Handbookofquantitativefinanceandriskmanagement

Handbook of quantitative finance and risk managementCheng- Few Lee· Alice o.Lee。 John leeEditorsHandbook of QuantitativeFinance and riskManagementSpringereditorsCheng-Few LeeRutgers UniversilyCenter for pbbef researchDepartment of Finance and economicsNorth brunswick. nj94 Rockafeller RoadUSANew brunswickjohnleeexcelvba@gmail.com08854-8054. Janice H. Levin bldUSAlee@business rutgers. eduAlice C. LeeState Street CorpBoston MAUSAalicefinance@@gmail.comISBN978-0-387-77116-8e-ISBN9780-387-77117-5DOI10.1007/9780-38777117-5Springer New York Dordrecht Heidelberg LondonLibrary of Congress Control Number: 2010921816C Springer Science+Business Media, LLC 2010All rights reserved. This work may not be translated or copied in whole or in part without the written permission of thepublisher(Springer Science+Business Media, LLC, 233 Spring Street, New York, NY 10013, US.A), except for briefexcerpts in connection with reviews or scholarly analysis. Use in connection with any form of information storage andretrieval,electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafterdeveloped is forbiddThe use in this publication of trade names, trademarks, service marks, and similar terms, even if they are not identifiedas such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rightsPrinted on acid-free paperSpringerispartofSpringerScience+BusinessMedia(www.springer.com)PrefaceQuantitative finance and risk management is a combination of economics, accounting, statistics, econometrics, mathematics, stochastic process, and computer science and technologyThis handbook is the most comprehensive handbook in quantitative finance and risk management, which integrates theory, methodology, and application. Due to the importance of quan-titative finance and risk management in the finance industry, it has become one of the mostpopular subjects in business schools and departments of mathematics, operation research, andstatistics. In addition, the finance industry has many job opportunities for people with goodtraining in quantitative finance and risk management. Thus, a handbook should have a broadaudience and be of interest to academics, educators, students, and practitionersBased on our years of experience in industry, teaching, research, textbook writing, andjournal editing on the subject of quantitative finance and risk management, this handbook willreview, discuss, and integrate theoretical, methodological and practical issues of quantitativefinance and risk management. This handbook is organized into five parts as follows:Part I Overview of Quantitative Finance and risk management researchPart II. Portfolio Theory and Investment AnalysisPart Ill. Options and Option Pricing TheoryPart Iv risk managementPart V Theory, Methodology, and applicationsPart I of this handbook covers three chapters: they are"Chapter I. Theoretical Framework of Finance, " Chapter 2. Investment, Dividend, Financing, and Production Policiesand"Chapter 3. Research Methods of Quantitative Finance and Risk management. Part IIof this handbook covers 18 chapters of portfolio theory and investment analysis Part Ill of thishandbook includes 21 chapters of options and option pricing theory. Part Iv of this handbookincludes 23 chapters of theory and practice in risk management. Finally, Part V of this hand-book covers 44 chapters of theory, methodology, and applications in quantitative finance andsk managementIn the preparation of this handbook, first, we would like to thank the members of advisoryboard and contributors of this handbook. In addition, we note and appreciate the extensive helpfrom our Editor, Ms Judith Pforr, our research assistants Hong-Yi Chen, Wei-Kang Shih andShin- Ying Mai, and our secretary Ms Miranda Mei-Lan Luo. Finally, we would like to thankthe Wintek Corporation and the polaris Financial Group for the financial support that alloweds to write this bookThere are undoubtedly some errors in the finished product, both typographical and concep-tual. We invite readers to send suggestions, comments criticisms, and corrections to the authorProfessor Cheng-Few Lee at the Department of Finance and Economics, Rutgers University atJanice H Levin Building Room 141, Rockefeller road, Piscataway, NJ 08854-80.54New brunswick. NJCheng-Few LeeBoston maAlice C. LeeNorth brunswick, NJJohn leeAbout the editorsCheng- Few Lee is Distinguished Professor of Finance at Rutgers Business School, RutgersUniversity and was chairperson of the Department of Finance from 1988 to 1995. He has alsoserved on the faculty of the University of Illinois (IBE Professor of Finance)and the Universityof georgia. He has maintained academic and consulting ties in Taiwan, hong Kong, china,and the United States for the past three decades. He has been a consultant to many prominentgroups, including the American Insurance Group, the world bank, the United Nations, TheMarmon Group Inc, Wintek Corporation, and Polaris Financial Group.Professor Lee founded the review of Quantitative Finance and Accounting(rQFa)in 1990and the review of Pacific Busin Financial Markets and Policies(rPBFMP)in 1998, and servesas managing editor for both journals. He was also a co-editor of the Financial review (19851991)and the Quarterly Review of Economics and Business(1987-1989). In the past 36 yearsDr Lee has written numerous textbooks ranging in subject matters from financial managementto corporate finance, security analysis and portfolio management to financial analysis, planningand forecasting, and business statistics. In addition, he edited a popular book entitled encyclopedia of Finance(with Alice C. Lee). Dr. Lee has also published more than 170 articles inmore than 20 different journals in finance, accounting, economics, statistics, and managementProfessor Lee was ranked the most published finance professor worldwide during the period1953-2008.Professor Lee was the intellectual force behind the creation of the new masters of Quantitative Finance program at Rutgers University. This program began in 2001 and has beenranked as one of the top ten quantitative finance programs in the United states. These topten programs are located at Carnegie Mellon University, Columbia University, Cornell University, New York University, Princeton University, Rutgers University, Stanford University,University of California at berkley university of chicago, and university of michiganAlice C. Lee is currently a Director in the Model Validation Group, Enterprise Risk Management, at State Street Corporation. Most recently, she was an Assistant Professor of financeat San Francisco State University. She has more than 20 years of experience and has a diversebackground, which includes academia, engineering, sales, and management consulting. Herprimary areas of teaching and research are corporate finance and financial institutions. She iscoauthor of Statistics for Business and Financial Economics, 2e(with Cheng F. Lee and JohnC. Lee) and Financial Analysis, Planning and Forecasting, 2e(with Cheng F. Lee and John CLee). In addition, she has co-edited other annual publications including Advances in InvestmentAnalysis and Portfolio Management(with Cheng F. LeeJohn C. Lee is a microsoft Certified Professional in Microsoft Visual Basic and MicrosoftExcel VBA. He has a bachelor and masters degree in accounting from the University of illinoisat Urbana-ChampaignJohn has more than 20 years'experience in both the business and technical fields as anaccountant, auditor, systems analyst, and as a business software developer. He has authoreda book on how to use MINitAB and Microsoft Excel to do statistical analysis this book isAbout the editorsa companion text to Statistics of Business and Financial Economics, of which he is one ofthe co-authors. John has been a senior technology officer at the Chase Manhattan Bank andassistant vice president at Merrill Lynch. He is currently Director of the Center for PBBEFResearchContentsPrefabPart i Overview of Quantitative Finance and risk Management research1 Theoretical framework of finance1.1 Introduction1. 2 Discounted Cash-Flow Valuation Theory1.3 M and m valuation Theory······61. 4 Markowitz portfolio theor101.5 Capital Asset Pricing model101.6 Arbitrage Pricing Theory..................121.7 Option valuation141.8 FuturesⅤaluId Hedging159 Conclusion2 Investment, Dividend, Financing, and Production Policies: Theorynd implication232.1 Introduction2Investment and Dividend Interactions: The Internal versus externalFinancing decision232.3 Interactions Between Dividend and Financing Policies. ......... 252. 4 Interactions Between Financing and Investment decisions2.5 Implications of Financing and Investment Interactionsfor Capital budget2.6 Implications of Different Policies on the Beta Coefficient2. 7 Conclusion36References6Appendix 2A Stochastic Dominance and its Applications to Capital-StructureAnalysis with default risk382A.1 Introduction382A.2 Concepts and Theorems of Stochastic Dominance ....... 382A. 3 Stochastic-Dominance Approach to Investigating theCapital-Structure Problem with Default risk2A.4 Summary..…Contents3 Research Methods in Quantitative Finance and risk Management413.1 Introduction413.2S413.3 Econometrics433.4 Mathematics3.5 Other disciplines3.6 Conclusior49References50Part II Portfolio Theory and Investment analysis4 Foundation of Portfolio Theory.,,,,,.53Cheng-Few lee, Alice C. Lee, and John lee4.1 Introduction534.2 Risk Classification and measurement4.3 Portfolio Analysis and application4.4 The efficient portfolio and risk diversification604.5 Determination of Commercial Lending rate644.6 The Market Rate of return and Market Risk premium4.7 ConclusionReferences5 Risk-Aversion, Capital Asset Allocation, and Markowitz Portfolio-SelectionModelCheng-Few Lee, Joseph e. Finnerty, and Hong-Yi Chen5.1 Introduction5.2 Measurement of Return and Risk695.3 Utility Theory, Utility Functions, and Indifference Curves........ 715. 4 Efficient portfolios775.5 Conclusion91References916 Capital Asset Pricing Model and Beta Forecasting93Cheng-Few Lee, Joseph e. Finnerty, and Donald h. wort6.1 Introduction6.2 A Graphical Approach to the Derivation of the Capital AssetPricing Model936.3 Mathematical Approach to the Derivation of the Capital AssetPricing model6. 4 The market Model and risk decomposition6.5 Growth Rates, Accounting Betas, and Variance in EBIT..1006. 6 Some Applications and Implications of the Capital Asset Pricing Model.. 1046.7Conclusion..105References105Appendix 6A Empirical Evidence for the Risk-Return Relationshipl06Appendix 6B Anomalies in the Semi-strong Efficient-Market Hypothesis1097 Index models for Portfolio selectionCheng-Few Lee, Joseph E. Finnerty, and Donald H Wort7.1 Introductionl117.2 The Single-Index Model..1117.3 Multiple Indexes and the multiple-Index modell187. 4 Conclusion121ReferencesContentsAppendix 7A a Linear-Programming Approach to Portfolio-Analysis Models122Appendix 7B Expected Return, Variance, and Covariancefor a multi-index model1238 Performance-Measure Approaches for Selecting Optimum Portfolios125Cheng-Few Lee, Hong- Yi Chen, and Jessica Shin-Ying Mai8.1 Introductio1258.2 Sharpe Performance-Measure Approach with Short Sales Allowed1258.3 Treynor-Measure Approach with Short Sales Allowed1288.4 Treynor-Measure Approach with Short Sales Not Allowed1308.5 Impact of Short Sales on Optimal-Weight Determination.1328.6 Economic Rationale of the Treynor performance-Measure method1328.7 ConclusionReferences13Appendix 8A Derivation of Equation (8.6)...133Appendix &B Derivation of Equation(8.10)Appendix8 C Derivation of equation(8./…………1341359 The Creation and Control of Speculative Bubbles in a Laboratory Setting... 137James s Ang, Dean Diavatopoulos, and Thomas v Schwarz9.1 Introduction1379.2 Bubbles in the asset markets..1399.3 Experimental Design1409. 4 Results and Analysis1459.5 Conclusions..16lReferences10 Portfolio Optimization Models and Mean-Variance Spanning Tests165Wei-Peng Chen, Huimin Chung, Keng-Yu Ho, and Tsui-Ling Hsu10.1 Introduction of markowitz Portfolio-Selection model16510.2 Measurement of return and risk16610.3 Efficient portfolio10.4 Mean-Variance STg tes17210.5 Alternative Computer Program to Calculate Efficient Frontier17510.6 Conclusion182References184OIlFundntaI Ms for Stock selectie185Kenton K Yee11.1 Introduction18511. 2 Bayesian T18711.3 Triangulation in Forensic Valuation18911.4 Bayesian Triangulation in Asset Pricing Settings19011. 5 The data snooping ti19411.6 USing Guidance from Theory to Mitigate Data Snooping19511.7 Avoiding Data-SIPitfalls in Financial Statement Analys19711. 8 ConclusionReferences200Appendix 1la Proof of Theorem20111A.1 Generalization of theorem 11.1201