Handbook of Quantitative Finance and Risk Management PDF
Preview Handbook of Quantitative Finance and Risk Management
Handbook of Quantitative Finance and Risk Management Editors Cheng-FewLee,RutgersUniversity,USA AliceC.Lee,StateStreetCorp.,USA(cid:2) JohnLee,CenterforPBBEFResearch,USA Advisory Board IvanBrick,RutgersUniversity,USA StephenBrown,NewYorkUniversity,USA CharlesQ.Cao,PennStateUniversity,USA Chun-YenChang,NationalChiaoTungUniversity,Taiwan WayneFerson,BostonCollege,USA LawrenceR.Glosten,ColumbiaUniversity,USA MartinJ.Gruber,NewYorkUniversity,USA HyleyHuang,WintekCorporation,Taiwan RichardE.Kihlstrom,UniversityofPennsylvania,USA E.H.Kim,UniversityofMichigan,USA RobertMcDonald,NorthwesternUniversity,USA EhudI.Ronn,UniversityofTexasatAustin,USA (cid:2) Disclaimer:Anyviewsoropinionspresentedinthispublicationaresolelythoseoftheauthorsanddonot necessarilyrepresentthoseofStateStreetCorporation.StateStreetCorporationisnotassociatedinanyway withthispublicationandacceptsnoliabilityforthecontentsofthispublication. Cheng-Few Lee Alice C. Lee John Lee (cid:2) (cid:2) Editors Handbook of Quantitative Finance and Risk Management 123 Editors Cheng-FewLee JohnLee RutgersUniversity CenterforPBBEFResearch DepartmentofFinanceandEconomics NorthBrunswick,NJ 94RockafellerRoad USA NewBrunswick,NJ [email protected] 08854-8054,JaniceH.LevinBldg. USA [email protected] AliceC.Lee StateStreetCorp. Boston,MA USA alice.fi[email protected] ISBN978-0-387-77116-8 e-ISBN978-0-387-77117-5 DOI10.1007/978-0-387-77117-5 SpringerNewYorkDordrechtHeidelbergLondon LibraryofCongressControlNumber:2010921816 (cid:3)c SpringerScience+BusinessMedia,LLC2010 Allrightsreserved.Thisworkmaynotbetranslatedorcopiedinwholeorinpartwithoutthewrittenpermissionofthe publisher(SpringerScience+BusinessMedia,LLC,233SpringStreet,NewYork,NY10013,USA),exceptforbrief excerptsinconnectionwithreviewsorscholarlyanalysis.Useinconnectionwithanyformofinformationstorageand retrieval,electronicadaptation,computersoftware,orbysimilarordissimilarmethodologynowknownorhereafter developedisforbidden. Theuseinthispublicationoftradenames,trademarks,servicemarks,andsimilarterms,eveniftheyarenotidentified assuch,isnottobetakenasanexpressionofopinionastowhetherornottheyaresubjecttoproprietaryrights. Printedonacid-freepaper SpringerispartofSpringerScience+BusinessMedia(www.springer.com) Preface Quantitativefinanceandriskmanagementisacombinationofeconomics,accounting,statis- tics, econometrics, mathematics, stochastic process, and computer science and technology. Thishandbookisthemostcomprehensivehandbookinquantitativefinanceandriskmanage- ment,whichintegratestheory,methodology,andapplication.Duetotheimportanceofquan- titative finance and risk managementin the finance industry, it has become one of the most popularsubjectsinbusinessschoolsanddepartmentsofmathematics,operationresearch,and statistics. In addition, the finance industry has many job opportunities for people with good trainingin quantitativefinanceandrisk management.Thus,a handbookshouldhavea broad audienceandbeofinteresttoacademics,educators,students,andpractitioners. Based on our years of experience in industry, teaching, research, textbook writing, and journaleditingonthesubjectofquantitativefinanceandriskmanagement,thishandbookwill review,discuss, and integratetheoretical, methodologicaland practicalissues of quantitative financeandriskmanagement.Thishandbookisorganizedintofivepartsasfollows: PartI.OverviewofQuantitativeFinanceandRiskManagementResearch PartII.PortfolioTheoryandInvestmentAnalysis PartIII.OptionsandOptionPricingTheory PartIV.RiskManagement PartV.Theory,Methodology,andApplications Part I of this handbook covers three chapters: they are “Chapter 1. Theoretical Frame- work of Finance,” “Chapter 2. Investment, Dividend, Financing, and Production Policies,” and “Chapter 3. Research Methods of Quantitative Finance and Risk Management.” Part II ofthishandbookcovers18chaptersofportfoliotheoryandinvestmentanalysis.PartIIIofthis handbookincludes21chaptersofoptionsandoptionpricingtheory.PartIVofthishandbook includes23chaptersoftheoryandpracticeinriskmanagement.Finally,PartVofthishand- bookcovers44chaptersoftheory,methodology,andapplicationsin quantitativefinanceand riskmanagement. Inthepreparationofthishandbook,first,wewouldliketothankthemembersofadvisory boardandcontributorsofthishandbook.Inaddition,wenoteandappreciatetheextensivehelp fromourEditor,Ms.JudithPforr,ourresearchassistantsHong-YiChen,Wei-KangShihand Shin-YingMai,andoursecretaryMs.MirandaMei-LanLuo.Finally,wewouldliketothank theWintekCorporationandthePolarisFinancialGroupforthefinancialsupportthatallowed ustowritethisbook. Thereareundoubtedlysomeerrorsinthefinishedproduct,bothtypographicalandconcep- tual.Weinvitereaderstosendsuggestions,comments,criticisms,andcorrectionstotheauthor ProfessorCheng-FewLeeattheDepartmentofFinanceandEconomics,RutgersUniversityat JaniceH.LevinBuildingRoom141,RockefellerRoad,Piscataway,NJ08854-8054. NewBrunswick,NJ Cheng-FewLee Boston,MA AliceC.Lee NorthBrunswick,NJ JohnLee v About the Editors Cheng-Few Lee is Distinguished Professor of Finance at Rutgers Business School, Rutgers UniversityandwaschairpersonoftheDepartmentofFinancefrom1988to1995.Hehasalso servedonthefacultyoftheUniversityofIllinois(IBEProfessorofFinance)andtheUniversity of Georgia. He has maintained academic and consulting ties in Taiwan, Hong Kong, China, andtheUnitedStatesforthepastthreedecades.Hehasbeenaconsultanttomanyprominent groups, including the American Insurance Group, the World Bank, the United Nations, The MarmonGroupInc.,WintekCorporation,andPolarisFinancialGroup. ProfessorLeefoundedtheReviewofQuantitativeFinanceandAccounting(RQFA)in1990 andtheReviewofPacificBasinFinancialMarketsandPolicies(RPBFMP)in1998,andserves asmanagingeditorforbothjournals.Hewasalsoaco-editoroftheFinancialReview(1985– 1991)andtheQuarterlyReviewofEconomicsandBusiness(1987–1989).Inthepast36years, Dr.Leehaswrittennumeroustextbooksranginginsubjectmattersfromfinancialmanagement tocorporatefinance,securityanalysisandportfoliomanagementtofinancialanalysis,planning andforecasting,andbusinessstatistics.Inaddition,heeditedapopularbookentitledEncyclo- pedia of Finance (with Alice C. Lee). Dr. Lee has also published more than 170 articles in morethan20differentjournalsinfinance,accounting,economics,statistics,andmanagement. ProfessorLee was rankedthe mostpublishedfinance professorworldwideduringthe period 1953–2008. Professor Lee was the intellectual forcebehind the creation of the new Masters of Quan- titative Finance program at Rutgers University. This program began in 2001 and has been ranked as one of the top ten quantitative finance programs in the United States. These top ten programs are located at Carnegie Mellon University, Columbia University, Cornell Uni- versity, New York University, Princeton University, Rutgers University, Stanford University, UniversityofCaliforniaatBerkley,UniversityofChicago,andUniversityofMichigan. AliceC.LeeiscurrentlyaDirectorintheModelValidationGroup,EnterpriseRiskMan- agement,atStateStreetCorporation.Mostrecently,shewasanAssistantProfessorofFinance atSanFranciscoStateUniversity.Shehasmorethan20yearsofexperienceandhasadiverse background, which includes academia, engineering, sales, and management consulting. Her primaryareasofteachingandresearcharecorporatefinanceandfinancialinstitutions.Sheis coauthorofStatisticsforBusinessandFinancialEconomics,2e(withChengF.LeeandJohn C.Lee)andFinancialAnalysis,PlanningandForecasting,2e(withChengF.LeeandJohnC. Lee).Inaddition,shehasco-editedotherannualpublicationsincludingAdvancesinInvestment AnalysisandPortfolioManagement(withChengF.Lee). JohnC.LeeisaMicrosoftCertifiedProfessionalinMicrosoftVisualBasicandMicrosoft ExcelVBA.HehasabachelorandmastersdegreeinaccountingfromtheUniversityofIllinois atUrbana-Champaign. John has more than 20 years’ experience in both the business and technical fields as an accountant, auditor, systems analyst, and as a business software developer. He has authored a book on how to use MINITAB and Microsoft Excel to do statistical analysis; this book is vii viii AbouttheEditors a companion text to Statistics of Business and Financial Economics, of which he is one of the co-authors.John has been a senior technologyofficer at the Chase Manhattan Bank and assistant vice president at Merrill Lynch. He is currently Director of the Center for PBBEF Research. Contents Preface..................................................................... v PartI OverviewofQuantitativeFinanceandRiskManagementResearch 1 TheoreticalFrameworkofFinance :::::::::::::::::::::::::::::::::::::: 3 1.1 Introduction...................................................... 3 1.2 DiscountedCash-FlowValuationTheory.............................. 3 1.3 MandMValuationTheory ......................................... 6 1.4 MarkowitzPortfolioTheory ........................................ 10 1.5 CapitalAssetPricingModel ........................................ 10 1.6 ArbitragePricingTheory........................................... 12 1.7 OptionValuation.................................................. 14 1.8 FuturesValuationandHedging...................................... 15 1.9 Conclusion....................................................... 22 References............................................................. 22 2 Investment,Dividend,Financing,andProductionPolicies:Theory andImplications::::::::::::::::::::::::::::::::::::::::::::::::::::: 23 2.1 Introduction...................................................... 23 2.2 Investmentand Dividend Interactions:The InternalVersus External FinancingDecision................................................ 23 2.3 InteractionsBetweenDividendandFinancingPolicies .................. 25 2.4 InteractionsBetweenFinancingandInvestmentDecisions ............... 28 2.5 ImplicationsofFinancingandInvestmentInteractions forCapitalBudgeting.............................................. 30 2.6 ImplicationsofDifferentPoliciesontheBetaCoefficient................ 34 2.7 Conclusion....................................................... 36 References............................................................. 36 Appendix2AStochasticDominanceanditsApplicationstoCapital-Structure AnalysiswithDefaultRisk ......................................... 38 2A.1 Introduction............................................... 38 2A.2 ConceptsandTheoremsofStochasticDominance............... 38 2A.3 Stochastic-Dominance Approach to Investigating the Capital-StructureProblemwithDefaultRisk ................... 39 2A.4 Summary................................................. 40 ix x Contents 3 ResearchMethodsinQuantitativeFinanceandRiskManagement :::::::::: 41 3.1 Introduction...................................................... 41 3.2 Statistics......................................................... 41 3.3 Econometrics..................................................... 43 3.4 Mathematics ..................................................... 46 3.5 OtherDisciplines ................................................. 48 3.6 Conclusion....................................................... 49 References............................................................. 50 PartII PortfolioTheoryandInvestmentAnalysis 4 FoundationofPortfolioTheory ::::::::::::::::::::::::::::::::::::::::::5:3 Cheng-FewLee,AliceC.Lee,andJohnLee 4.1 Introduction...................................................... 53 4.2 RiskClassificationandMeasurement................................. 53 4.3 PortfolioAnalysisandApplication................................... 57 4.4 TheEfficientPortfolioandRiskDiversification ........................ 60 4.5 DeterminationofCommercialLendingRate........................... 64 4.6 TheMarketRateofReturnandMarketRiskPremium................... 66 4.7 Conclusion....................................................... 68 References............................................................. 68 5 Risk-Aversion,CapitalAssetAllocation,andMarkowitzPortfolio-Selection Model :::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: 69 Cheng-FewLee,JosephE.Finnerty,andHong-YiChen 5.1 Introduction...................................................... 69 5.2 MeasurementofReturnandRisk .................................... 69 5.3 UtilityTheory,UtilityFunctions,andIndifferenceCurves ............... 71 5.4 EfficientPortfolios ................................................ 77 5.5 Conclusion....................................................... 91 References............................................................. 91 6 CapitalAssetPricingModelandBetaForecasting :::::::::::::::::::::::: 93 Cheng-FewLee,JosephE.Finnerty,andDonaldH.Wort 6.1 Introduction...................................................... 93 6.2 AGraphicalApproachtotheDerivationoftheCapitalAsset PricingModel .................................................... 93 6.3 MathematicalApproachtotheDerivationoftheCapitalAsset PricingModel .................................................... 96 6.4 TheMarketModelandRiskDecomposition........................... 97 6.5 GrowthRates,AccountingBetas,andVarianceinEBIT ................. 100 6.6 SomeApplicationsandImplicationsoftheCapitalAssetPricingModel ... 104 6.7 Conclusion....................................................... 105 References............................................................. 105 Appendix6AEmpiricalEvidencefortheRisk-ReturnRelationship ............. 106 Appendix6BAnomaliesintheSemi-strongEfficient-MarketHypothesis ........ 109 7 IndexModelsforPortfolioSelection :::::::::::::::::::::::::::::::::::: 111 Cheng-FewLee,JosephE.Finnerty,andDonaldH.Wort 7.1 Introduction...................................................... 111 7.2 TheSingle-IndexModel............................................ 111 7.3 MultipleIndexesandtheMultiple-IndexModel........................ 118 7.4 Conclusion....................................................... 121 References............................................................. 122
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