Keith Cuthbertson

• City, University of London

We re-examine performance persistence amongst UK mutual funds. Specifically, we investigate performance persistence amongst small portfolios of past high-performing funds. In contrast to the more common analysis of decile portfolios of funds, we focus on persistence in the more extreme positive tail of the cross section of fund performance. This pa...

We re-examine US mutual fund performance persistence. We investigate persistence (i) using both “academic” factor models and “practitioner” index models, (ii) using decile-size recursive portfolios and also portfolios formed from smaller numbers of funds, (iii) using nonparametric bootstrap p-values as well as conventional t-tests and (iv) using bo...

We develop a performance evaluation model that incorporates the factors proposed by Huij and Derwall (2008) and a fund-specific benchmark to analyse the performance of US fixed income funds. Using the full sample, and accounting for the possibility of false discoveries, we find that fund management companies extract most of any abnormal performance...

Banks can reduce the credit risk on their ‘banking book’ by securitisation. They ‘bundle up’ a portfolio of loans and sell securities which entitle the investor (e.g. a hedge fund or pension fund) to the promised future cash flows from these loans – so the credit risk is transferred from banks to the holders of the securitised assets. Senior tranch...

This chapter explains how to price many different fixed income derivatives using the BOPM with an arbitrage‐free lattice for the short‐rate of interest. This ‘no‐arbitrage’ approach ensures that the interest rate lattice is constructed so it is impossible to make risk‐free profits by trading (different bonds) along the current yield curve. The latt...

This chapter demonstrates how bull and bear spreads are speculative strategies based on forecasting the direction of change in stock prices. It shows how options can be combined to benefit from strategies based on forecasting the range of future movements in stock prices. These are volatility strategies and include straddles, strangles, butterfly s...

This chapter examines different conventions when returns or interest rates are ‘annualised’ – namely ‘simple interest’, ‘compound interest’ and ‘continuously compounded interest’. It shows how a Forward Rate Agreement is priced. The chapter provides an overview of the key interest rates used in the market and different day‐count and interest rate c...

This chapter examines contract specifications for foreign currency options and the payoffs fromcalls and puts. It analyses the advantages and disadvantages of hedging future foreign currency receipts/payments with either futures or options. Most contracts traded are against the US dollar and the option premium is quoted in cents per unit of foreign...

This chapter shows how plain vanilla interest rate swaps can be used to convert uncertain future floating‐rate interest cash flows into known fixed‐rate cash flows. It examines the role of swap dealers, settlement procedures, pricing schedules and the termination of swap agreements. By using the swap, Microsoft has transformed an initial floating r...

This chapter demonstrates how spot‐rates for different maturities give rise to the (spot) yield curve. It shows how duration and convexity can be used to provide an approximation to the change in bond prices, after a change in the yield to maturity. The (spot) yield curve shows the relationship between (spot) interest rates for different maturity i...

This chapter explains how some of the more exotic options contracts can be used in speculation and hedging. Some path‐dependent options have closed‐form solutions for the options price, as long as one assumes that the underlying asset price is monitored continuously. Path‐dependent options can often be priced using either the binomial option pricin...

There are three main types of derivative securities, namely futures, options and swaps. Derivative securities are assets whose price depends on the price of some other (underlying) asset. Derivatives are a bit like nuclear fission – they can be used in ‘goodways’ or in ‘bad ways’ (like nuclear bombs) – if used incorrectly they may become ‘financial...

This chapter demonstrates simple delta hedging of calls and puts and the need for rebalancing. It shows how dynamic delta hedging is used to protect the value of an options portfolio from (small) changes in the price of the underlying asset. A portfolio can be constructed so that any gain or loss from a small change in the option price is offset by...

Forward contracts are analytically easier to deal with than futures contracts and so people often apply mathematical results from forwards (e.g. pricing forward contracts) to futures contracts. However, there are differences in practice between the two types of contract and this chapter discusses the mechanics of both of these contracts. Since futu...

This chapter demonstrates how a payer swaption can be used to set an effective maximum swap rate that begins at expiration of the swaption but also allows the holder of the swaption to take advantage of lower swap rates, should they occur in the future. It shows how a long position in a forward swap locks in a known swap rate which will begin at ex...

A great deal of analytic work in pricing derivative securities and in constructing hedge portfolios uses continuous time stochastic processes. Any variable (such as the stock price) which changes over time in a random way is said to be stochastic. This chapter explains a standard Wiener process and how this leads to a stochastic process for the sto...

This chapter discusses contract specifications, settlement procedures and price quotes for futures contracts on three‐month Sterling deposits, three‐month Eurodollar deposits and US T‐bills. It shows how interest rate futures contracts are priced. The chapter examines arbitrage strategies using the implied repo rate on T‐bill futures. It explores s...

This chapter discusses the organisation of options markets including the role of the clearing house and interpreting newspaper quotes. For US options markets the Options Clearing Corporation standardises contracts and acts as an intermediary, effectively creating two separate contracts. The chapter explains some terminology applied to calls and put...

This chapter analyses how forward and future prices are determined as functions of known variables such as the current market price of the underlying asset and the risk‐free interest rate. Cash‐and‐carry arbitrage can be used to determine the correct (no‐arbitrage) futures price where the underlying assets involve intermediate cash flows and that i...

This chapter shows how static stock+put insurance can achieve a lower bound for the value of a diversified stock portfolio, while maintaining most of the upside potential. It analyses how day‐to‐day price changes of a ‘stock+put’ portfolio can be replicated using either a ‘stock+futures’ portfolio or a ‘stock+T‐Bill’ portfolio. Replication portfoli...

This chapter aims to price fixed income options using Monte Carlo simulation (MCS). Black's model assumes the price of the underlying asset in the options contract has a lognormal distribution, at maturity of the option. Black's model, which was originally used for pricing options on commodity futures can be adapted to give a closed‐form solution f...

This chapter examines stock options and stock index options (SIO). It shows how readers can hedge a portfolio of stocks using dynamic delta hedging. Investors can insure or hedge a cash market position consisting of stocks held in a specific firm or in certain specific industries or in a ‘market portfolio’ using various types of SIO. A static hedge...

This chapter analyses how plain vanilla European options can be priced under risk‐neutral valuation (RNV), using Monte Carlo Simulation (MCS). It shows how we can reduce computational time in MCS and how ‘the Greeks’ are calculated using MCS. The concept of RNV can be used to determine option premia using MCS. Pricing options using MCS requires a s...

This chapter describes the standard Black–Scholes formula to price European options on stocks that pay dividends. It presents European foreign currency options and futures options. The chapter demonstrates the links between pricing formulas for European options on dividend. It examines the links between the put–call parity relationship for European...

This chapter demonstrates how equity swaps allow an investor to gain temporary exposure to the stock market without actually buying or selling the stocks in her existing portfolio. It shows how to price a domestic equity‐for‐domestic equity swap, or swap of the return on a domestic equity for the return on a foreign equity. Often the notional princ...

This chapter examines contract details for UK Gilt futures and US T‐bond futures including the conversion factor, the cheapest‐to‐deliver bond and wild card play. It describes the optimal number of T‐bond futures contracts for hedging. The chapter provides the fair price of a T‐bond futures contract using cash‐and‐carry arbitrage. It explains sprea...

This chapter examines the use of options on T‐bonds and options on T‐bond futures and Eurodollar futures. It shows how a collar is used to limit the maximum and minimum interest rates payable in the future, on an existing LIBOR bank loan or bank deposit. The chapter discusses hedging a single interest rate payment or receipt, using a caplet or floo...

The equilibrium yield curve approach assumes a specific continuous time stochastic process for the one period (short) rate. The parameters of this process are then estimated from historical data. Bond prices and fixed income derivatives prices can then be derived mathematically and these prices depend directly on the estimated parameters of the sto...

This chapter shows how a protective put is used to control downside risk for an individual stock ora portfolio of stocks. If readers already hold stocks‐XYZ then they may wish to limit any potential losses on the stocks but also be able to take advantage of any rise in the price of the stock, should this occur. Finance Blog 15.1 sets the scene by i...

This chapter shows how the debt and equity of a firm can be valued using options theory. Then it examines equity warrants, which are stock options ‘attached to’ bonds. Equity warrants are one of the oldest manifestations of options. They are call options written by a firm on its own stock. European warrants can only be exercised on a certain day. T...

This chapter provides details of contract specification, settlement procedures and quotes for stock index futures (SIF) contracts. SIF are contracts whose price depends on an underlying stock market index such as the S&P 500, FTSE 100 or Nikkei 225 indices. Such futures contracts are widely used in hedging, speculation, and index arbitrage. The cha...

This chapter aims to establish upper and lower bounds for the price of European calls and puts on futures. It examines payoffs and trading strategies using futures options. The expiration date of a futures option is usually on, or a few days before, the maturity date of the underlying futures contract. Writers of calls or puts, must post margin pay...

In this chapter, the author use concepts from portfolio theory to provide us with a simple yet useful forecast of market risk, namely, value at risk — which is the industry standard. It explains the concept of value at risk (VaR). The chapter measures VaR using the variance‐covariance approach. It outlines methods used in forecasting volatility. Th...

This chapter examines the reasons for undertaking a plain vanilla currency swap of fixed‐USD for fixed‐Euros. It shows how to value a ‘fixed‐fixed’ USD‐Euro currency swap at any time after inception, using a replication portfolio of: a USD bond and Euro bond or by considering the swap as a strip of foreign exchange‐forward contracts. UncleSam is re...

This chapter examines alternative ways of measuring and forecasting volatility and describes the validity of the Black–Scholes equation. It assesses the limitations of the Black–Scholes equation for pricing European options. In the Black–Scholes formula all variables are directly observable, except for the volatility of stock returns. There are a v...

This chapter shows that cash flows in a swap are equivalent to a replication portfolio consisting of a position in a fixed rate bond and a floating rate note (FRN). It analyses how the mark‐to‐market value of a swap changes through time in response to changes in interest rates and the number of remaining payments in the swap. An FRN is a bond with...

This chapter outlines contract specifications, settlement procedures and price quotes for selected foreign exchange futures contracts also called ‘currency futures’. Currency forwards and futures are very similar analytically, even though in practice the contractual arrangements differ. Currency forwards and futures are used to hedge future cash fl...

Credit derivatives allow companies and financial institutions to hedge their credit risks and allow investors to hold assets whose value depends (in part) on the creditworthiness of companies and individuals. There are two main ways banks can reduce their credit risk. First, they can ‘bundle up’ a portfolio of loans and sell bonds to investors who...

This chapter shows how stock index futures (SIF) can be used to protect an active ‘stock picking’ strategy from general movements in the overall stock market return (e.g. S&P 500 index). It demonstrates how an investor (e.g. long‐short hedge fund) holding a well‐diversified portfolio of stocks can benefit from speculating on underpriced or overpric...

This chapter explains spot rates and the ‘yield to maturity’ on a bond. It shows that the ‘fair’ price of a coupon paying bond is determined by spot yields – otherwise risk‐free arbitrage profits can be made by a strategy known as coupon stripping. The chapter suggests how the yield to maturity is ‘derived’ from the market price of the bond. It dis...

This chapter examines how interest rate futures can be used for either hedging the value of fixed income assets, or to ‘lock in’ future borrowing or lending rates. It shows how interest rate futures contracts allow investors to hedge spot positions in cash market assets, such as T‐bills, bank deposits, and loans. The chapter considers futures contr...

This chapter shows how the Black–Scholes formula is used to price European calls and puts. A speculator would purchase a call option if she expected a bull market, that is, a rise in stock prices. The call premium depends positively on the current stock price relative to the strike price and the volatility of the stock return over the life of the o...

This chapter shows how a derivative's price can be replicated using stocks and bonds, which eliminates any uncertainty represented by the stochastic variable. This results in a partial differential equation (PDE) for the price of the derivative which is deterministic and can be interpreted in terms of risk‐neutral valuation. This Black–Scholes PDE...

This chapter examines how derivatives are used to hedge against price volatility found in spot energy markets and how weather derivatives are used to mitigate changes in profits which result from changes in the volume of output, caused by abnormal changes in the weather. Well ‘crack’ appears in energy markets too, in the form of the ‘crack spread’....

This chapter demonstrates how to hedge the credit risk of a swap position using collateral, netting and credit enhancements. One party to the swap has cash flows determined by a foreign interest rate but these foreign cash flows are based on a notional principal in the home currency. They embed a fixed currency exchange rate in the swap deal. The c...

Futures contracts can be used for hedging an existing position in a spot (cash‐market) asset. Hedging with futures can be used to reduce such risk to a minimum. In practice, using futures contracts cannot reduce price‐risk to zero so a ‘perfect hedge’ is usually not possible. If people are long the cash‐market asset (e.g. stocks) and hence fear a p...

This chapter shows how ‘the Greeks’ (e.g. delta, gamma, rho, vega, and theta) provide useful ‘summary statistics’ for options, which can be used to provide an approximation to the change in the option price. It also shows how the Greeks are used to protect the value of an options portfolio from small changes (delta hedging) and large changes (delta...

The aim of the European Union's Emissions Trading Scheme (EU ETS) is that by 2020, emissions from sectors covered by the EU ETS will be 21% lower than in 2005. In addition to large CO2 emitting companies covered by the scheme, other participants have entered the market with a view of using emission allowances for the diversification of their invest...

This paper surveys and critically evaluates the literature on the role of management effects and fund characteristics in mutual fund performance. First, a brief overview of performance measures is provided. Second, empirical findings on the predictive power of fund characteristics in explaining future returns are discussed. Third, the paper reviews...

There is now a substantial literature on the effects of rebalancing on portfolio performance. However, this literature contains frequent misattribution between ‘rebalancing returns’, which are specific to the act of rebalancing, and ‘diversification returns’, which can be earned by both rebalanced and unrebalanced strategies. Confusion on this issu...

We apply parametric and non-parametric estimates to test market and style timing ability of individual German equity and bond mutual funds using a sample of over 500 equity and 350 bond funds, over the period 1990–2009. For equity funds, both approaches indicate no successful market timers in the 1990–1999 or 2000–2009 periods, but in 2000–2009 the...

There are three main types of derivative securities, namely futures, options, and swaps. Derivative securities are assets whose value depends on the value of some other (underlying) asset and their value is derived from the value of this underlying asset. A key feature of futures and options is that the contract calls for deferred delivery of the u...

Using a comprehensive data set of almost 300 UK closed-end equity funds over the period 1990 to 2013, we use the false discovery rate to assess the alpha-performance of individual funds with both domestic and other mandates, using self-declared benchmarks and additional risk factors. We find evidence to indicate that up to 16% of the funds have tru...

We investigate the performance of the German equity mutual fund industry over 20 years (monthly data 1990-2009) using the false discovery rate (FDR) to examine both model selection and performance measurement. When using the Fama-French three factor (3F) model (with no market timing) we find that at most 0.5% of funds have truly positive alpha-perf...

It is widely claimed by both academics and practitioners that periodic rebalancing of portfolios to keep asset weights constant will directly boost geometric returns by buying on downticks and selling on upticks. This paper refutes this claim by showing that comparable improvements arise even without rebalancing. This misattribution of returns has...

We use a multiple hypothesis testing framework to estimate the false discovery rate (FDR) amongst UK equity mutual funds. Using all funds, we find a relatively high FDR for the best funds of 32.8% (at a 5% significance level), which implies that only around 3.7% of all funds truly outperform their benchmarks. For the worst funds the FDR is relative...

We use a multiple hypothesis testing framework to estimate the false discovery rate (FDR) amongst UK equity mutual funds. For all funds, we find a relatively high FDR for the best funds of 67% (at a 10% significance level), which indicates that only around 2% of all funds truly outperform their benchmarks. For the worst funds the FDR (at a 10% sign...

We investigate the performance of winners and losers for German equity mutual funds (1990–2009), using empirical order statistics. When using gross returns and the Fama–French three-factor model, the number of statistically significant positive alpha funds is zero but increases markedly when market timing variables are added. However, when using a...

We investigate the performance of the German equity mutual fund industry over 20 years (monthly data 1990-2009) using the false discovery rate (FDR) to examine both model selection and performance measurement. When using the Fama-French three factor (3F) model (with no market timing) we find at most 0.5% of funds have truly positive alpha-performan...

The paper provides a critical review of empirical findings on the performance of mutual funds, mainly for the US and UK. Ex-post, there are around 0-5% of top performing UK and US equity mutual funds with truly positive-alpha performance (after fees) and around 20% of funds that have truly poor alpha performance, with about 75% of active funds whic...

We apply a recent nonparametric methodology to test the market timing skills of UK equity and balanced mutual funds. The methodology has a number of advantages over the widely used regression based tests of Treynor-Mazuy (1966) and Henriksson-Merton (1981) . We find a relatively small number of funds (around 1%) demonstrate positive market timing a...

The UK's defined benefit pensions industry makes widespread use of pooled investment vehicles which are provided by a large number of fund management groups. In this paper we provide the first comprehensive performance analysis of these funds. Using data on 734 pooled funds, that had a combined value of just over 400 billion pounds at the end of 20...

The puzzle is that spreads on corporate bonds are about twice as large as can be explained by defaults, taxes and illiquidity. The higher a bond's rating and the shorter its maturity, the greater is the puzzle. We use a large dataset of bonds to identify the relevant risk factors. Systematic factors fail to generate large spreads, regardless of whe...

Using a comprehensive data set on (surviving and non-surviving) UK equity mutual funds, we use a cross-section bootstrap methodology to distinguish between 'skill' and 'luck' for individual funds. This methodology allows for non-normality in the idiosyncratic risk of the funds -- a major issue when considering those funds which appear to be either...

We use a multiple hypothesis testing framework to estimate the false discovery rate (FDR) amongst UK equity mutual funds. For all funds, we find a relatively high FDR for the best funds of 67% (at a 10% significance level), which indicates that only around 2% of all funds truly outperform their benchmarks. For the worst funds the FDR (at a 10% sign...

Abstract There have been major advances in both theory and econometric techniques in mainstream macro-models and parallel advances in knowledge of the monetary transmission mechanism acting via asset prices. At the same time, behavioural finance has provided evidence that not all actors in the economy are ‘fully rational’ and this has influenced mo...

The Carr-Darby ‘shock-absorber’ hypothesis, that unanticipated changes in the money supply influence the demand for real money balances but anticipated changes do not, is tested on UK data for narrow money, M1. For comparison with earlier studies on US data we take the (real first order) partial adjustment model as one example of a ‘conventional’ d...

There are three main types of derivative securities, namely futures, options, and swaps. Derivative securities are assets whose value depends on the value of some other (underlying) asset and their value is derived from the value of this underlying asset. A key feature of futures and options is that the contract calls for deferred delivery of the u...

We evaluate the academic research on mutual fund performance in the US and UK concentrating particularly on the literature published over the last 20 years where innovation and data advances have been most marked. The evidence suggests that ex-post, there are around 2-5% of top performing UK and US equity mutual funds which genuinely outperform the...

There have been major advances in both theory and econometric techniques in mainstream macro-models and parallel advances in knowledge of the monetary transmission mechanism acting via asset prices. At the same time, behavioral finance has provided evidence that not all actors in the economy are 'fully rational' and this has influenced models of as...

We apply a recent nonparametric methodology to test the market timing skills of UK equity mutual funds. The methodology has a number of advantages over the widely used regression based tests of Treynor-Mazuy (1966) and Henriksson-Merton (1981). We find a relatively small number of funds (around 1.5%) demonstrate positive market timing ability at a...

In this paper we analyse whether the consumption based capital asset pricing model is consistent with asset return data from the French and German stock markets. We evaluate the performance of the C-CAPM by applying the non-parametric methodology of Hansen and Jagannathan and adopting five alternative specifications of utility. In addition to stand...

We use a bootstrap technique to construct a distribution of abnormal performance among UK equity mutual funds under a null hypothesis of zero abnormal performance. Such a distribution of random sampling variation around no abnormal performance is employed as an estimate of, or proxy for, luck in mutual fund performance. Actual performance is then c...

No Abstract

We examine the possibility that the apparent failure of the expectations hypothesis EH on UK data at the long end of the maturity spectrum, may be due to the presence of a time varying (yet stationary) term premium. The presence of a time varying term premium (TVP) can result in the ‘over reaction hypothesis’ namely, that actual movements in the sp...

In this paper we analyse whether the consumption based capital asset pricing model is consistent with asset return data from the French and German stock markets. We evaluate the performance of the CCAPM by applying the non-parametric methodology of Hansen and Jagannathan (1991) and adopting alternative specifications of utility. The first specifica...

An aggregate consumption function for the Czech Republic since its transition to market status is estimated. Economic theory and the "general to specific" methodology are used to guide the choice of dynamic equation. Previous empirical evidence on the consumption function in Eastern Europe focused on the centrally planned period and so faced the "l...

In this paper, we analyse whether the French and German stock markets can be classified to be efficient or whether they exhibit excess volatility. We assess efficiency in each market by employing the VAR methodology of Campbell and Shiller (Campbell, J.Y., Shiller, R.J., 1988b. The dividend–price ratio and expectations of future dividends and disco...

This paper calculates indices of central bank autonomy (CBA) for 163 central banks as of end-2003, and comparable indices for a subgroup of 68 central banks as of the end of the 1980s. The results confirm strong improvements in both economic and political CBA over the past couple of decades, although more progress is needed to boost political auton...

We analyse the demand for money since the “break up” of the Czech-Slovak Republics at the beginning of 1993 and for the aggregates M0, Ml, and M2 using monthly data. Due to the widespread use of foreign currency in formally centrally planned economies, we also investigate the issue of currency substitution. Because of our relatively small sample pe...

We test the expectations hypothesis (EH) of the term structure of interest rates for the German money market at the short end of the maturity spectrum using a variety of metrics, and on balance we argue that the results tend to broadly support the hypothesis. We utilise monthly data on pure discount bonds with a maturity from 1 to 12 months over th...

Using a number of short-term maturities and monthly data, 1984-1997, we provide a number of tests of the expectations hypothesis (EH) of the term structure. The paper draws on cointegration techniques and the methodological approach of Campbell and Shiller (1987,1991). On balance our results lend support to the EH and are broadly consistent with re...

We employ Campbell and Shiller’s (1989) VAR methodology to examine the relative performance of the CAPM and the consumption-CAPM. We find that although neither provides a complete description of stock price behaviour, the former clearly dominates the latter. We then consider the implications for sub-sectors of the market. According to the CAPM, sub...

We examine movements in aggregate UK stock prices by decomposing the variance of unexpected real stock returns into components due to revisions in expectations of future dividends, discount rates, and the covariance between the two. The contribution of news about future discount rates is about four times that of news about future dividends, with no...

We analyse the demand for M1 and M3 and in particular the presence of a portfolio balance effect for Mexico over the period 1978–90 using quarterly data. The analysis uses economic theory and cointegration to guide the choice of appropriate independent variables. However, because of potential problems in applying the full system cointegration appro...

In this paper, we investigate the response of stock returns at an industry level to macroeconomic shocks for the UK, Germany and France. The betas between the stock returns and the macroeconomic factors provide a metric for the markets view of the homogeneity of industry response to the various macroeconomic shocks. We find that the market seems to...

The authors test the expectations hypothesis (EH) of the term structure using U.K. and German weekly data on short dated instruments with maturities up to one year. For both data sets comprising k interest rates the authors find that the rank of the cointegrating space is (k - 1); but they can only accept that the cointegrating parameter estimates...

The VAR methodology of J. Y. Campbell and R. J. Shiller (1989) is employed under four different assumptions regarding equilibrium expected returns to assess the efficiency of the U.K. stock market. In the authors' first model, equilibrium expected (real) returns are assumed to be constant, while in the second model, excess returns are assumed to be...