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Abstract:
The 1998 failure of Long-Term Capital Management (LTCM) is said to have nearly blown up the world's financial system. For such a near-catastrophic event, the finance profession has precious little information to draw from. By piecing together publicly available information, this paper draws lessons from risk management practices at LTCM.

LTCM's strategies are analyzed in terms of the fund's Value at Risk (VAR) and the amount of capital necessary to support its risk profile. The paper shows that LTCM has severely underestimated its risk due to its reliance on short-term history and risk concentration. LTCM also provides a good example of risk management taken to the extreme. Using the same covariance matrix to measure risk and to optimize positions inevitably leads to biases in the measurement of risk. This approach also pushes the strategy to take positions that appear to generate ``arbitrage'' profits based on recent history but also represent bets on extreme events, like selling options. Overall, LTCM's strategy exploited the intrinsic weaknesses of its risk management system.

Abstract:
The expected return on equity capital is possibly the most important driving factor in asset allocation decisions. Yet, the long-term estimates we typically use are derived from U.S. data only. There are reasons to suspect, however, that these estimates of return on capital are subject to survivorship, as the United States is arguably the most successful capitalist system in the world; most other countries have been plagued by political upheaval, war, and financial crises. The purpose of this paper is to provide estimates of return on capital from long-term histories for world equity markets. By putting together a variety of sources, we collected a database of capital appreciation indexes for 39 markets with histories going back as far back as the l920s. Our results are striking. We find that the United States has by far the highest uninterrupted real rate of appreciation of all countries, at about 5 percent annually. For other countries, the median real appreciation rate is about 1.5 percent. The high return premium obtained for U.S. equities therefore appears to be the exception rather than the rule. Our global databases also allow us to reconstruct monthly real and dollar-valued capital appreciation indices for global markets, providing further evidence on the benefits of international diversification.

Abstract:
The value relevance of financial and non-financial information is viewed in light of the theory of life-cycle stages. The study tests the evolving role of common financial statement and web traffic metrics for Internet companies. Previous work has reported that web usage measures are of high value relevance, or offer much greater explanatory power than conventional financial accounting information for market values. We do find that conventional financial data, including gross profit and realized growth rates in sales and in gross profit, are value relevant, but to a lower extent than web traffic data. As the industry matures, however, we would expect these relationships to change.

Indeed we find that gross profit and R&D become increasingly value relevant as indicated by time trends. Importantly, there is a clear negative time trend in the eyeball measures. Hence, although still of high importance, the value relevance of non-financial metrics has materially diminished over the 24 months testing period. Accounts for the change in market sentiment during the testing period does not change this finding. The results confirm the view that different value metrics should be used at different stages of the life of an industry. Testing whether the life-cycle theory is anchored more to the maturity of the industry or to that of the individual company, we find the value relevance of non-financial vis-a-vis financial measures to be tied only to the maturity of the sector as a whole.

Internet valuation, web traffic, life-cycle

Abstract:
Recent research shows that emerging markets are distinguished by high returns and low covariances with global market factors. These are striking results because of their immediate implications for the international investor. One key issue is whether these results may be attributed to recent emergence. Most of today's emerging markets are actually re-emerging markets, i.e. markets that attracted international attention earlier in the century, and for various political, economic and institutional reasons experienced discontinuities in data sources. To analyze the effects of conditioning on recent emergence, we simulate a simple, general model of global markets in which markets are priced according to their exposure to a world factor; returns are only observed if the price level exceeds a threshold at the end of the observation period. The simulations reveal a number of new effects. In particular, we find that the brevity of a market history is related to the bias in annual returns as well as to the world beta. These patterns are confirmed by long-term histories of global capital markets and by recent empirical" evidence on emerging and submerged markets. Even though these results can also be explained by alternative theories, the common message is that basing investment decisions on the past performance of emerging markets is likely to lead to disappointing results.

Abstract:
Recent research shows that emerging markets are distinguished by high returns and low covariances with global market factors. These are striking results, because of their immediate implications for the international investor. One key issue is whether these results may be attributed to selection biases. In particular, we only observe markets that have "emerged," where emergence is typically conditioned upon recently exceeding a size threshold. We often do not have information about markets that "submerged" in the past, and then "re-emerged" recently. Most of today's emerging markets are actually re- emerging markets, but data before their last submergence is difficult to obtain. We simulate a simple, general model of global markets, in which markets are priced according to a world factor, but for which returns are only observed if the market capitalization exceeds a threshold at the end of the observation period. The simulations reveal that recently emerged markets display substantial biases in observed returns -- returns are too high. Conditioning upon recent emergence "picks out" markets with low betas. Turning to recent empirical evidence, we show that there are reasons to suspect conditioning biases. In particular, returns immediately after emergence are greater than later on, and than before emergence. We also report that the performance of less-followed submerged markets is typically inferior to that of emerged markets.

Abstract:
This paper provides the first systematic analysis of performance patterns for emerging hedge funds and managers in the hedge fund industry. Emerging managers have particularly strong financial incentives to create investment performance and, because of their size, may be more nimble than established ones. Performance measurement, however, needs to control for the usual biases afflicting hedge fund databases. Backfill bias, in particular, is severe for this type of study. After adjusting for such biases and using a novel event time approach, we find strong evidence of outperformance during the first two to three years of existence. Controlling for size, each additional year of age decreases performance by 48 basis points, on average. Cross-sectionally, early performance by individual managers is quite persistent, with early strong performance lasting for up to five years.

hedge funds, emerging managers, incentives, performance evaluation

Abstract:
This paper studies changes in the information environment brought about by Regulation Fair Disclosure (FD), which was implemented on October 23, 2000. FD now prohibits U.S. public companies from making selective, non-public disclosures to favored investment professionals. FD, however, has a number of exclusions, one of which still allows disclosure of non-public information to credit rating agencies. As a result, credit analysts at rating agencies now have access to confidential information that is not made available to equity analysts any more. This can potentially increase the value of credit ratings to equity investors. We examine a sample of credit rating changes and their effect on the company's stock price. We find that the informational effect of downgrades and upgrades is much bigger in the post-FD period. Apparently, FD conferred a strategic advantage to the ratings agencies.

Regulation Fair Disclosure, Regulation FD, credit rating agencies, market reaction, event study

Abstract:
This study examines the information transfer effect of credit events across the industry, as captured in the Credit Default Swaps (CDS) and stock markets. Positive correlations across CDS spreads imply dominant contagion effects, whereas negative correlations indicate competition effects. We find strong evidence of dominant contagion effects for Chapter 11 bankruptcies and competition effect for Chapter 7 bankruptcies. We also introduce a purely unanticipated event, which is a large jump in a company's CDS spread, and find that this leads to the strongest evidence of credit contagion across the industry. These results have important implications for the construction of portfolios with credit-sensitive instruments.

credit default swaps, bankruptcy, contagion, market reaction, event study

Abstract:
Many portfolio strategies are "event-driven," i.e., try to benefit from price movements caused by corporate events such as restructurings, bankruptcies, mergers, acquisitions, or other special situations. Such trading strategies involve payoffs that have discontinuous and skewed distributions that cannot be measured well with conventional risk methods. This paper develops methods to measure the forward-looking risk of portfolios exposed to such discrete events, based on current positions. When events are independent, the portfolio follows a binomial distribution. This approach is extended to the more realistic case where events are not independent. For mergers and acquisitions, empirical estimates of deal break correlations are positive but relatively low, which implies that most event risk is idiosyncratic and diversifiable. This methodology can be used to evaluate the risk and return of different portfolio structures.

merger arbitrage, risk management, hedge funds, value at risk

Abstract:
Standard credit risk models cannot explain the observed clustering of default, sometimes described as "credit contagion." This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We examine the wealth effects of bankruptcy announcements on creditors using a unique database. On average, creditors experience severe negative abnormal equity returns and increases in CDS spreads. In addition, creditors are more likely to suffer from financial distress later. These effects are stronger for industrial creditors than financials. Simulations calibrated to these results indicate that counterparty risk can potentially explain the observed excess clustering of defaults. This suggests that counterparty risk is an important additional channel of credit contagion and that current portfolio credit risk models understate the likelihood of large losses.

credit contagion, counterparty risk, portfolio credit risk models, default correlation, trade credit

Abstract:
Standard credit risk models cannot explain the observed clustering of default, sometimes described as "credit contagion." This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors. In addition, creditors with large exposures are more likely to suffer from financial distress later. This suggests that counterparty risk is a potential additional channel of credit contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the credit crisis after the Lehman bankruptcy in September 2008.

credit risk, counterparty risk, contagion

Abstract:
Risk management is a challenge for hedge funds because traditional risk measurement methods based on return data are unreliable with dynamic trading strategies. This paper illustrates how Value at Risk (VAR) methods can be used to measure and control the market risk of hedge funds. VAR methods have two key features: (1) they are based on current position information, and (2) they focus on a lower quantile of the distribution of losses or some other risk metric. For rapidly changing positions, VAR should be measured at frequent interval, as is done for banks' proprietary trading portfolios. This paper demonstrates the usefulness of dynamic risk measures for a hypothetical hedge fund with short option positions, which are equivalent to dynamic trading. Imposing daily ex ante VAR limits using position information can be very successful at controlling realized risk.

G11, G23, G32

Abstract:
Over the latest twenty years, the average credit rating of U.S. corporations has trended down. This observation has been interpreted as evidence that rating agencies have been tightening credit standards. More formally, Blume, Lim, and MacKinlay (1998) model the credit rating process by an ordered probit regression and indeed find that the annual intercept, reflecting the average credit rating, has been drifting down, holding the effect of other variables constant. We reexamine the causes of the observed decreases in average credit ratings in several ways. First, we show that this downward trend does not apply to speculative-grade issuers. Second, our analysis of structural shifts in investment-grade issuers reveals that the apparent tightening of standards reported by Blume et al. (1998) can be attributed primarily to changes in accounting quality over time. Specifically, we find that the value-relevance of commonly used accounting ratios to creditors decreased and that earnings management increased for investment-grade firms, but not for speculative-grade firms. After incorporating changes in accounting quality into the credit ratings analysis, we find no evidence that rating agencies have tightened their credit standards. Our findings underscore the critical role of accounting quality in the credit ratings analysis.

credit rating agencies, credit standards, accounting quality, earnings management, value-relevance

Abstract:
The expected return on equity capital is possibly the most important driving factor in asset allocation decisions. Yet, the long-term estimates we typically use are derived from U.S. data only. There are reasons to suspects, however, that these estimates of return on capital are subject to survivorship, as the United States is arguably the most successful capitalist system in the world; most other countries have been plagued by political upheaval, war, and financial crises. The purpose of this paper is to provide estimates of return on capital from long-term histories for world equity markets. By putting together a variety of sources, we collected a database of capital appreciation indexes for 39 markets with histories going back as back as the 1920s. Our results are striking. We find that the United States has the highest uninterrupted real rate of appreciation of all countries, at 4.3 percent annually from 1921 to 1996. For other countries, the median real appreciation rate was 0.8 percent. The high return premium obtained for U.S. equities therefore appears to be the exception rather than the rule.

Abstract:
This paper provides an empirical analysis of the risk of trading revenues of U.S. commercial banks. We collect quarterly data on trading revenues, broken down by business line, as well as the Value at Risk-based market risk charge. The overall picture from these preliminary results is that there is a fair amount of diversification across banks and within banks across business lines. These low correlations do not corroborate systemic risk concerns. Neither is there evidence that the post-1998 period has witnessed an increase in volatility of trading revenues.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
This paper extends previous work on the information in the term structure at longer maturities to other countries besides the United States, using a newly constructed data set for 1 to 5 year interest rates from Britain, West Germany and Switzerland. Even with wide differences in inflation processes across these countries, there is we find strong evidence that the term structure does have significant forecasting ability for future changes in inflation, particularly so at long maturities. On the other hand, the ability of the term structure to forecast future changes in 1-year interest rates is somewhat weaker; only at the very longest horizon (5 years) is there significant forecasing ability for interest rate changes.

Abstract:
This paper shows that studies of announcement effects of bond rating changes should take into account the initial rating. First, we provide theoretical support for different price effects as a non-linear function of the initial credit rating, using a structural, Merton-type model linking the change in default probability to the change in the stock price. Next, we show that this theoretical prediction is verified in the empirical data. We find much stronger stock price effects for bond rating changes for low-rated firms relative to high-rated firms. Accounting for the role of the initial rating explains in large part the puzzling empirical regularity that stock price effects are associated with downgrades but not upgrades. In addition, it eliminates the investment-grade barrier effect reported in previous studies.

credit rating agencies, market reaction, event study, default probability

Abstract:
This paper provides two alternative estimation and testing procedures of a representative-agent model of asset pricing which relies on a particular parametrization of non-expected-utility preferences. The first is based on maximum-likelihood estimates, supplemented with an explicit model of time varying first and second moments (where the time-variation of second moments in modelled with an ARCH-Autoregressive Conditionally Heteroskedastic-process); the second is based on generalized-method-of moments estimates. We perform our tests on a data set that includes monthly observations of rates of return on US stock prices and US consumption of nondurables and services. Our results are directly comparable to a test of the dynamic capital asset pricing model performed by Hansen and Singleton (1983), and to a recent test of the model studied here performed by Epstein and Zin (1989).

Abstract:
This paper investigates information transfer effects of bond rating downgrades measured by equity abnormal returns for industry portfolios. Industry rivals can be subject to two opposing effects, the contagion effect and the competition effect. We find that the net effect is strongly dependent on the original bond rating of the downgraded firm. For investment-grade (speculative-grade) firms, industry abnormal equity returns are negative (positive), which implies a predominant contagion (competition) effect. The analysis reveals a rich pattern of positive and negative correlations across negative credit events, which can be used to improve our understanding of portfolio credit risk models.

bond rating downgrades, industry information transfer, contagion effects, competition effects

Abstract:
This research investigates the persistence of investment risk across time horizon, a crucial issue in asset allocation decisions. Previous empirical results have focused mainly on US data and suffer from limited sample size in the analysis of long-horizon returns. Investigation of a long-term sample of thirty countries provides additional empirical evidence. The results are not reassuring. There is no evidence of long-term mean reversion in the expanded data sample. Downside risk is not reduced as the horizon lengthens. On the positive side, a globally diversified portfolio would have displayed much less downside risk than any single market.

Abstract:
This study examines the information transfer effect of credit events across the industry, as captured in the Credit Default Swaps (CDS) and stock markets. Positive correlations across CDS spreads imply dominant contagion effects, whereas negative correlations indicate competition effects. We find strong evidence of dominant contagion effects for Chapter 11 bankruptcies and competition effect for Chapter 7 bankruptcies. We also introduce a purely unanticipated event, which is a large jump in a company’s CDS spread, and find that this leads to the strongest evidence of credit contagion across the industry. These results have important implications for the construction of portfolios with credit-sensitive instruments.

credit default swaps, bankruptcy, contagion, market reaction, event study

Abstract:
Risk management, even if flawlessly executed, does not guarantee that big losses will not occur. Big losses can occur because of business decisions and bad luck. Even so, the events of 2007 and 2008 have highlighted serious deficiencies in risk models. For some firms, risk models failed because of known unknowns. These include model risk, liquidity risk, and counterparty risk. In 2008, risk models largely failed due to unknown unknowns, which include regulatory and structural changes in capital markets. Risk management systems need to be improved and place a greater emphasis on stress tests and scenario analysis. In practice, this can only be based on position-based risk measures that are the basis for modern risk measurement architecture. Overall, this crisis has reinforced the importance of risk management.

Abstract:
This paper studies the hedging activities of 119 U.S. oil and gas producers from 1998 to 2001 and evaluates their effect on firm value. Theories of hedging based on market imperfections imply that hedging should increase the firm's market value. The oil and gas sample is ideal to test this hypothesis. It is a large sample of firms belonging to the same industry for which financial risk is important and with substantial variations in hedging ratios. We have collected detailed information on the extent of hedging and on the valuation of oil and gas reserves. We first verify that hedging reduces the firm's stock price sensitivity to oil and gas prices and that the effect is economically significant. Contrary to previous studies, however, we find that hedging does not seem to affect a firm's market value for this industry.

Risk management, hedging, derivatives, oil and gas

Abstract:
This article explores the risk and return relationship of active portfolios subject to a constraint on tracking-error volatility (TEV), which can also be interpreted in terms of value at risk. Such a constrained portfolio is the typical setup for active managers who are given the task of beating a benchmark. The problem with this setup is that the portfolio manager pays no attention to total portfolio risk, which results in seriously inefficient portfolios unless some additional constraints are imposed. The development in this article shows that TEV-constrained portfolios are described by an ellipse on the traditional mean-variance plane. This finding yields a number of new insights. Because of the flat shape of this ellipse, adding a constraint on total portfolio volatility can substantially improve the performance of the active portfolio. In general, plan sponsors should concentrate on controlling total portfolio risk.

Risk measurement and management: portfolio risk

Abstract:
Value at Risk (VAR), a measure of the dollar amount of potential loss from adverse market moves, has become a standard benchmark for measuring financial risk. Spurred by regulators and competitive pressures, more institutions are reporting VAR numbers in annual and quarterly financial reports. To provide preliminary evidence on the informativeness of these new disclosures, I investigate the relation between the trading VAR disclosed by a sample of U.S. commercial banks and the subsequent variability of their trading revenues. The empirical results suggest that VAR disclosures are informative in that they predict the variability of trading revenues. Thus, analysts and investors can use VAR disclosures to compare the risk profiles of trading portfolios.

Derivatives, risk management, value at risk, disclosure regulation, market risk disclosures, Basel Committee, SEC

Abstract:
Measures of volatility implied in option prices are widely believed to be the best available volatility forecasts. In this paper, we examine the information content and predictive power of Implied Standard Deviations (ISD's) derived from CME options on foreign currency futures. The paper finds that statistical time- series models, even when given the advantage of "ex post" parameter estimates, are outperformed by ISD's. ISD's, however, also appear to be biased volatility forecasts. Using simulations to investigate the robustness of these results, the paper finds that measurement errors and statistical problems can substantially distort inferences. Even accounting for these, however, ISD's appear to be too variable relative to future volatility.

Abstract:
Recent research shows that emerging markets are distinguished by high returns and low covariances with global market factors. To check whether these results can be attributed to their recent emergence, we simulate a simple, general model of global markets, with a realistic survival process. The simulations reveal a number of new effects. We find that pre-emergence returns are systematically lower than post-emergence returns, and that the brevity of a market history is related to the bias in returns as well as to the world beta. These patterns are confirmed by an empirical analysis of emerging and submerged markets.

Abstract:
This article re-examines the evidence on the ability of dividend yields to predict long-horizon stock returns. We use two new series beginning in 1871, a monthly series for the United States, and an annual series for the United Kingdom. Conditional on survival over the entire 122 years, dividend yields display only marginal ability to predict stock market returns in either country. We also argue that tests over long periods may be affected by survivorship. Simulations show that regression statistics based on a sample drawn solely from surviving markets can be seriously biased towards finding predictability.

Abstract:
On December 6, 1994, Orange County became the largest municipality ever to file for bankruptcy. This dramatic action was prompted by a loss of $1.64 billion on the Orange County Investment Pool that became "realized" as the pool was liquidated.This study provides an update to the Orange County situation and discusses whether the bankruptcy and liquidation were necessary. The bankruptcy decision seems to be justified by the fact that the county was facing liabilities far in excess of its assets. Indeed, the bankruptcy court has ruled that the county's petition was entirely appropriate as it was insolvent at the time of the filing. The liquidation decision, however, involved a substantial opportunity loss, as the subsequent drop in interest rates would have led to a recovery of the portfolio.Whether liquidation was appropriate cannot be judged by the path of interest rates after the fact. The article illustrates how the value at risk methodology could have been used to estimate the risks of the portfolio prior to the facts. By December 1994, there was an estimated 5% probability that the portfolio would suffer a further loss of $1.1 billion or more over the following year.

Abstract:
SUBJECT AREAS: Financial risk management, fixed-income portfolio.

CASE SETTING: 1995, local government investment fund. 

The purpose of this case is to explain how a municipality can lose $1.6 billion in financial markets and how this can be avoided in the future. The case also introduces the concept of "Value at Risk" (VAR), which is a simple method to express the risk of a portfolio. After the string of recent derivatives disasters, financial institutions, end- users, regulators, and central bankers are now turning to VAR as a method to control financial market risks. The case describes the portfolio composition, leverage, and risk exposure of the OC portfolio. It then introduces the various approaches to VAR and shows how VAR can be related to the concept of duration. The case illustrates how VAR could have been used to warn investors of the risks they were incurring. The case also discusses the recovery of Orange County and the impact of the bankruptcy on financial markets.

This is a stand-alone Web-based case. The case contains links to sites such as the Fed, Fannie Mae, and risk management sites. Students can also download a data file with historical yields, which allows them to compute the portfolio VAR based on a normal approximation or historical simulations.