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Byline: Mariana Blanco (1), Dirk Engelmann (2,3,4), Alexander K. Koch (5), Hans-Theo Normann (6,7) Keywords: Belief elicitation; Hedging; Experimental economics; Experimental methodology; C72; C90 Abstract: Belief-elicitation experiments usually reward accuracy of stated beliefs in addition to payments for other decisions. But this allows risk-averse subjects to hedge with their stated beliefs against adverse outcomes of the other decisions. So can we trust the existing belief-elicitation results? And can we avoid potential hedging confounds? We propose an experimental design that theoretically eliminates hedging opportunities. Using this design, we test for the empirical relevance of hedging effects in the lab. Our results suggest that hedging confounds are not a major problem unless hedging opportunities are very prominent. If hedging opportunities are transparent, and incentives to hedge are strong, many subjects do spot hedging opportunities and respond to them. The bias can go beyond players actually hedging themselves, because some expect others to hedge and best respond to this. Author Affiliation: (1) Economics Department, Universidad del Rosario, Calle 14 No. 4-80, Bogota, Colombia (2) Department of Economics, University of Mannheim, L7, 3-5, 68131, Mannheim, Germany (3) Centre for Experimental Economics, University of Copenhagen, Copenhagen, Denmark (4) Economics Institute of the Academy of Sciences of the Czech Republic, Prague, Czech Republic (5) School of Economics and Management, Aarhus University, Building 1322, 8000, Aarhus C, Denmark (6) Dusseldorf Institute for Competition Economics (DICE), Dusseldorf University, 40225, Dusseldorf, Germany (7) Max-Planck Institute for Research on Collective Goods, Bonn, Germany Article History: Registration Date: 01/07/2010 Received Date: 22/05/2008 Accepted Date: 01/07/2010 Online Date: 22/07/2010 Article note: Electronic Supplementary Material The online version of this article (doi: 10.1007/s10683-010-9249-1) contains supplementary material, which is available to authorized users.

Byline: Diane DeQing Li (1), Kenneth Yung (2) Keywords: institutional herding; ADR; momentum trading; positive feedback trading Abstract: This study examines institutional herding in the ADR market between 1985 and 1998. We find a significant positive relation between changes in institutional ownership and ADR returns over the same period. The positive relation persists after we control for the momentum effect in the US stock markets. We also find that in the ADR market, past winners (losers) in the herding period continue to be the winners (losers) in the post-herding period. The lack of a returns reversal suggests institutional herding is related to momentum trading. However, the positive relation between institutional ownership changes and ADR returns remains after controlling for momentum trading in the ADR market. Our results also rule out that positive feedback trading is related to institutional herding in the ADR market. Author Affiliation: (1) Department of Business, Management and Accounting, University of Maryland Eastern Shore, Princess Anne, MD, 21853, USA (2) College of Business &amp Public Administration, Old Dominion University, Norfolk, VA, 23529, USA Article History: Registration Date: 03/10/2004

Byline: Andrea L. DeMaskey (1), Wilfred L. Dellva (2), Jean L. Heck (3) Keywords: currency hedging; international diversification; risk management Abstract: This study presents empirical evidence on the efficiency and effectiveness of hedging U.S.-based international mutual funds with an Asia-Pacific investment objective. The case for active currency risk management is examined for a passive and a selective hedge, which is constructed with currency futures in the major currencies. Both static and dynamic hedging models are used to estimate the risk-minimizing hedge ratio. The results show that currency hedging improves the performance of internationally diversified mutual funds. Such hedging is beneficial even when based on prior optimal hedge ratios. Further, efficiency gains from hedging, as measured by the percent change in the Sharpe Index, are greatest under a selective portfolio strategy that is implemented with an optimal constant hedge ratio. Author Affiliation: (1) Department of Finance, Villanova University, Villanova, PA, 19085, USA (2) Department of Finance, Villanova University, Villanova, PA, 19085, USA (3) Department of Finance, Villanova University, Villanova, PA, 19085, USA Article History: Registration Date: 04/10/2004

Byline: Marco Schulmerich (1), Siegfried Trautmann (2) Keywords: hedging; self-financing strategies; superhedging; myopic hedging strategies; expected shortfall; coherent risk measures Abstract: This paper proposes a self-financing trading strategy that minimizes theexpected shortfall locally when hedging a European contingentclaim. A positive shortfall occurs if the hedger is not willing to follow a perfect hedging or a superhedging strategy. In contrast to the classicalvariance criterion, the expected shortfall criterion dependsonly on undesirable outcomes where the terminal value of the writtenoption exceeds the terminal value of the hedgeportfolio. Searching a strategy which minimizes the expected shortfallis equivalent to the iterative solution of linear programs whosenumber increases exponentially with respect to the number of tradingdates. Therefore, we partition this complex overall problem intoseveral one-period problems and minimize the expected shortfall onlylocally, i.e., only over the next trading period. This approximation is quite accurate and the number of linear programs to be solved increases only linearly with respect to the number of trading dates. Author Affiliation: (1) Barra International, Frankfurt, Germany (2) CoFaR Center of Finance and Risk Management, Johannes Gutenberg-Universitat, D-55099, Mainz, Germany Article History: Registration Date: 19/10/2004

Byline: Siim Kallast (1), Andi Kivinukk (1) Keywords: American options; early exercise boundary; hedging parameters; integral equations; numerical procedures; optimal exercise Abstract: We present an approximationmethod for pricing and hedging American options written on adividend-paying asset. This method is based on Kim (1990)equations. We demonstrate that a simple approximation of the Kimintegral equations by quadrature formulas leads to an efficientand accurate numerical procedure. This approximation isaccompanied by the Newton--Raphson iteration procedure in order tocompute the optimal exercise boundary at each time point. Theproposed sequence of approximations converges monotonically,convergence is fast and accuracy is high, even for long maturityoptions. We compare numerically our results with other competingapproaches by different authors. Author Affiliation: (1) Tallinn Pedagogical University, Narva Str. 25, Tallinn, 10120, Estonia Article History: Registration Date: 05/10/2004

Byline: Ren-Raw Chen (1), Jing-Zhi Huang (2) Keywords: forward measure; forward price; stochastic interest rates Abstract: The forward measure is convenient in calculating various contingent claim prices under stochastic interest rates. We demonstrate that caution needs to be drawn when the forward measure is used to price contingent claims that involve multiple cash flows. We also derive partial different equations for the forward price to demonstrate how forward contracts can be used for dynamic hedging and how hedges can be conducted if the payoff of a contingent claim depends on the forward price. Author Affiliation: (1) FOM/SOB-NB, Rutgers University, Levin Bldg., Rockafeller Rd., Piscataway, NJ, 08854 (2) Smeal College of Business, Penn State University, University Park, PA, 16802 Article History: Registration Date: 13/10/2004

Byline: J.A. Barria (1), S.G. Hall (2) Keywords: pricing derivative securities; hedging; non-parametric approaches Abstract: It is important for financial institutions to develop methods to predicttheir exposure and keep their risk under control. Portfolio managers caninsure themselves against the value (of a diversified stock portfolio)dropping below a certain level, by holding in conjunction with the stockportfolio, an index option derivative security. The work reported in thispaper is concerned with the study of non-parametric methods for estimatingthe pricing formula of option derivative securities. Two non-parametricapproaches, the projection pursuit method (PPR) and the local polynomialapproach (LOESS), are studied and compared to a benchmark parametricBlack--Scholes (B--S) approach. The practical relevance of theseapproaches is tested, when applied topricing and hedging of real-world LIFFE FTSE 100 index options from April 1997to November 1997. We compare the two methods by means of constructing ariskless portfolio of stocks, bonds and option derivatives securities. Theportfolio is then delta-hedged on a daily basis using a dynamic tradingstrategy in stocks and bonds during the lifetime of the option instrument.The tests carried out show that both methods generate similar responses,although each method can outperform the others depending on marketconditions, such as, time to maturity of the option instrument. Author Affiliation: (1) Electrical and Electronic Engineering Department, Imperial College of Science Technology and Medicine, Exhibition Road, London, SW7 2AZ, U.K (2) Management School, Imperial College of Science Technology and Medicine, Exhibition Road, London, SW7 2AZ, U.K Article History: Registration Date: 10/10/2004

Byline: Donald Lien (1), David R. Shaffer (2) Keywords: futures markets; multiperiod hedging; forward commitments Abstract: This paper empirically compares two multiperiod hedging strategies--a strip hedge and a stack-and-roll hedge--to hedge a forward commitment. The multiperiod strip hedge is found to outperform the stack-and-roll hedge when forward prices are subject to multiple sources of price uncertainty and to perform no better when only one source of uncertainty is present. Moreover, the relative superiority of the strip hedge increases with the presence of multiple sources of uncertainty. Last, the strip hedge is found to be more costly to trade than the stack-and-roll hedge however, its cost varies directly with its superiority at reducing risk. Author Affiliation: (1) College of Business, The University of Texas at San Antonio, 6900 North Loop 1604 West, San Antonio, TX, 78249-0631 (2) College of Commerce and Finance, Villanova University, 800 Lancaster Avenue, Villanova, PA, 19085-1678 Article History: Registration Date: 13/10/2004

Byline: Tim R. Adam (1) Keywords: Financial risk management; hedging; investments; financing policy; financial constraints; gold mining industry Abstract: This study investigates if the use of derivatives by corporations is likelyto affect their financing strategies. I find a strong positive relationbetween the minimum revenue guaranteed by hedging and investmentexpenditures. This result implies that hedging increases the likelihood thatinvestments can be financed internally. I also find that firms tend tofinance their investment expenditures externally rather than internally. Ifexternal capital is more costly than internal capital it would clearly be ina firm's interest to reduce its dependence on external capital. Consistentwith this result, I find that the median firm that does not hedge finances100% of its investment expenditures externally, while the median firm thathedges finances only 86% of investments externally. Author Affiliation: (1) Department of Finance, Hong Kong University of Science &amp Technology, Clear Water Bay, Kowloon, Hong Kong Article History: Registration Date: 10/10/2004

Byline: John Y. Campbell (1,2), Joao Cocco (2), Francisco Gomes (2), Pascal J. Maenhout (3), Luis M. Viceira (4) Keywords: hedging demand; intertemporal portfolio choice; mean reversion Abstract: This paper solves numerically the intertemporalconsumption and portfolio choiceproblem of an infinitely-lived investor whofaces a time-varying equity premium.The solutions we obtain are very similarto the approximate analytical solutionsof Campbell and Viceira (1999), except atthe upper extreme of the state spacewhere both the numerical consumption andportfolio rules flatten out.We also consider a constrained version ofthe problem in which the investor facesborrowing and short-sales restrictions.These constraints bind when the equitypremium moves away from its mean in eitherdirection, and are particularly severe forrisk-tolerant investors. The constraints havesubstantial effects on optimalconsumption, but much more modest effects onoptimal portfolio choice in theregion of the state space where they are notbinding. Author Affiliation: (1) Department of Economics, Harvard University, Littuaer Center 213, Cambridge, MA, 02138 (2) NBER, USA (3) INSEAD, USA (4) Harvard Business School, USA Article History: Registration Date: 12/10/2004

Byline: Donald Lien (1), David R. Shaffer (2) Keywords: hedging; forward commitment; quantity uncertainty; variance minimization Abstract: This article considers the hedging problem of a producer with along-term forward commitment to deliver a commodity at multiple futurepoints in time. The aggregate quantity to be delivered over time is knownwith certainty however, the period-by-period quantity is determined bythe customer and is unknown to the producer. A minimum-variancemultiperiod futures position that considers both price uncertainty andperiod-by-period quantity uncertainty is derived. The following resultsare obtained: The individual effects of price uncertainty and quantityuncertainty on the multiperiod minimum-variance are separable. In thetwo-period case, if the spot price is expected to decrease over time, therisk-minimizing hedge considering both price and quantity uncertaintiesis greater than that which considers price uncertainty only. If the spotprice is expected to increase over time, then the hedger would beover-hedged if only price uncertainty were considered. Convenience yieldpromotes a larger risk-minimizing futures position, whereas storage costsand financial costs reduce the size of the risk-minimizing futuresposition. In the multiperiod case, if forward prices are unbiasedestimators of future spot prices, or if spot prices are expected todecrease over time, then quantity uncertainty increases the size of therisk-minimizing hedge. If spot prices are expected to increase, then theeffect of period-by-period quantity uncertainty isindeterminate. Author Affiliation: (1) Department of Economics, Summerfield Hall, University of Kansas, Lawrence, KS, 66045 (2) College of Commerce and Finance, Villanova University, 800 Lancaster Avenue, Villanova, PA, 19085-1678 Article History: Registration Date: 03/10/2004

Byline: Jow-ran Chang (1), Mao-wei Hung (2) Keywords: international asset pricing; hedging risk; GARCH Abstract: This paper employs a two-factor international equilibrium asset pricing model to examine the pricing relationships among the world's five largest equity markets. In addition to the traditional market factor premium, a hedging factor premium is included as the second factor to explain the relationship between risks and returns in the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is needed to explain rates of return on international equities. Furthermore, the restriction that the coefficient on the hedge-portfolio covariance is one smaller than the coefficient on the market-portfolio covariance can not be rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to explain the returns on the five largest stock market indices. Author Affiliation: (1) College of Management, National Taiwan University, Taiwan (2) College of Management, National Taiwan University, Taiwan Article History: Registration Date: 08/10/2004

Byline: Sally C. Yeh (1), Gerard L. Gannon (1) Keywords: dynamic bi-varite GARCH; dynamic hedging; profit/loss performance Abstract: The constant and dynamic hedge models, with the presence of transaction costs are compared for the Share Price Index futures contract trading on the Sydney Futures Exchange. The optimal hedge ratio is estimated by using a dynamic, bivariate two-stage model for the return equation with a dynamic GARCH error structure for the conditional hedge ratios. When portfolio projections are compared based on their profit positions (net of transaction costs), the GARCH hedge model dominates the next best competitor in terms of trading profit. Author Affiliation: (1) University of Melbourne, Parkville, Victoria, Australia Article History: Registration Date: 08/10/2004

Byline: Michael J. Brennan (1), Yihong Xia (2) Keywords: dynamic portfolio policy; hedging; asset allocation puzzle Abstract: The optimal bond-stock mix is examined in light of an apparent inconsistency between the Tobin Separation Theorem and the advice of popular investment advisors which has beenpointed out by Canner et al. (1997). It is shown that the apparent inconsistency is largely explicable in terms of the hedging demands of optimising long-term investors in an environment in which the investment opportunity set is subject to stochastic shocks. The analysis points to the importance of considering investors' time horizons in analyzing optimal portfolio policies. Author Affiliation: (1) University of California, Los Angeles, CA (2) Department of Finance, The Wharton School, University of Pennsylvania, 2300 SH-DH, Philadelphia, PA, 19104, U.S.A. Article History: Registration Date: 07/10/2004

Byline: Lucie Tepla (1) Keywords: incomplete markets; martingale approach; nontraded assets; optimal portfolio choice; valuation Abstract: This paper examines a number of valuation problems faced by an expected-utility-maximizing investor who, over a given time horizon, is constrained to hold an asset which cannot be replicated by dynamic trading and which therefore does not have a unique no-arbitrage price. We first derive the private valuation which the investor assigns to the nontradedasset in order to determine his optimal investment in the traded assets. We thereby show that, as part of this portfolio, the investor hedges the private valuation process of the nontraded asset, rather than its market price process. We also study the price at which the investor would be willing to sell the nontraded asset if he were subsequently prohibited from trading in it, as well as the amount the investor would be willing to pay to removethe trading restriction. All three values are shown to depend in an intuitive manner on the investor's risk aversion, the residual risk of the nontraded asset unhedged by the traded assets, the difference between the constrained holding and optimal unconstrained holding of the asset and the length of the time horizon over which the asset cannot be traded. Author Affiliation: (1) INSEAD, Boulevard de Constance, 77305, Fontainebleau cedex, France Article History: Registration Date: 07/10/2004

Byline: Jerome Detemple (1,2), Carlton Osakwe (2) Keywords: American options; early exercise premium; European options; hedging; optimal exercise; stochastic volatility; viability Abstract: This paper examines the valuation of European- and American-style volatilityoptions based on a general equilibrium stochastic volatility framework.Properties of the optimal exercise region and of the option price areprovided when volatility follows a general diffusion process. Explicitvaluation formulas are derived in four particular cases. Emphasis is placedon the MRLP (mean-reverting in the log) volatility model which has receivedconsiderable empirical support. In this context we examine the propertiesand hedging behavior of volatility options. Unlike American options,European call options on volatility are found to display concavity at highlevels of volatility. Author Affiliation: (1) Boston University School of Management, 595 Commonwealth Avenue, Boston, MA, 02215, U.S.A. (2) CIRANO, USA Article History: Registration Date: 07/10/2004

Byline: F. S. Lhabitant (1), C. Martini (2), A. Reghai (2) Abstract: This paper focuses on pricing and hedging options on a zero-coupon bond in a Heath--Jarrow--Morton (1992) framework when the value and/or functional form of forward interest rates volatility is unknown, but is assumed to lie between two fixed values. Due to the link existing between the drift and the diffusion coefficients of the forward rates in the Heath, Jarrow and Morton framework, this is equivalent to hedging and pricing the option when the underlying interest rate model is unknown. We show that a continuous rangeof option prices consistent with no arbitrage exist. This range is bounded by the smallest upper-hedging strategy and the largest lower-hedging strategy prices, which are characterized as the solutions of two non-linear partial differential equations. We also discuss several pricing and hedging illustrations. Author Affiliation: (1) The American Graduate School of International Management, Union Bancaire Privee (Switzerland) and Thunderbird, Switzerland (2) INRIA Sophia - Antipolis, France Article History: Registration Date: 07/10/2004

Byline: Jimmy E. Hilliard (1) Abstract: In a highly publicized example, a marketing and refining subsidiary of Metallgesellschaft controlled short term derivative positions reportedly equivalent to 160 million barrels of oil, 80 times the daily output of Kuwait. Presumably, the short term positions were taken to hedge oil contracts to customers over an extended period. This paper develops the analytics underlying the hedging of long term flow commitments with short term futures contracts. Its contributions includes the determination of minimum variance hedging paths for multiperiod flow portfolios and the evaluation of both period-by-period and end-of-horizon volatilities under various hedging schemes. The analysis allows for basis risk, non-zero cost-of-carry, and spot diffusion processes that have a non-zero market price of risk. The results are developed in the context of an efficient market and standard equilibrium pricing models. Author Affiliation: (1) The University of Georgia, Department of Banking and Finance, 452 Brooks Hall, The University of Georgia, Athens, GA, 30602-2410 Article History: Registration Date: 15/10/2004

Byline: Pradipkumar Ramanlal (1), Steven V. Mann (1) Abstract: Option-based portfolio insurance can result in coordinated buying and selling, which destabilizes markets such that hedgers fail to achieve their objective. Gennotte and Leland (1990) show portfolio insurance strategies can have an impact on price movements. Ramanlal and Mann (1996) show how price movements, in turn, can alter hedging strategies. In this paper, we combine these separate effects and develop an equilibrium, executable hedging strategy. This hedging strategy requires less rebalancing than traditional portfolio insurance more important, it achieves downside protection with a less destabilizing impact on security prices. Author Affiliation: (1) College of Business Administration, University of South Carolina, Columbia Article History: Registration Date: 13/10/2004

Byline: George Allayannis (1) Author Affiliation: (1) Graduate School of Business Administration, University of Virginia, USA Article History: Registration Date: 13/10/2004

Byline: Ian A. Cooper (1), Antonio S. Mello (2,3) Abstract: This article examines the contribution of hedging to firm value and the cost of hedging in a unified framework. Optimal hedging and firm value are explicitly linked to firm risk, the type of debt covenants and the relative priority of the hedging contract. It is shown that in some cases hedging is possible only if the counterparty to the forward contract also holds a significant portion of the debt. Also, the spread in the hedging contract reduces the optimal amount of hedging to less than the minimum-variance hedge ratio. Among other results this article elucidates why some firms hedge using forward contracts while other firms hedge in the futures markets, as well as why higher priority forward contracts are more efficient hedging vehicles. Author Affiliation: (1) London Business School, UK (2) School of Business, University of Wisconsin-Madison, Madison, WI, USA (3) CEPR, London, UK Article History: Registration Date: 13/10/2004

Byline: Jean-Pierre Danthine (1), Serge Moresi (2) Abstract: This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that her front-running activity reduces the liquidity costs of her customers, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, however, for those investors who are not subject to front-running. In aggregate, front-running has either no or positive consequences for welfare. Author Affiliation: (1) Universite de Lausanne and CEPR, Swizerland (2) Georgetown University, USA Article History: Registration Date: 13/10/2004

Byline: Harald Hau (1) Author Affiliation: (1) GROUPE ESSEC, School of Management, Avenue Bernard Hirsch BP 105, 95001, Cergy-Pontoise Cedex, France Article History: Registration Date: 13/10/2004