Estimation with Flexible Probabilities: Identifying Rand Hedges, Finding Diversifiers, Enhancing Style Analysis

28 Pages Posted: 4 Feb 2019 Last revised: 10 Feb 2019

See all articles by Emlyn James Flint

Emlyn James Flint

Legae Peresec; Department of Actuarial Science, University of Cape Town

Anthony Seymour

University of Cape Town (UCT)

Florence Chikurunhe

Peregrine Securities

Date Written: January 28, 2019

Abstract

At its core, portfolio and risk management is about gathering and processing market-related data in order to make effective investment decisions. To this end, risk and return statistics are estimated from relevant financial data and used as inputs within the investment process. It is this estimation step which is ultimately key in transforming raw financial data into useful investment information. Therefore, having a flexible and robust estimation process is of crucial importance to all market participants.

In this work we make use of the Flexible Probabilities framework and show how to incorporate different forms of time-conditioning and market state-conditioning into any estimation procedure. This framework allows one to calculate conditional risk and return statistics in a simple manner for a wide range of portfolio and risk management applications.

We then make use of this framework in three applications which we believe to be directly relevant to South African market participants. Firstly, we address the long-standing issue of identifying rand-hedge stocks and quantifying the extent of their hedging ability, specifically in times of rand weakness and strength. Secondly, we examine whether the ‘myth of diversification’ – that diversification disappears when one needs it most – holds true for South African markets. Finally, we extend the original returns-based style analysis framework to allow for time- and state-conditioned weights and estimate the style mix of the South African equity market across time and market regime.

Keywords: flexible probabilities, state-weighted estimation, currency exposure, diversification, style analysis

JEL Classification: C1, C2, C22, C32, C51, C53, C58, C61, G11

Suggested Citation

Flint, Emlyn James and Seymour, Anthony and Chikurunhe, Florence, Estimation with Flexible Probabilities: Identifying Rand Hedges, Finding Diversifiers, Enhancing Style Analysis (January 28, 2019). Available at SSRN: https://ssrn.com/abstract=3324076 or http://dx.doi.org/10.2139/ssrn.3324076

Emlyn James Flint (Contact Author)

Legae Peresec ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.legaeperesec.co.za

Department of Actuarial Science, University of Cape Town ( email )

Actuarial Science Section, University of Cape Town
Private Bag X3, Rondebosch
Cape Town, Western Cape 7701
South Africa
+27 21 650 2475 (Phone)

Anthony Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

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