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Overreaction in the Financial Times Stock Exchange (FTSE)

By Yusuke Ewan Tanaka Legard

The Overreaction Hypothesis suggests that investors overreact to unexpected news in the financial world, which leads to a mispricing of equities. This paper investigates the presence of overreaction in the Financial Times Stock Exchange (FTSE) between 1995 and 2018. The empirical methodology studies the monthly returns of equities in the FTSE 100. The empirical results are consistent with the overreaction hypothesis and indicate the presence of overreaction within the FTSE. Furthermore, the results highlight whether the information revolution has exacerbated or lessened overreaction. The results suggest that investor overreaction has not altered, for better or worse, since the information revolution.

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Advisors: Professor Emma Rasiel, Professor Kent Kimbrough | JEL Codes: E7; E70; D83

Volatility and Correlation Modeling for Sector Allocation in International Equity Markets

By Melanie Fan

Reliable estimates of volatility and correlation are crucial in asset allocation and risk management. This paper investigates Static, RiskMetrics, and Dynamic Conditional Correlation (DCC) models for estimating volatility and correlation by testing them in an asset allocation context. Optimal allocation weights for one year found using estimates from each model are carried to the subsequent year and the realized Sharpe ratio is computed to assess portfolio performance. We also study cumulative risk-adjusted returns over the entire sample period. Our ndings indicate that DCC does not consistently have an advantage over the other two models, although it is optimal in certain scenarios.

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Advisor: Aino Levonmaa, Emma Rasiel | JEL Codes: C32, C51, G11, G15 | Tagged: Asset Allocation, Dynamic Correlation, Emerging Markets, Volatilita

Crisis Period Forecast Evaluation of the DCC-GARCH Model

By Yang Ding

The goal of this paper is to investigate the forecasting ability of the Dynamic Conditional Correlation Generalized Autoregressive Conditional Heteroskedasticity (DCC-GARCH). We estimate the DCC’s forecasting ability relative to unconditional volatility in three equity-based crashes: the S&L Crisis, the Dot-Com Boom/Crash, and the recent Credit Crisis. The assets we use are the S&P 500 index, 10-Year US Treasury bonds, Moody’s A Industrial bonds, and the Dollar/Yen exchange rate. Our results suggest that the choice of asset pair may be a determining factor in the forecasting ability of the DCC-GARCH model.

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Advisor: Aino Levonmaa, Emma Rasiel

Rebalancing, Conditional Value at Risk, and t-Copula in Asset Allocation

By Irving Wang

Traditional asset allocation methods for modeling the tradeo between risk and return do not fully reect empirical distributions. Thus, recent research has moved away from assumptions of normality to account for risk by looking at fat tails and asymmetric distributions. Other studies have also considered multiple period frameworks to include asset rebalancing. We investigate the use of rebalancing with fat tail distributions and optimizing with downside risk as a consideration. Our results verify the underperformance of traditional methods in the single period framework and also demonstrate the underperformance of traditional methods in a multiple period rebalancing
framework.

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Advisor: Aino Levonmaa, Emma Rasiel

Contagion in Risk Markets

By Matthew Moore

During periods of market dislocation, which can be characterized by high asset volatility, correlations between assets generally tend to increase. However, there has been little research on the behavior of correlations between risk measures across securities markets. The aim of our research is to examine correlation dynamics between alternative risk measures rather than asset classes. Correlations between credit default swaps, equity volatility skew, and at-the-money volatility were found to increase during the recent period of market dislocation. To ascertain when the dislocation period began, we built a regime shift model to estimate the date at which the dislocation began. We have chosen to focus our analysis on risk measures for financial institutions in particular, as this industry has been most severely affected by the current financial crisis.

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Advisor: Emma Rasiel

Leveraging the American Dream: Explaining the Shift Towards Mortgage Debt since the 1970’s

By James Melnick

We show that the determinants of mortgage borrowing and other forms of consumer credit differ: borrowers tend to consider asset holdings when taking out a mortgage, but focus on short-term economic expectations when borrowing other consumer credit. We hypothesize that this “mortgage wealth effect” occurs in part due to a borrower’s ability to collateralize real estate assets, and a growing perception of the house as an investment as well as a residence. Further, we propose that this wealth effect contributed to an increase in mortgage debt from the 1970s forward, and that legislative changes and the growth of securitization in the 1990s magnified this effect.

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Advisor: Emma Rasiel

Does Risk Pay? An Analysis of Short Gamma Trading Strategies and Volatility Forecasting in the Swaptions Market

By Tasha Staer Bollerslev

We evaluate short gamma trading strategies in the interest rate swaptions market from January 4th, 1999 to January 19th, 2007, and test the effectiveness of swaption proprietary forecasted volatility at predicting future realized volatility. We find that swaptions market proprietary forecasted volatility is an effective estimator; there is no risk premium priced into swaption prices and hence short gamma strategies are not profitable. We find that the market on average underprices interest rate swaptions by underestimating forward realized volatility.

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Advisor: Emma Rasiel

The VIX as a Fix: Equity Volatility as a Lifelong Investment Enhancer

By Michael Sloyer

The VIX, a measure of the implied volatility of S&P 500 index options, is the premier gauge of investor sentiment and market volatility. This analysis examines the effectiveness of adding the VIX to passively managed equity-bond portfolios. Furthermore, this study extends the existing literature by examining the efficacy of the VIX in a life-cycle investing context. Due to the large negative correlation between the VIX and the major equity indices, we find that a relatively small allocation to the VIX would have significantly improved the risk-return profile of standard equity-bond portfolios from 1986 through 2007. Additionally, we find that younger investors (i.e. investors with higher risk tolerances and thus more exposure to equities rather than fixed income) will benefit from having greater exposure to the VIX.

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Advisor: Emma Rasiel

Questions?

Undergraduate Program Assistant
Jennifer Becker
dus_asst@econ.duke.edu

Director of the Honors Program
Michelle P. Connolly
michelle.connolly@duke.edu