adjusted option return variances are further consistent with a model of strategic trading by informed and discretionary liquidity traders this paper examines the daily and intraday behavior of returns on options we have two goals our first objective is to identify systematic patterns in the means and variances of daily and intraday returns on options our second objective is to decompose option returns into patterns that are related to the means and variances of the underlying stocks and by inference those patterns that are independent of patterns in the means and variances of the underlying assets 1 our work is important for a number of reasons first options have become as important as common stocks yet there is no detailed investigation of the behavior of returns on options second it is important to identify similarities and differences in return patterns across different securities and market structures an understanding of these similarities and differences would allow us to develop better models of returns that capture these properties closely related to this it is instructive to examine option returns in light of the partial equilibrium models we use to value them specifically are the return patterns in options driven exclusively by the underlying stocks or do option returns contain patterns of their own identifying independent yet similar patterns in options returns may lead to an identification of factors that are common across two different market structures the new york

a nonlinear factor analysis of s p 500 index option returns growing evidence suggests that extraordinary average returns may be obtained by trading equity index options and that at least part of this abnormal performance is attributable to volatility and jump risk premia this paper asks whether such priced risk factors are alone sufficient to explain these average returns to provide an answer in as general as possible a setting i estimate a flexible class of nonlinear models using all s p 500 index futures options traded between 1986 and 2000 the results show that priced factors contribute to these expected returns but are insufficient to explain their magnitudes particularly for short term out of the money puts in a recent paper c oval and shumway 2001 examine the returns on deltahedged option positions focusing on the at the money straddle and find average returns close to minus 3 per week since over short time horizons these positions are approximately invariant to movements in the underlying index coval and shumway argue that their capm betas should be near zero and their expected returns close to the risk free rate they conclude that large deviations from the capm are the norm which they suggest is evidence that some other systematic factor such as stochastic volatility might be priced by the market similar conclusions are made by jackwerth 2000 who finds risk adjusted profitability from selling puts and by bakshi and kapadia 2003 who find that the volatility risk premium contributes significantly to higher prices for calls and puts buraschi and jackwerth 2001 concur suggesting that more than one priced risk factor is necessary to explain option prices a less direct set of evidence is the now standard observation that the black scholes implied volatilities of equity index options are upward biased predictors of future realized volatility numerous studies such as fleming ostdiek and whaley 1995 and christensen and prabhala 1998 document that implied volatilities of short term at the money equity index options are on average several percentage points higher than the volatilities realized over the option s

inferring volatility dynamics and risk premia from the s p 500 and vix markets abstract we estimate a flexible affine model using an unbalanced panel containing s p 500 and vix index returns and option prices and analyze the contribution of vix options to the model s in and out of sample performance we find that they contain valuable information on the risk neutral conditional distributions of volatility at different time horizons which is not spanned by the s p 500 market this information allows enhanced estimation of the variance risk premium we gain new insights on the term structure of the variance risk premium present a trading strategy exploiting these insights and show how to improve s p 500 return forecasts

cumulative prospect theory option returns and the variance premium the variance premium and the pricing of out of the money otm equity index options are major challenges to standard asset pricing models we develop a tractable equilibrium model with cumulative prospect theory cpt preferences that can overcome both challenges the key insight is that the variance premium can be written as the expected return on a portfolio of otm call and put options and the probability weighting feature of cpt can explain the puzzlingly low returns observed for these options using gmm on a sample of u s index option returns between 1996 and 2010 we show that the cpt model ts well observed option prices and therefore the variance premium in a dynamic setting probability weighting and time varying equity return volatility combine to match the observed time series pattern of the variance premium

the factor structure in equity options principal component analysis of equity options on dow jones rms reveals a strong factor structure the rst principal component explains 77 of the variation in the equity volatility level 77 of the variation in the equity option skew and 60 of the implied volatility term structure across equities furthermore the rst principal component has a 92 correlation with sp g12 g13

do investors follow the herd in option markets we investigate the previously unexplored herding behaviour of investors in option markets by examining equity option contracts traded in the us between 1996 and 2012 we document strong herding effects in option trading activity that are conditional on a set of systematic factors related to periods of market stress more specifically we find that option investors tend to herd during periods of high market volatility risk on dates of macroeconomic announcements during the financial crisis of 2008 when a large number of market option positions is either opened or closed and during periods of a large average dispersion of analysts forecasts

portfolio performance evaluation old issues and new insights this article presents a model that provides insights about various measures of portfolio performance the model explores several criticisms of these measures these include the problem of identifying an appropriate benchmark portfolio the possibility of overestimating risk because of market timing ability and the failure of informed investors to earn positive risk adjusted returns because of increasing risk aversion the article argues that these need not be serious impediments to performance evaluation

systemic risk and international portfolio choice returns on international equities are characterized by jumps moreover these jumps tend to occur at the same time across countries leading to systemic risk we capture these stylized facts using a multivariate system ofjump diffusion processes where the arrival of jumps is simultaneous across assets we then determine an investor s optimal portfolio for this model of returns systemic risk has two effects one it reduces the gains from diversification and two it penalizes investors for holding levered positions we find that the loss resulting from diminished diversification is small while that from holding very highly levered positions is large returns on international equities are characterized by jumps 1 moreover these jumps tend to occur at the same time across countries implying that conditional correlations between international equity returns tend to be higher in periods of high market volatility or following large downside moves 2 our objective in

the jump component of s p 500 volatility and the vix index much research has investigated the differences between option implied volatilities and econometric model based forecasts implied volatility is a market determined forecast in contrast to model based forecasts that employ some degree of smoothing of past volatility to generate forecasts implied volatility has the potential to reflect information that a model based forecast could not this paper considers two issues relating to the informational content of the s p 500 vix implied volatility index first whether it subsumes information on how historical jump activity contributed to the price volatility followed by whether the vix reflects any incremental information pertaining to future jump activity relative to model based forecasts it is found that the vix index both subsumes information relating to past jump contributions to total volatility and reflects incremental information pertaining to future jump activity this issue has not been examined previously and expands our understanding of how option markets form their volatility forecasts

u s stock market crash risk 1926 2010 abstract this paper examines how well alternate time changed levy processes capture stochastic volatility and the substantial outliers observed in u s stock market returns over the past 85 years the autocorrelation of daily stock market returns varies substantially over time necessitating an additional state variable when analyzing historical data i estimate various one and two factor stochastic volatility levy models with time varying autocorrelation via extensions of the bates 2006 methodology that provide filtered daily estimates of volatility and autocorrelation the paper explores option pricing implications including for the volatility index vix during the recent financial crisis

optimal portfolio allocation with volatility and co jump risk that markowitz would like abstract we study a continuous time optimal portfolio allocation problem with volatility and co jump risk allowing prices variances and covariances to jump simultaneously differently from the traditional approach we deviate from affine models by specifying a flexible wishart jump diffusion for the co precision the inverse of the covariance matrix the optimal portfolio weights that solve the dynamic programming problem are genuinely dynamic and proportional to the instantaneous co precision reconciling optimal dynamic allocation with the static markowitz type economic intuition an application to the optimal allocation problem across hedge fund investment styles illustrates the importance of having jumps in volatility associated with jumps in price

understanding index option returns this paper studies the returns from investing in index options previous research documents significant average option returns large capm alphas and high sharpe ratios and concludes that put options are mispriced we propose an alternative approach to evaluate the significance of option returns and obtain different conclusions instead of using these statistical metrics we compare historical option returns to those generated by commonly used option pricing models we find that the most puzzling finding in the existing literature the large returns to writing out of themoney puts is not even inconsistent with the black scholes model moreover simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data at the money straddle returns are more challenging to understand and we find that these returns are not inconsistent with explanations such as jump risk premia peso problems and estimation risk

the returns and risk of alternative put option portfolio investment strategies this paper is the second in a series of analyses we have prepared based on simulations of a variety of portfolio strategies over a significant period of time the first of these analyses examined the fully covered call option writing strategy and the buying strategy which combines purchase of call options and commercial paper in the study presented here we examine the uncovered put writing strategy and the buying strategy which combines the purchase of put options and the underlying stocks as a preface to the simulations we analyze the quantitative discrepancies between the parity model of put pricing and a model which takes into account the possibility of early exercise of the put in connection with this analysis we simulate the returns to the conversion strategy which combines the purchase of put options and the underlying stocks with the simultaneous sale of the corresponding call options as in our earlier paper on call option strategies we find in this study that investors can use uncovered putoption writing and protective put optionbuying strategies to produce patterns of returns for investment portfolios not reproducible by any simple strategy of combining stock with fixed income securities put options are viewed as term insurance insuring against a loss in value of underlying stock investors sell insurance by using the uncovered put writing strategies and investors buy insurance protecting the value of stocks within a portfolio by using protective put optionbuying strategies no put strategy or call strategy can dominate any other strategy if options are priced correctly although there is no single best strategy for all investors they are not indifferent among strategies because the patterns of returns differ we therefore show these important patterns of returns on put option strategies not only using single stocks but also using portfolios of stocks this research was financed in part by grants from donaldson lufkin jenrette new york the center for research in security prices university of chicago and the national science foundation washington d c 1 merton scholes and gladstein 1978 in the present paper all references to our earlier paper are to this study

humps in the volatility structure of the crude oil futures market new evidence abstract this paper analyses the volatility structure of commodity derivatives markets the model encompasses hump shaped unspanned stochastic volatility which entails a finite dimensional affine model for the commodity futures curve and quasi analytical prices for options on commodity futures using an extensive database of crude oil futures and futures options spanning 21 years we find the presence of hump shaped partially spanned stochastic volatility in the crude oil market the hump shaped feature is more pronounced when the market is more volatile and delivers better pricing as well as hedging performance under various dynamic factor hedging schemes

the congressional budget process aggregate spending and statutory budget rules abstract this paper compares the congressional budget process instituted in 1974 and the piecemeal appropriations process that preceded it previous theoretical analysis using spatial models of legislator preferences finds no systematic difference in relative spending levels under the two regimes this paper instead uses a model of interest group lobbying a legislature determines spending on a national public good and on subsidies to sector specific interest groups in the appropriations process the appropriations committee proposes a budget that because of interest group influence involves overspending on subsidies in the budget process the budget committee proposes an aggregate level of spending the budget resolution then the appropriations committee proposes a budget a free rider problem among the interest groups inhibits the lobbying of the budget committee to increase the aggregate budget if each group is sufficiently small it takes the budget resolution as given and lobbies the appropriations committee aggregate spending is lower and social welfare is higher under the budget process however provision of the national public good is suboptimal the paper also analyzes statutory budget rules that limit spending levels but can be revised by a simple majority vote here the free rider problem prevents the groups from securing the required changes to budget rules

the equilibrium allocation of diffusive and jump risks with heterogeneous agents abstract we study a two agent pure exchange equilibrium subject to both nondiversifiable diffusive and jump risks agents can trade in a financial market consisting of a stock market a money market and an insurance market for jump risk heterogeneity is introduced through different levels of relative risk aversion in the framework of standard expected utility we find the surprising result that the less risk averse agent purchases insurance contracts against jump risk from the more risk averse agent this equilibrium allocation is linked to the non linear wealth sharing rule in such an economy and preserves the wealth effects studied by dumas rev financ stud 2 1989 157 in the case of pure diffusive risk since the benchmark economy with homogeneous agents generates no excess uncertainty in the stock market we study the effect on excess volatility and excess jump size solely due to different levels of relative risk aversion we observe 3 excess uncertainty in jump sizes for a reasonable specification of economic fundamentals

the rationality of federal funds rate expectations evidence from a survey this study finds that expectations of two week maintenance period average federal funds rates as measured by the money market services survey from march 1984 to november 1987 are biased only marginally outperform random walk forecasts and have forecast errors that are correlated with in sample information however these results are tempered by findings that the survey forecasts incorporate the information in out of sample arima forecasts although the latter are less accurate than random walk forecasts in addition the accuracy of the survey forecasts increases for maintenance periods in which the discount rate changes copyright 1989 by ohio state university press

testing the rationality of state revenue forecasts recent revenue shortfalls in several states focus attention on the question of whether states do a good job of forecasting revenues in modem economics forecasts are eval uated on the basis of whether or not they are rational do the forecasts optimally incorporate all available information this paper develops a method for testing the rationality of state revenue forecasts and applies it to the analysis of data from new jersey massachusetts and maryland one of our main findings is that in all three states the forecasts of own revenues are systematically biased downward tn 1985 the 50 states raised 349 billion in revenues from their own sources and received 84 billion in grants from the federal government u s bureau of the census 1987 p 266 state governments are clearly important players in the u s system of public finance and the efficiency with which they conduct their financial affairs has an important impact on consumer welfare one important determinant of a state s ability to con duct reasonable fiscal policies is the quality of its revenue forecasts sensible deliberations about ex penditures cannot be made in the absence of good forecasts indeed in the presence of con stitutional or statutory provisions for balanced budgets unanticipated changes in revenues can wreak havoc not only on proposals that are sched uled for funding but on plans that have already been put into effect as well in recent months two powerful governors michael dukakis of massachusetts and mario cuomo of new york have suffered major politi cal embarrassments because actual revenues fell substantially short of the predictions in their re spective states such episodes focus attention on the question of whether states do a good job of forecasting revenues in modem economics fore casts are evaluated on the basis of whether or not they are rational do the forecasts optimally incorporate all information that is available at the time they are made although there is a large literature on state revenue forecasting methods that literature focuses mostly on state budgetary institutions forecasts themselves are evaluated only in an informal fashion 1 although the theory and econometric methods of rational expectations have been used to evaluate forecasts made by households and businesses 2 these powerful tools have not been applied to state government fore casts this paper applies these methods to the problem of state revenue forecasting and as an example uses them to analyze data from new jersey massachusetts and maryland the results cast light not only on the question of rationality per se but on issues such as the impact of political factors on forecasts section ii presents the conceptual framework for testing rational expectations the relevant in stitutional issues and data are described in section iii the results are discussed in section iv we find that in all three states forecasts of own rev enues are systematically biased downward section v concludes with a summary

rational expectations and macroeconomic forecasts the article presents extensive results from testing for bias and serially correlated errors in a collection of time series of quarterly multiperiod forecasts for six variables including real gnp growth inflation and unemployment the analysis covers responses by 79 frequent participants in economic outlook surveys conducted regularly since 1968 it shows much greater incidence of apparently systematic errors for inflation than for the other variables also the tests are more favorable to composite group forecasts than to most of the individual forecast sets

fiscal forecasts at the fomc evidence from the greenbooks abstract this paper examines fiscal policy forecasts prepared for the federal open market committee and its influence on u s monetary policy the forecasts contain useful information beyond that i

optimal portfolios when variances and covariances can jump abstract we analyze the optimal portfolio choice in a multi asset wishart model in which return variances and correlations are stochastic and subject to jump risk the optimal portfolio is characterized by the positions in stock diffusion risk variance covariance diffusion risk and jump risk we find that including jumps in the second moments changes the optimal positions and particularly variance covariance hedging demands significantly erroneously omitting these jumps gives rise to substantial model risk furthermore variance covariance jump risk can have a significant impact on potential utility gains when the market is completed by adding derivatives as a robustness check we compare our results to those obtained for other parametrizations of wishart models from the literature as well as to various single asset models

robustness of stable volatility strategies abstract the paper analyzes the robustness of stable volatility strategies i e strategies in which the portfolio weight of the stock is inversely proportional to its local volatility these strategies are optimal for a crra investor if the stock follows a diffusion process the expected excess return is proportional to its volatility and the hedging demand is zero we assess the performance of stable volatility strategies when these restrictive assumptions do not hold in particular when the risk premium is not proportional to volatility and when the stock price is subject to jumps we find that stable volatility strategies are indeed robust or close to robust under a maxmin decision rule in addition to our theoretical results we perform a simulation analysis to evaluate strategies that scale the portfolio weight by the volatility variance or a constant portfolio weight and also analyze the strategies using empirical excess returns both analyses confirm the robustness of stable volatility strategies

tails fears and risk premia we show that the compensation for rare events accounts for a large fraction of the average equity and variance risk premia exploiting the special structure of the jump tails and the pricing thereof we identify and estimate a new investor fears index the index reveals large time varying compensation for fears of disasters our empirical investigations involve new extreme value theory approximations and high frequency intraday data for estimating the expected jump tails under the statistical probability measure and short maturity out of the money options and new model free implied variation measures for estimating the corresponding risk neutral expectations

asset allocation how much does model choice matter abstract this paper analyzes the optimal portfolio decision of a crra investor in models with stochastic volatility and stochastic jumps the investor follows a buy and hold strategy in the stock the money market account and one additional derivative we show that both the type of the model and the structure of the risk premia have a significant impact on the optimal portfolio on the utility gain from having access to derivatives and on whether the investor prefers to trade otm or atm options we also show that model mis specification results in significant utility losses omitting jumps in volatility can be devastating in particular if the investor chooses the seemingly optimal otm put options a misestimation of the structure of the risk premia has a less devastating effect but can still lead to a loss of around 4 in the annual certainty equivalent return

legislative influences in japanese budgetary politics following world war ii w w ii japan adopted a democratic parliamentary system since its formation in 1955 the liberal democratic party ldp had monopolized japanese legislature diet for over 35 years however it is said that at the center of the budgetary process was the ministry of finance mof elite bureaucrats rather than politicians are typically seen as the agenda setter the action of politicians in particular members of the ldp to influence the budgetary resource allocation has been largely unexamined this paper empirically examines the influence of the ldp on the supplementary budget formation and on the revenue sharing we find that the ldp had a significant impact on the budget formation further we find that the ldp manipulated transfers from the central government to local governments presumably to maintain its electoral positions

optimal option portfolio strategies deepening the puzzle of index option mispricing traditional methods of asset allocation such as mean variance optimization are not adequate for option portfolios because the distribution of returns is non normal and the short sample of option returns available makes it difficult to estimate their distribution we propose a method to optimize a portfolio of european options held to maturity with a myopic objective function that overcomes these limitations in an out of sample exercise incorporating realistic transaction costs the portfolio strategy delivers a sharpe ratio of 0 82 with positive skewness this performance is mostly obtained by exploiting mispricing between options and not by loading on jump or volatility risk premia

a tractable framework for option pricing with dynamic market maker inventory and wealth we develop a tractable dynamic model of an index option market maker with limited capital we solve for the variance risk premium and option prices as a function of the asset dynamics and market maker option holdings and wealth the market maker absorbs end users positive demand and requires a more negative variance risk premium when she incurs losses we estimate the model using returns options and inventory and find that it performs well especially during the financial crisis the restrictions imposed by nested existing reduced form stochastic volatility models are strongly rejected in favor of the model with a market maker

cojumps and asset allocation in international equity markets abstract this paper examines the patterns of intraday cojumps between international equity markets as well as their impact on international asset holdings and portfolio diversification benefits using intraday index based data for exchange traded funds as proxies for international equity markets we document evidence of significant cojumps with the intensity increasing during the global financial crisis of 2008 2009 the application of the hawkes process also shows that jumps propagate from the us and other developed markets to emerging markets correlated jumps are found to reduce diversification benefits and foreign asset holdings in minimum risk portfolios whereas idiosyncratic jumps increase the diversification benefits of international equity portfolios in contrast the impact of higher order moments induced by idiosyncratic and systematic jumps on the optimal composition of international portfolios is not significant

correlation risk and optimal portfolio choice we develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the de gree of correlation across industries countries or asset classes is stochastic optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk we find that the hedging demand is typically larger than in univari ate models and it includes an economically significant covariance hedging compo nent which tends to increase with the persistence of variance covariance shocks the strength of leverage effects the dimension of the investment opportunity set and the presence of portfolio constraints this paper develops a new multivariate modeling framework for intertempo ral portfolio choice under a stochastic variance covariance matrix we consider an incomplete market economy in which stochastic volatilities and stochastic correlations follow a multivariate diffusion process in this setting volatili ties and correlations are conditionally correlated with returns and optimal portfolio strategies include distinct hedging components against volatility and correlation risk we solve the optimal portfolio problem and provide simple closed form solutions that allow us to study the volatility and covariance hedg ing demands in realistic asset allocation settings we document the importance of modeling the multivariate nature of second moments especially in the con text of optimal asset allocation and find that the optimal hedging demand can be significantly different from the one implied by more common models with constant correlations or single factor stochastic volatility an important thread within the asset pricing literature has documented the characteristics of the time variation in the covariance matrix of asset

optimal portfolios when volatility can jump abstract we consider an asset allocation problem in a continuous time model with stochastic volatility and jumps in both the asset price and its volatility first we derive the optimal portfolio for an investor with constant relative risk aversion the demand for jump risk includes a hedging component which is not present in models without volatility jumps we further show that the introduction of derivative contracts can have substantial economic value we also analyze the distribution of terminal wealth for an investor who uses the wrong model either by ignoring volatility jumps or by falsely including such jumps or who is subject to estimation risk whenever a model different from the true one is used the terminal wealth distribution exhibits fatter tails and in some cases significant default risk

why do option returns change sign from day to night abstract average delta hedged returns for standard poor s 500 index options are large 0 7 per day when we decompose these option returns into intraday and overnight components average close to open returns are 1 per day and open to close returns are positive 0 3 a similar return pattern holds for all maturity and moneyness categories and equity options these positive intraday returns are particularly difficult to explain however our results are consistent with option prices failing to account for the well known fact that stock volatility is substantially higher intraday than overnight these findings help explain price formation in the options market

information in the term structure of yield curve volatility using a novel no arbitrage model and extensive second moment data we decompose conditional volatility of u s treasury yields into volatilities of short rate expectations and term premia short rate expectations become more volatile than premia before recessions and during asset market distress correlation between shocks to premia and shocks to short rate expectations is close to zero on average and varies with the monetary policy stance while treasuries are nearly unexposed to variance shocks investors pay a premium for hedging variance risk with derivatives we illustrate the dynamics of the yield volatility components during and after the financial crisis

keep on smiling the pricing of quanto options when all covariances are stochastic the paper introduces a model for the joint dynamics of asset prices which can capture both a stochastic correlation between stock returns as well as between stock returns and volatilities stochastic leverage by relying on two factors for stochastic volatility the model allows for stochastic leverage and is thus able to explain time varying slopes of the smiles the use of wishart processes for the covariance matrix of returns enables the model to also capture stochastic correlations between the assets our model offers an integrated pricing approach for both quanto and plain vanilla options on the stock as well as the foreign exchange rate we derive semi closed form solutions for option prices and analyze the impact of state variables quanto options offer a significant exposure to the stochastic covariance between stock prices and exchange rates in contrast to standard models the smile of stock options the smile of currency options and the price differences between quanto options and plain vanilla options can change independently of each other

technological paradigms past present and future the special issue is introduced and contextualised technological paradigms emerged as science push models of innovation were being displaced by demand pull models that justified a more international market focussed political economy technological paradigms help explain the strengths and weaknesses of both models and why the governance choice is not between either markets or governments but an appropriate mixture of both while technological paradigms have successfully shifted policy and management attention to building stocks of knowledge they still have substantial underexploited analytical potential

time diversification definitions and some closed form solutions abstract we establish general conditions under which younger investors should invest a larger proportion of their wealth in risky assets than older ones in the finite horizon dynamic setting we show that such phenomenon known as time diversification can occur in the presence of human wealth guaranteed consumption or mean reverting stock returns we formalize two alternative notions of time diversification commonly confounded in the literature analytic solutions are provided for both time series and cross sectional forms of time diversification to our best knowledge this paper is the first to solve in closed form the hedging demand for a cara investor with inter temporal consumption and a finite horizon facing mean reverting expected returns our results indicate that horizon can have a significant effect on the portfolio demand of a cara investor due to inter temporal hedging

the world price of jump and volatility risk abstract we study international integration of markets for jump and volatility risk using index option data for the main global markets to explain the cross section of expected option returns we focus on return based multi factor models for each market separately we provide evidence that volatility and jump risk are priced risk factors there is little evidence however of global unconditional pricing of these risks we show that uk and us option markets have become increasingly interrelated and using conditional pricing models generates some evidence of international pricing finally the benefits of diversifying jump and volatility risk internationally are substantial but declining

returns of claims on the upside and the viability of u shaped pricing kernels abstract when the pricing kernel is u shaped then expected returns of claims with payout on the upside are negative for strikes beyond a threshold determined by the slope of the u shaped kernel in its increasing region and have negative partial derivative with respect to strike in the increasing region of the kernel using returns of i s p 500 index calls ii calls on major international equity indexes iii digital calls iv upside variance contracts and v a theoretical construct that we denote as kernel call we find broad support for the implications of u shaped pricing kernels a possible theoretical reconciliation of our empirical findings is explored through a model that accommodates heterogeneity in beliefs about return outcomes and short selling

earning the right premium on the right factor in portfolio planning abstract the optimal portfolio as well as the utility from trading stocks and derivatives depends on the risk factors and on their market prices of risk we analyze this dependence for a crra investor in models with stochastic volatility jumps in the stock price and jumps in volatility we find that the compartment of the total variance into diffusion risk and jump risk has a small impact on the utility in an incomplete market only in contrast the decomposition of the equity risk premium into a diffusion component and a jump risk component and the compartment of the latter into its various elements has a huge impact on the utility in a complete market the more extreme the market prices of risk i e the more they deviate from their equilibrium values the larger the utility of the investor additionally we show that the structure of the optimal exposures to jump risk crucially depends on which elements of jump risk are priced

price and volatility co jumps abstract the nature of the dependence between discontinuities in prices and contemporaneous discontinuities in volatility co jumps has been reported by many as being elusive in terms of sign magnitude and statistical significance using a novel identification strategy in continuous time relying on trade level information for spot variance estimation as well as infinitesimal cross moments we document that a sizeable proportion of discontinuous changes in prices are associated with strongly anti correlated contemporaneous discontinuous changes in volatility assuming a possibly nonmonotonic pricing kernel we illustrate the equilibrium implications of price and volatility co jumps for return and variance risk premia

multivariate fx models with jumps triangles quantos and implied correlation we propose an integrated model of the joint dynamics of fx rates and asset prices for the pricing of fx derivatives including quanto products the model is based on a multivariate construction for levy processes which proves to be analytically tractable the approach allows for simultaneous calibration to market volatility surfaces of currency triangles and also gives access to market consistent information on dependence between the relevant variables a successful joint calibration to real market data is presented for the particular case of the variance gamma process

political biases despite external expert participation an empirical analysis of tax revenue forecasts in germany this paper explores whether and how political biases arise in an institutional setting where revenue forecasting is delegated to a body that includes experts from institutions neither part of nor controlled by the government the empirical analysis focuses on the performance of german federal tax revenue forecasts in the preparation of which the advice of external experts has a long tradition as an institutional safeguard while on average revenue forecasts turn out to be unbiased the results show that the government exerts an influence in particular optimism pessimism in the government s gdp forecast helps to explain why the revenue forecast turns out too optimistic pessimistic in addition governmental estimates of the revenue effects of tax law changes are found to contribute to forecast errors

beyond demand and supply curves in macroeconomics this paper surveys recent issues in macroeconomics from the viewpoint of dynamic economic theory the need to look beyond demand and supply curves and the insights that come from doing so are emphasized examples of issues in debt management and fiscal policy are analyzed

general equilibrium pricing of options on the market portfolio with discontinuous returns when the price process for a long lived asset is of a mixed jump diffusion type pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlaying asset and a risk less bond using a general equilibrium framework we derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns the premium for the risk of jumps and the diffusion risks forms a significant part of the prices of the options in this economy an attempted replication of call and put options by the black scholes type of trading strategies may require substantial infusion of funds when jumps occur we study the cost and risk implications of such dynamic hedging plans article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

tests of the rational expectations hypothesis this paper reviews evidence on the structure of anticipation from a number of empirical studies jack muth s rational expectations hypothesis is compared with a variety of alternative models including ferber s law the implicit expectations model of edwin mills and muth s new errors in the variables model the cumulative evidence is of such strength as to compel the suspension of belief in the concept of rational expectations this implies that it is a mistake to proceed under the maintained hypothesis that expectations are rational instead it is necessary to test the sensitivity of empirical and theoretical results to alternative assumptions about the structure by which anticipations are generated copyright 1986 by american economic association

option portfolio strategies measurement and evaluation it is well known that options can increase the flexibility of returns available from investment strategies papers by ross 1976 breeden and litzenberger 1978 and arditti and john 1980 point toward spanning opportunities which increase the efficiency of the financial markets in meeting the investment objectives of investors while these and other studies have demonstrated the potential of option portfolio strategies in molding the return distribution to better fit risk preferences a number of other studies have used simulation techniques to give an empirical view of just what effect particular option stock and option bond strategies will have in altering risk return patterns a major study in this area is that of merton scholes and gladstein 1978 1982 their study presented in two papers one on call option portfolio strategies hereinafter msgl and the other on put option portfolio strategies hereinafter msg2 presents a broad and insightful discussion of many of the implications of combining options with stock portfolios the msg study employs a 12 5 year period for simulations in the first paper on portfolios using call options and a 14 year simulation period in the second paper on portfolios using put options as they are careful to point out their results depend on market trends which may not match ex ante expecta

a simple formula for the expected rate of return of an option over a finite holding period under conditions consistent with the black scholes formula a simple formula is developed for the expected rate of return of an option over a finite holding period possibly less than the time to expiration of the option under these conditions surprisingly the expected future value of a european option even prior to expiration is shown equal to the current black scholes value of the option except that the expected future value of the stock at the end of the holding period replaces the current stock price in the black scholes formula and the future value of a riskless invesment of the striking price replaces the striking price an extension of this result is used to approximate moments of the distribution of returns from an option portfolio