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Recent Research: Highlights from March 2013

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"Derivatives in Islamic Finance: There is No Right Way to Do the Wrong Thing – Opportunities for Investors"
The Journal of Investing (Spring 2013)
Andreas A. Jobst

Derivatives are few and far between in countries where the compatibility of financial transactions with Islamic law requires the development of shari’ah-compliant structures. However, as Islamic finance continues to develop rapidly, the rising opportunity cost of limited shari’ah-compliant risk transfer mechanisms has raised questions about the scope of religious restrictions on the use of derivatives, and the scope for efficient risk management techniques for investors. Islamic finance is governed by the shari’ah, which bans speculation and gambling, and stipulates that income must be derived as profits from the shared generation of goods and services between counterparties rather than interest or a guaranteed return. The article explains the fundamental legal principles underpinning Islamic derivatives by reviewing accepted contracts and the scholastic debate surrounding existing financial innovation in this area, in order to generate an axiomatic perspective on a principle-based permissibility of derivatives under Islamic law. An overview of recent standardization efforts also is provided.

"Pricing American Options in the Heston Model: A Close Look at Incorporating Correlation"
The Journal of Derivatives (Spring 2013)
Peter Ruckdeschel, Tilman Sayer, and Alexanger Szimayer

The Binomial model and similar lattice methods are workhorses of practical derivatives valuation. But returns processes more realistic than lognormal diffusions with constant parameters easily create difficulties for them. One of the most important extensions of the Black-Scholes paradigm is to allow stochastic volatility, but even nonstochastic timevarying volatility destroys the important property that the tree recombines, which limits the growth in the number of nodes as time advances. Stochastic volatility introduces a second random variable, which then requires adding another dimension to the tree, under the constraint that the return and volatility changes must maintain the same degree of correlation as in the data. The Heston model features correlation in return and volatility shocks, but building it into a lattice is tricky. In this article, Ruckdeschel, Sayer, and Szimayer develop a lattice method that begins with a binomial tree for the volatility and a trinomial tree for stock price, and then connects them in such a way that the empirical degree of correlation between return and volatility is maintained. Efficiency relative to existing methods is increased, and in some cases it is possible to improve performance further by matching higher moments as well.

"Key Drivers of Private Equity Firm Certification at Initial Public Offering"
The Journal of Private Equity (Spring 2013)
Mike Hopkins and Donald G. Ross

Private equity firms have been shown to add considerable value to investee companies. This article examines buy-side financial analyst perceptions of the determinants of private equity firm value added. The findings reveal significant relationships between the attractiveness of private equity firms’ IPOs and 1) their reputations, 2) their level of retained ownership, 3) the duration of their involvement prior to the IPO, and 4) the interaction between duration and intensity of involvement. The research reveals certification effects are best explained by theories of resource exchange and reduced informational asymmetries with reduced agency risk being a much lesser influence.

"An Investor’s Low Volatility Strategy"
The Journal of Index Investing (Spring 2013)
Li-Lan Kuo and Feifei Li

Investors are displaying a fast-rising appetite for low volatility strategies, given growing academic and empirical evidence of consistent outperformance over the markets from which they are drawn. However, many existing low volatile strategies are optimized, creating biases toward smaller cap stocks and over-concentration in a small number of sectors and/or countries. Instead, we develop a heuristic-based design that leads to a practical portfolio with a superior Sharpe ratio as well as more investor-friendly attributes, including a lower turnover rate, higher investment capacity, relative transparency, and broader market representativeness.

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