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Recent Research: Highlights from June 2014

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"Go Big or Go Home: The Case for an Evolution in Risk Taking"
The Journal of Investing (Summer 2014
Mike Sebastian

This article argues that alternative investments—private equity, real estate, and hedge funds—have natural advantages in risk and return over traditional stock and bond investments. A large allocation to alternatives relative to current institutional practice is needed for a material contribution to an institutional investor’s bottom line. Investors should consider whether moving toward an “efficiency” portfolio with an emphasis on low-cost passive management or an “opportunity” portfolio with heavy reliance on value added through active management—especially alternative investments—is most appropriate for them. Investors who can tolerate the cost, complexity, and illiquidity should consider opportunity-type allocations of 40% of their return-seeking assets to private equity, non-core real estate, and hedge funds. Over time, institutional investors will likely choose alternative investments and indexing as their primary investment options, and traditional active management will likely transform to take on qualities currently associated with alternative investments.

"Barrier Caps and Floors under the LIBOR Market Model with Double Exponential Jumps"
The Journal of Derivatives (Summer 2014)
Jui-Jane Chang, Son-Nan Chen, Chun-Chao Wang, and Ting-Pin Wu

The LIBOR market model (LMM) has become the standard model for many kinds of interest rate derivatives, such as cap contracts. It assumes that the distribution of the one-period interest rate at each future repricing date is lognormal, so that every caplet can be easily priced using the Black model. Volatilities at different dates are tied together by assumptions that restrict the number of parameters to a manageable set. But interest rates are strongly affected by things like monetary policy decisions, which can lead to sharp, nondiffusive jumps when policy changes. The effect may be seen in the leptokurtosis of the empirical distributions of interest rates and in volatility smiles for caplets. The low probability of extreme rate moves in the standard LMM is especially problematical for barrier options. In this article, the authors introduce a new jump-diffusion process for the LLM that can capture the effects of jumps on interest rate barrier contracts. The authors allow exponential jumps, both up and down, so the model is called the LMM with a double-jump process, or LMMDJ. Explicit valuation equations are provided for the four classes of barrier contracts and are shown to be quite accurate in Monte Carlo simulations.

"Global Energy: The Private Equity Opportunity of the Century"
The Journal of Private Equity (Summer 2014)
David Haarmeyer

The article looks at private equity/infrastructure opportunities and its drivers across the oil, gas, and power sectors. It concludes that the opportunity is global, unfolding in developing and developed countries; is reverberating across entire value chains; and is massive—it will be a multi-decade, multi-trillion dollar endeavor.

"Stock Price Volatility of Banks and Other Financials Emanating from the Inception of Leveraged, Inverse, and Traditional ETFs"
The Journal of Index Investing (Summer 2014)
Richard J. Curcio, Randy I. Anderson, Hany Guirguis

Changes in stock price volatility of banks and other financials resulting from the inception of the first-ever, leveraged, inverse and traditional, purely financial exchange-traded funds (ETFs) are investigated. Financials have become much more accessible to investors through these creative and increasingly popular ETF securities. Results from using a constant-variance, first-order, Markov regime-switching model show a significant increase in the volatility of banks and other financials following the introduction of XLF, the traditional ETF representing the Financial Select Sector SPDR, and the leveraged (long and inverse) ETFs, UYG and SKF, benchmarked to the Dow Jones U.S. Financials Index. Volatility emanating from the inception of the leveraged ETFs was several orders of magnitude greater than that of the traditional ETF. Banking and large-cap financials were most prominently affected by the XLF. All sectors and size categories of financial firms were significantly impacted by UYG and SKF, the leveraged ETFs.

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