Pricing Survivor Swaps with Mortality Jumps and Default Risk

In this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing.

Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System

Purpose The purpose of this paper is to present a clear path to securitize the longevity risk with two distinct swaps in order to inspire a new Chinese life market. Design/methodology/approach Studies on longevity risk securitization consist of three aspects, respectively, instrument design, pricing methodology and mortality projection. The swaps designed are referenced, respectively, to vanilla and complex survivor swaps (Dowd et al., 2006; Lin and Cox, 2005). Methods applied are RHH model and Gompertz law for mortality projection, as well as two-factor Wang transformation for pricing. Findings This paper figures out the market price of risk in Chinese annuity market, checks for the sensitivity of the price to parameters and tests the hedging effects by Monte Carlo simulation. Originality/value Based on the theoretical and numerical results, this paper suggests an effective way to possibly witness the birth of New Life Market in China.

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

Through a new «law and finance» approach (they teach International Law and FinancialMathematics-Risk Management, respectively), the Authors analyse the guaranteesissued by the Member States of the Euro Area to the Esm fund in the framework ofthe European model of financial assistance to Member States. The A. point out theuncertainties of an evaluation of state guarantees due to technical and legal variables.As for the former, such guarantees are quite peculiar, i) because both parties are exposedto counterparty default risk and the risk of the guarantor could be higher thanthe one of the borrower, and ii) because of the structure of dependence that mightexists between the two risks. The A. compare numerical results on the value of a defaultableand correlated guarantee contract, for different values of the default intensitiesand using two different models, finding relevant differences and counter-intuitivedependence on the attainable correlation. As the level of default risk cannot providefor satisfactory diagnoses, it is hard to evaluate the state guarantees to the Esm, thelevel of dependence being an element of systemic nature, not directly observable. Asfor the legal variables, the aim of the financial aid on one side (a full fulfilment), andthe lack of tools for sanctioning properly a possible non-fulfilment by the beneficiaryon the other side, add further uncertainty.The A. deem crucial for facing such evaluation uncertainty the Ecb role of guarantor oflast resort: the credibility of the whole European financial assistance model lies bothon the number and range of tools available to the Ecb, and on the potentially unlimiteduse of some of them (Omt). Should the unlimited use of the Omt be questioned in thenear future, negative effects on the state guarantees to the Esm and on the Esm operationwould be hardly quantifiable.

This paper presents a developed java android application for KMV-Merton model in predicting the defaut rate of a firm. Predicting default rate is essential in the risk management area as default risk can be immediately transmitted from one entity to another entity. This is the reason default risk is known as a global risk. Although there are several efforts, instruments and methods used to manage the risk, it is said to be insufficient. To the best of our knowledge, there has been limited innovation in developing the default risk mathematical model into a mobile application. Therefore, through this study, default risk is predicted quantitatively using the KMV-Merton model. The KMV-Merton model has been integrated in the form of java program using the Android Studio Software. The developed java android application is tested by predicting the levels of default risk of the three different rated companies. It is found that the levels of default risk are equivalent to the ratings of the respective companies. This shows that the default rate predicted by the KMV-Merton model using the developed java android application can be a significant tool to the risk mangement field. The developed java android application grants users an alternative to predict level of default risk within less procedure.

This thesis consists of three essays in financial economics, more precisely in the field of asset pricing and optimal portfolio choice. The first essay studies the asset pricing implications of heterogeneity in preferences coupled with long run risk in a dynamic general equilibrium pure exchange economy. It is concerned with the understanding of how risk sharing among different types of agents affects the assets returns moments in equilibrium and moreover, how these agents reacts dynamically to the long run risk that they perceive. The second and third essay approach the question of optimal portfolio with stochastic opportunity sets. The second essay proposes an approximation methodology for deriving approximate closed form solutions of dynamic optimal portfolio allocation problems. The third essay examines the optimal consumption, portfolio rule and life insurance purchase problem of a wage earner having uncertain lifetime when the market price of risk follows a mean-reverting stochastic process.

It is argued that firms make the choice of the term to maturity of a new corporate bond issue so as to minimize the aggregate of the agency costs and transaction costs. Issuing bonds with longer terms to maturity will allow firms to reduce the transaction costs associated with bond issues. However, the longer the term to maturity, the higher the agency costs associated with the issue. It is hypothesized that high agency costs associated with both the longer maturities and the default risk of a bond issue will force firms at high risk of default to issue short- or medium-term bonds. Bond covenants such as convertibility, the call provision, the sinking fund provision, and the put provision reduce agency costs of a bond issue. Therefore, firms at high risk of default will make use of such bond covenants to increase the term to maturity of a bond issue and consequently reduce the aggregate of the agency costs and transaction costs associated with debt. Firms with low default risk will be more flexible regard...

This paper examines the meaningfulness of fine wine as an alternative investment, with particular focus on the costs of investing in fine wine. Is fine wine suitable for further diversifying and thus improving the risk-return profile of portfolios invested in global equities and bonds? This analysis takes place in an initial stage on an index basis and in a second stage on the basis of real investment opportunities. The reference currencies are the US dollar and the euro. In order to observe stock indexes, the MSCI World Index is used, and for bonds the JPM World Government-Bond Index is deployed. Regarding the data for investment in fine wine, the main focus is on the Liv-ex-50 Index. The time period is defined by the availability of the data. For the observation of indices, the period is from the beginning of 2004 to May 2018. For observation on the basis of a real investment the period is from March 2010 to May 2018. In the case of the real investment, index funds are used for the data analysis of equities and bonds. As there is no index fund for fine wine, the Liv-ex-50 index is used including all of the costs of a real investment. Various portfolio compositions are used for the periods indicated. On the one hand, a portfolio of 50% equities and 50% bonds is compared to a portfolio of 45% equities, 45% bonds and 10% fine wine. On the other hand, a portfolio of 25% equities and 75% bonds is compared to a portfolio of 20% equities, 70% bonds and 10% fine wine. As benchmarks, the annualised return, the standard deviation and the Sharpe ratio of the respective portfolios are calculated. The results for the periods indicated are sobering. The inclusion of fine wine leads - at an index level - to only a slight improvement of the annualised return, but to a marked increase in risk. When considering the real investment, the considerable costs of an investment in fine wine come to bear. The annualised return is lower and at the same time the risk is higher than that of portfolios which do not include fine wine. It is only when the index is viewed in euros that a slight improvement of the Sharpe ratio in one portfolio can be recorded. When costs are considered, the inclusion of fine wine leads to a worsening of the Sharpe ratio in all cases. This results is a significantly more critical verdict on this diversification opportunity than was noted in the previous studies by Masset and Weisskopf (2010), Masset and Henderson (2010), Bouri (2014), Bouri et al. (2016) and Aytac et al. (2016). By contrast, our results confirm the studies which point out the high costs of investment in fine wine and which reach largely negative findings when analysing real investments in wine investment funds (Burton and Jacobsen, 2001, Masset and Weisskopf, 2015).

We estimate the pricing of sovereign risk for sixty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005-10. We measure how accurately the model predicts sovereign credit default swap (CDS) spreads, focusing in particular on the five countries in the South-West Eurozone Periphery (Greece, Ireland, Italy, Portugal, and Spain). Dynamic panel estimates of the model suggest that fiscal space and other macroeconomic factors are statistically significant and economically important determinants of market-based sovereign risk. Although the explanatory power of fiscal space measures drop during the crisis, the TED spread, trade openness, external debt and inflation play a larger role. As expectations of market volatility jumped during the crisis, the weakly concavity of creditors' payoff probably accounts for the emergence of TED spread as a key pricing factor. However, risk-pricing of the South-West Eurozone Periphery countries is not predicted accurately by the model either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We "match" the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. We find that Eurozone periphery default risk is priced much higher than the "matched" countries in 2010, even allowing for differences in fundamentals. One interpretation is that the market has mispriced risk in the Eurozone periphery. An alternative interpretation is that the market is pricing not on current fundamentals but future fundamentals, expecting the periphery fiscal space to deteriorate markedly and posing a high risk of debt restructuring. Adjustment challenges of the Eurozone periphery may be perceived as economically and politically more difficult than the matched group of middle income countries because of exchange rate and monetary constraints.

Prior research uses the basic one-period European call-option pricing model to compute default measures for individual firms and concludes that both the size and book-to-market effects are related to default risk. For example, small firms earn higher return than big firms only if they have higher default risk and value stocks earn higher returns than growth stocks if their default risk is high. In this paper we use a more advanced compound option pricing model for the computation of default risk and provide a more exhaustive test of stock returns using univariate and double-sorted portfolios. The results show that long/short hedge portfolios based on Geske measures of default risk produce significantly larger return differentials than Merton’s measure of default risk. The paper provides new evidence that mediates between the rational and behavioral explanations of value premium.

Tail risk of hedge funds: an extreme value application

Risk considerations have become increasingly important in nowadays agriculture, due to a variety of reasons. Surprisingly, the practice of formalized risk management is not widespread despite the huge amount of scientific literature on this topic. This discrepancy between risk science and extension is described by many authors. This paper presents a communicative method, rooted in financial economics, to evaluate risk-return profiles in a way that is communicative for individual farmers. The method is derived from the modern portfolio theory, in which individual assets are implicitly compared to the risk-return trade-off of that asset with the highest Sharpe ratio. We use this idea to compare individual risk-return profiles to a particular benchmark. The method can be used for evaluating different risk-return profiles of different farms, different risk management instruments and different production systems. To illustrate the communicative nature of our method, it is applied to evaluate risk-return profiles of conventional versus organic cropping systems.

This study provides evidence on the role of accounting conservatism in debt contracting. I hypothesize that (i) there is positive association between conflicts of bondholders-shareholders over dividend policy and the use of conservative accounting (ii) there is positive association between bond ratings and the use of conservative accounting. Conflicts of bondholders-shareholders arise because of default risk in that the firm cannot pay at maturity because of having not enough net assets and this unavailability of enough net assets is caused by dividend overpayment to shareholders. The alternative solution to prevent dividend overpayment is to consistently use the conservative accounting. The conservative accounting affects earnings in that it leads to conservative earnings and reduces the possibility of earnings management by the firm. The second hypothesis which investigates the association between bonds rating and the level of conservatism based on theory that the lower the firm’s default risk, the higher the bonds rating. The firms with conservative accounting is expected to have lower default risk in that conservatism prevent dividend overpayment which cause the firm ’s net asset is not enough to pay at maturity. The first model result supports the hypothesis that there is positive association between conflicts of bondholders-shareholders and the use of conservative accounting. For the second model, the result does not support the hypothesis that there is a positive association between the bonds rating and the use of conservative accounting. The association between conflicts and conservative accounting provides evidence on the role of accounting conservatism in facing conflicts over dividend policy Kata kunci: conservatism, conservative accounting, conflict bondholders-shareholders over dividend policy, bonds rating.

ABSTRACTThis is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book‐to‐market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama–French (FF) factors SMB and HML contain some default‐related information, but this is not the main reason that the FF model can explain the cross section of equity returns.