[show abstract][hide abstract] ABSTRACT: This paper explores how the returns of country exchange traded funds (ETFs) respond to global risk factors in different market regimes. We consider the ETFs for the U.S., Canada, U.K., Germany, France, Italy, Japan, and Australia from May 30, 2000 to March 31, 2011. To answer this question, we use the Bayesian information criterion to select a regime switching model (RS) with six global risk factors and identify three market regimes - bull, transitory and bear markets. The empirical results show that both the returns of country ETFs and their sensitivities to the risk factors are highly regime dependent. First, the U.S. size and value factors are significant in explaining most of selected ETFs across regimes. More specifically, small capitalization is associated with lower returns for all country ETFs (except for Canada) in at least one market regime. High book-to-market ratio generates higher returns for all ETFs in most market regimes. Second, the global stock market return has a positive impact on the returns of all country ETFs. Third, all ETFs returns are negatively correlated with market volatility in bull and bear market regimes. Fourth, a stronger U.S. dollar generates a higher return for the U.S. ETF and lower returns for the other seven country ETFs across market regimes. Finally, the returns of Australia, Canada and U.K. ETFs, which invest heavily in materials, are positively correlated with commodity prices while other country ETF returns are negatively associated with these prices across market regimes.
[show abstract][hide abstract] ABSTRACT: In capital growth under uncertainty, an investor must determine howmuch capital to invest in riskless and risky instruments at each point intime, with a focus on the trajectory of accumulated capital to a planninghorizon. Assuming that prices are not aected by individual investmentsbut rather aggregrate investments, individual decisions are made basedon the projected price process given the history of prices to date. An in-vestment strategy which has generated considerable interest is the growthoptimal or Kelly strategy, where the expected logarithm of wealth is maxi-mized period by period. In this paper the traditional capital growth modeland modications to control risk are developed. A mixture model basedon Markov transitions between normally distributed market regimes isused for the dynamics of asset prices. Decisions on investment in assetsare based on a constrained growth model, where the trajectory of wealthis required to exceed a specied path over time with high probability, andthe path violations are penalized using a convex loss function. This allowsthe determination of the optimal constrained growth wagers at discretepoints in time.
[show abstract][hide abstract] ABSTRACT: This volume provides the definitive treatment of fortune's formula or the Kelly capital growth criterion as it is often called. The strategy is to maximize long run wealth of the investor by maximizing the period by period expected utility of wealth with a logarithmic utility function. Mathematical theorems show that only the log utility function maximizes asymptotic long run wealth and minimizes the expected time to arbitrary large goals. In general, the strategy is risky in the short term but as the number of bets increase, the Kelly bettor's wealth tends to be much larger than those with essentially different strategies. So most of the time, the Kelly bettor will have much more wealth than these other bettors but the Kelly strategy can lead to considerable losses a small percent of the time. There are ways to reduce this risk at the cost of lower expected final wealth using fractional Kelly strategies that blend the Kelly suggested wager with cash. The various classic reprinted papers and the new ones written specifically for this volume cover various aspects of the theory and practice of dynamic investing. Good and bad properties are discussed, as are fixed-mix and volatility induced growth strategies. The relationships with utility theory and the use of these ideas by great investors are featured.
[show abstract][hide abstract] ABSTRACT: This chapter describes the use of the Kelly capital growth model. This model, dubbed Fortune’s Formula by Thorp and used in the title by Poundstone (Fortune’s Formula: The Untold Story of the Scientific System That Beat the
Casinos and Wall Street, 2005), has many attractive features such as the maximization of asymptotic long-run wealth; see Kelly
(Bell System Technical Journal 35:917–926, 1956), Breiman (Proceedings of the 4th Berkely Symposium on Mathematical Statistics
and Probability 1:63–68, 1961), Algoet and Cover (Annals of Probability 16(2):876–898, 1988) and Thorp (Handbook of Asset
and Liability Management, 2006). Moreover, it minimizes the expected time to reach asymptotically large goals (Breiman, Proceedings
of the 4th Berkeley Symposium on Mathematical Statistics and Probability 1:63–68, 1961) and the strategy is myopic (Hakansson,
Journal of Business 44:324–334, 1971). While the strategy to maximize the expected logarithm of expected final wealth computed
via a nonlinear program has a number of good short- and medium-term qualities (see MacLean, Thorp, and Ziemba, The Kelly Capital
Growth Investment Critria, 2010b), it is actually very risky short term since its Arrow–Pratt risk aversion index is the reciprocal
of wealth and that is essentially zero for non-bankrupt investors. The chapter traces the development and use of this strategy
from the log utility formulation in 1738 by Bernoulli (Econometrica 22:23–36, 1954) to current use in financial markets, sports
betting, and other applications. Fractional Kelly wagers that blend the E log maximizing strategy with cash tempers the risk and yield smoother wealth paths but with generally less final wealth.
Great sensitivity to parameter estimates, especially the means, makes the strategy dangerous to those whose estimates are
in error and leads them to poor betting and possible bankruptcy. Still, many investors with repeated investment periods and
considerable wealth, such as Warren Buffett and George Soros, use strategies that approximate full Kelly which tends to place
most of one’s wealth in a few assets and lead to many monthly losses but large final wealth most of the time. A simulation
study is presented that shows the possibility of huge gains most of the time, possible losses no matter how good the investments
appear to be, and possible extreme losses from overbetting when bad scenarios occur. The study and discussion shows that Samuelson’s
objections to E log strategies are well understood. In practice, careful risk control or financial engineering is important to deal with
short-term volatility and the design of good wealth paths with limited drawdowns. Properly implemented, the strategy used
by many billionaires has much to commend it, especially with many repeated investments.
KeywordsKelly investment criterion-Long-range investing-Logarithmic utility functions-Fractional Kelly strategies
[show abstract][hide abstract] ABSTRACT: The accumulated wealth from investment in risky assets is a random variable. If investment strategies are to be ordered, so
that one is preferred to another, then the ordering of random variables is required. In this paper the levels of stochastic
dominance for random variables are used to define bi-criteria problems for determining an efficient investment strategy. The
criteria are characterized as growth and security, respectively, and produce an ordering of strategies consistent with stochastic
dominance. In the case where the dynamics of asset returns follow geometric Brownian motion in continuous time, the efficient
strategies are shown to be proportional to the growth optimum or Kelly strategy. The analogous problem in discrete time requires
solving a stochastic program. An example is provided which compares the continuous and discrete time solutions.
[show abstract][hide abstract] ABSTRACT: We consider the presence of regimes in currency markets and their implications for interest rate parity. A weak form of interest rate parity is postulated and tested which assumes that the hedged risk premiums are identical within each regime across currencies. Both the in-sample (January 2002 - December 2004) and the out-of-sample (January 2005 - December 2007) daily data support weak interest rate parity. Furthermore, using the Federal Exchange Rate Index as a proxy of the currency market portfolio and T-Bills as the risk free asset, we find strong evidence that the weak interest rate parity hypothesis is consistent with standard portfolio equilibrium theory. The similarity between the benchmark and the implied equilibrium portfolio provides strong evidence that regime switching with weak interest rate parity is appropriate for modeling currency returns.
[show abstract][hide abstract] ABSTRACT: Using three simple investment situations, we simulate the behavior of the Kelly and fractional Kelly proportional betting strategies over medium term horizons using a large number of sce-narios. We extend the work of Bicksler and Thorp (1973) and Ziemba and Hausch (1986) to more scenarios and decision periods. The results show: (1) the great superiority of full Kelly and close to full Kelly strategies over longer horizons with very large gains a large fraction of the time; (2) that the short term performance of Kelly and high fractional Kelly strategies is very risky; (3) that there is a consistent tradeo of growth versus security as a function of the bet size determined by the various strategies; and (4) that no matter how favorable the investment opportunities are or how long the nite horizon is, a sequence of bad results can lead to poor nal wealth outcomes, with a loss of most of the investor's initial capital.
[show abstract][hide abstract] ABSTRACT: Standard delta hedging fails to exactly replicate a European call option in the presence of transaction costs. We study a pricing and hedging model similar to the delta hedging strategy with an endogenous volatility parameter for the calculation of delta over time. The endogenous volatility depends on both the transaction costs and the option strike prices. The optimal hedging volatility is calculated using the criterion of minimizing the weighted upside and downside replication errors. The endogenous volatility model with equal weights on the up and down replication errors yields an option premium close to the Leland (1985) heuristic approach. The model with weights being the probabilities of the option's moneyness provides option prices closest to the actual prices. Option prices from the model are identical to the Black-Scholes option prices when transaction costs are zero. Data on S\&P 500 index cash options from January to June 2008 illustrate the model.
[show abstract][hide abstract] ABSTRACT: 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 The trading prices for securities in financial markets can exhibit sudden shifts or reversals in direction. In this paper a methodology for asset price dynamics is presented where the diffusive component is combined with a risk process. The risk process accommodates deviations from an equilibrium process and reversions. The bond–stock yield differential is considered as a risk factor affecting the risk process. An approach using a "peaks over threshold" technique and conditional maximum likelihood is used to estimate parameters in the model. Numerical results for the period 1985–2004 in the US market validate the effectiveness of the model.
[show abstract][hide abstract] ABSTRACT: This paper considers the estimation of the expected rate of return on a set of risky assets. The approach to estimation focuses on the covariance matrix for the returns. The structure in the covariance matrix determines shared information which is useful in estimating the mean return for each asset. An empirical Bayes estimator is developed using the covariance structure of the returns distribution. The estimator is an improvement on the maximum likelihood and Bayes–Stein estimators in terms of mean squared error. The effect of reduced estimation error on accumulated wealth is analyzed for the portfolio choice model with constant relative risk aversion utility.
[show abstract][hide abstract] ABSTRACT: This paper presents a dynamic model of optimal currency returns with a hidden Markov regime switching process. We postulate a weak form of interest rate parity that the hedged risk premiums on currency investments are identical within each regime across all currencies. Both the in-sample and the out-of-sample data during January 2002 - March 2005 strongly support this hypothesis. Observing past asset returns, investors infer the prevailing regime of the economy and determine the most likely future direction to facilitate portfolio decisions. Using standard mean variance analysis, we find that an optimal portfolio resembles the Federal Exchange Rate Index which characterizes the strength of the U.S. dollar against world major currencies. The similarity provides a strong implication that our three-regime switching modelis appropriate for modeling the hedged returns in excess of the U.S. risk free interest rate. To investigate the impact of the equity market performance on changes of exchange rates, we include the S&P500 index return as an exogenous factor for parameter estimation.
[show abstract][hide abstract] ABSTRACT: The risk inherent in the accumulation of investment capital depends on the true return distributions of the risky assets, the accuracy of estimated returns, and the investment strategy. This paper considers risk control with Value-at-Risk and Conditional Value-at-Risk, using control limits to determine times for portfolio rebalancing. Optimal strategies and control limits are determined for a geometric Brownian motion asset pricing model with random parameters. The approaches to risk control are applied to the fundamental problem of investment in stocks, bonds, and cash over time.
Journal of Banking & Finance. 02/2006; 30(2):317-339.
[show abstract][hide abstract] ABSTRACT: This paper considers the estimation of parameters in a dynamic stochastic model for securities prices, where the expected rate of return is a random variable. An empirical Bayes estimator is developed from the model structure. The estimator is an improvement on other popular estimators in terms of mean squared error. The effect of reduced estimation error on accumulated wealth is analyzed for the portfolio choice model with constant relative risk aversion utility.
[show abstract][hide abstract] ABSTRACT: This paper discusses the allocation of capital over time with several risky assets. The capital growth log utility approach is used with conditions requiring that specific goals are achieved with high probability. The stochastic optimization model uses a disjunctive form for the probabilistic constraints, which identifies an outer problem of choosing an optimal set of scenarios, and an inner (conditional) problem of finding the optimal investment decisions for a given scenarios set. The multiperiod inner problem is composed of a sequence of conditional one period problems. The theory is illustrated for the dynamic allocation of wealth in stocks, bonds and cash equivalents.
Journal of Economic Dynamics and Control. 02/2004;
[show abstract][hide abstract] ABSTRACT: The problem of misdirected investment strategies based on erroneous forecasts is the motivation for a Process Control (PC) approach to volatility and risk. Upper and lower limits on the capital accumulation process are used to determine if the current investment strategy continues. If a limit is reached then rebalancing occurs, where returns are re-estimated, new limits are established and a new strategy is determined. This variable planning horizon approach is compared to the standard Value-at-Risk (VaR) methodology, where the time horizon is fixed. In an application to asset allocation involving stocks, bonds and cash, it is shown that for any VaR strategy there exists process control limits so that the corresponding PC strategy has greater expected return with equivalent downside risk. The advantage in the process control approach comes from intervening when the wealth process deviates significantly from expectations.
Computational Intelligence for Financial Engineering, 2003. Proceedings. 2003 IEEE International Conference on; 04/2003
[show abstract][hide abstract] ABSTRACT: This paper considers the use of treatment resources in a health service system. The particular aspect of system use which is identified is resource absorption – excessive use by a small subset of users and unmet need by others. A dynamic stochastic model for health status with treatment interventions is formulated and the distribution of accumulated treatment time (service) is developed. The characterization of heavy tails in the distribution, the essential feature of resource absorption, is based on the Lorenz curve and an Index of Resource Absorption is defined for any feasible Lorenz curve. The index is applied to the use of psychiatric hospital resources in a Province of Canada.
Health Care Management Science 01/2001; 4(4):337-345. · 1.05 Impact Factor