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Category Archives: G13

Distribution of Risk and Return in Variations of Volatility Arbitrage

by Maksym Kosachevskyy

Abstract

The effectiveness of volatility arbitrage has been a source of debate for researchers. On one hand, some have found the strategy to be immensely profitable, indicating a potential structural mispricing in the options market. Other researchers have claimed these profits arise from hidden risk in the form of higher distribution moments like kurtosis and skewness or that the strategy is highly susceptible to jump risk. In this paper, I examine the risk and return of a set of options volatility arbitrage strategies over the last 6 years to determine the magnitude of a possible mispricing. I construct a portfolio of long straddles using the options in the decile with the greatest positive IV-HV difference and a portfolio of short straddles using the options in the decile with the greatest negative difference. I then calculate the Compound Annual Growth Rate and standard deviation of monthly and weekly strategies, find the optimal Sharpe ratio, and adjust for potential liquidity issues. I find that the combined monthly portfolio can be a strong performer if properly hedged but that only the long portfolio is necessary in the weekly strategy. Both weekly and monthly portfolios can highly effective investments if risk is managed correctly.

Professor Jia Li, Faculty Advisor
Professor Kent Kimbrough, Faculty Advisor

JEL Codes: G11, G13, G14

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Forecasting Corporate Bankruptcy: Applying Feature Selection Techniques to the Pre- and Post-Global Financial Crisis Environments

By Parker Levi   

I investigate the use of feature selection techniques to forecast corporate bankruptcy in the years before, during and after the global financial crisis. Feature selection is the process of selecting a subset of relevant features for use in model construction. While other empirical bankruptcy studies apply similar techniques, I focus specifically on the effect of the 2007-2009 global financial crisis. I conclude that the set of bankruptcy predictors shifts from accounting variables before the financial crisis to market variables during and after the financial crisis for one-year-ahead forecasts. These findings provide insight into the development of stricter lending standards in the financial markets that occurred as a result of the crisis. My analysis applies the Least Absolute Shrinkage and Selection Operator (LASSO) method as a variable selection technique and Principal Components Analysis (PCA) as a dimensionality reduction technique. In comparing each of these methods, I conclude that LASSO outperforms PCA in terms of prediction accuracy and offers more interpretable results.

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Advisors: Professor Andrew Patton, Professor Michelle Connolly | JEL Codes: G1, G01, G33

Market Dynamics and the Forward Premium Anomaly: A Model of Interacting Agents

By Phillip Hogan and Evan Myer

This paper presents a stochastic model of exchange rates, which is used to explain the forward premium anomaly. In the model, agents switch between four trading strategies, and these changes drive the evolution of the exchange rate. This framework is meant to more realistically represent the important market dynamics of exchange rates, as we suspect these to be the cause of the forward premium anomaly. Our simulations of the model indicate two conclusions: (i) many of the statistical regularities observed in currency markets, including the forward premium anomaly, can be thought of as macro-level scaling laws emerging from micro-level interactions of heterogeneous agents, and (ii) the dynamics of estimates of the beta coefficient in tests of UIP are driven by perceived relationships between changes in interest rates and agents’ aggregate views on the value of the exchange rate, which we call the fundamental value. Section I presents an introduction to the topic and section II reviews the relevant literature. Section III provides the theoretical basis of the forward premium anomaly and our model, then the mathematical definition of the model. Section IV presents the results of a typical simulation which section V compares to relevant stylized facts of the currency markets. Sections VI and VII present our results and a conclusion of what we have drawn from the model.

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Advisor: Craig Burnside, Michelle Connolly | JEL Codes: G1, G13, G15 | Tagged: Exchange Rates, Forward Premium Anomaly

A Case Study on the Informational Role of Futures Markets: Can Weather Futures Forecast Electricity Consumption?

by Ying Chiat Ho

Abstract 

This paper provides a case study on the informational role of futures prices by investigating the ability of Cooling Degree Day (CDD) futures prices to forecast electricity consumption for New York State. I develop a cross-sectional model relating electricity consumption with the cumulative CDDs in a month for New York City and utilize the 30-day ahead settlement prices of the New York CDD futures contracts within the model to forecast electricity consumption. The forecasts derived explain up to 94.68% of the variation in actual electricity consumption, suggesting that the CDD futures prices contain useful forward-looking information about electricity consumption.

Professor Edward Tower, Faculty Advisor

JEL Codes: G13,

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