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HANDBOOK OF FINANCIAL ENGINEERING
Managing Editor Panos M. Pardalos (University of Florida)
Editor—Combinatorial Optimization Ding-Zhu Du (University of Texas at Dallas)
Advisory Board J. Birge (University of Chicago) C.A. Floudas (Princeton University) F. Giannessi (University of Pisa) H.D. Sherali (Virginia Polytechnic and State University) T. Terlaky (McMaster University) Y. Ye (Stanford University)
Aims and Scope Optimization has been expanding in all directions at an astonishing rate during the last few decades. New algorithmic and theoretical techniques have been developed, the diffusion into other disciplines has proceeded at a rapid pace, and our knowledge of all aspects of the field has grown even more profound. At the same time, one of the most striking trends in optimization is the constantly increasing emphasis on the interdisciplinary nature of the field. Optimization has been a basic tool in all areas of applied mathematics, engineering, medicine, economics and other sciences.
The series Optimization and Its Applications publishes undergraduate and graduate textbooks, monographs and state-of-the-art expository works that focus on algorithms for solving optimization problems and also study applications involving such problems. Some of the topics covered include nonlinear optimization (convex and nonconvex), network flow problems, stochastic optimization, optimal control, discrete optimization, multi-objective programming, description of software packages, approximation techniques and heuristic approaches.
VOLUME
Springer Optimization and Its Applications
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University of Florida, Gainesville, Florida
123
Edited By
HANDBOOK OF FINANCIAL ENGINEERING
CONSTANTIN ZOPOUNIDIS
MICHAEL DOUMPOS
PANOS M. PARDALOS
Technical University of Crete, Chania, Greece
Technical University of Crete, Chania, Greece
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Managing Editor: Editor/ Combinatorial OptimizationPanos M. Pardalos Ding-Zhu Du
Panos M. Pardalos
Library of Congress Control Number: 2008923930
Department of Industrial
University of Florida Gainesville, FL 32611
Department of Computer Science
University of Texas at DallasR
and Engineering
and Systems Engineering
Richardson, TX 75083
NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in
Department of ProductionEngineering and Management
Department of Industrialand Systems Engineering
Printed on acid-free paper
Constantin Zopounidis
Financial
University Campus
ineering LaboratoryEng
731 00 ChaniaGreece
Michael Doumpos
niversity of CreteTechnical U
Department of ProductionEngineering and Management
University Campus731 00 ChaniaGreece
niversity of CreteTechnical U
University of Florida303 Weil Hall P.O. Box 116595Gainesville FL 32611-6595USA
2008 by Springer Scienc
ISBN: 978-0-387-76681-2 e-ISBN: 978-0-387-76682-9 DOI: 10.1007/978-0-387-76682-9
ISSN: 1931-6828
To our families
Preface
From the beginning of the 20th century, finance has consolidated its positionas a science of major practical importance for corporate entities, firms, or-ganizations, and investors. Over this period finance has undergone significantchange keeping pace with the technological innovations that occurred after theWorld War II and the socio-economic changes that affected the global businessenvironment. The changes in the field of finance resulted in a transformationof its nature from a descriptive science to an analytic science, involved withthe identification of the relationship among financial decisions and the de-cision environment and ultimately to an engineering science, involved withthe design of new financial products and the development of innovations withregard to financial instruments, processes, and solutions.
This transformation began in the late 1950s with the work of Markowitzon portfolio selection and later, during the 1970s, with the work of Black andScholes on option pricing. These pioneering works have demonstrated that thedescriptive character of financial theory was gradually progressing toward amore analytic one that ultimately led to the engineering phase of finance bythe late 1980s.
Several financial researchers and practitioners consider the engineeringphase as a new era in finance. This led to the introduction of the term“financial engineering” to describe the new approach to the study of financialdecision-making problems. Since the late 1980s, financial engineering has con-solidated its position among financial researchers and practitioners, referringto the design, development, and implementation of innovative financial instru-ments and processes and the formulation of innovative solutions to financialdecision-making problems.
For an analyst (practitioner or academic researcher) to be able to addressthe three major aspects of financial engineering (design, development, im-plementation) in an innovative way, the knowledge of financial theory is notenough. While the financial theory constitutes the underlying knowledge re-quired to address financial engineering problems, some synthesis and analysisare also necessary for innovation. Thus, the major characteristic of this new
VIII Preface
context is the extensive use of advanced decision analysis and modeling tools tomanage the increasing complexity of the financial and business environments.These tools originate from a variety of different disciplines including statisticalanalysis, econometrics, artificial intelligence, and operations research. Thus,the role of financial decision makers (financial engineers) within the financialengineering context becomes even more complex. They are involved not onlywith the application of the financial theory, but also with the implementa-tion of advanced methodological tools and quantitative analysis techniques inorder to address effectively financial decision problems.
Over the past decade the financial and business environments have under-gone significant changes. During the same period several advances have beenmade within the field of financial engineering, involving both the methodolog-ical tools used as well as the application areas. These findings motivate thepreparation of a book with the aim to present, in a comprehensive way, themost recent advances within the field of financial engineering, focusing notonly on the description of the existing areas in financial engineering research,but also on the new methodologies that have been developed for modelingand addressing financial engineering problems more efficiently.
The objective for the preparation of this book has been to address thisrequirement through the collection of up-to-date research and real-world ap-plications of financial engineering, in a comprehensive edited volume.
The book is organized into four major parts, each covering different aspectsof financial engineering and modeling.
Part I is devoted to portfolio management and trading. It covers severalimportant issues, including portfolio optimization, efficiency analysis, financialtrading, and technical analysis.
The first paper in this part, by Steuer, Qi, and Hirschberger, discussesthe role of multicriteria optimization in portfolio selection. In the traditionalportfolio theory the expected return and the associated variance are the onlytwo criteria used to select efficient portfolios. The authors extend this settingto a multicriteria context. This seems to be a more realistic setting, becausebeyond the random variable of portfolio return, an investor’s utility functioncan take additional stochastic and deterministic arguments, such as dividends,liquidity, the number of securities in a portfolio, turnover, and the amount ofshort selling. The authors discuss the stochastic and deterministic nature ofportfolio selection, illustrate how multiple-argument utility functions lead tomultiple criteria portfolio selection formulations, analyze the mean-variancenondominated frontier and the nondominated sets of multiple criteria portfolioselection problems, and discuss issues involved in their computation.
The second paper, by Konno and Yamamoto, involves the recent de-velopments in integer programming formulations for financial optimizationproblems. In the context of financial engineering optimization plays a majorrole, especially in large-scale and difficult problems. Konno and Yamamotoshow that nonconvex financial optimization problems can be solved withina practical amount of time using state-of-the-art integer programming
Preface IX
methodologies. The authors focus on three classes of problems. The firstinvolves mean-variance portfolio optimization subject to nonconvex con-straints related to the minimal transaction unit and the number of assets inthe portfolio. Nonconvex transaction costs are also discussed. It all cases itis shown that these problems can be formulated as integer linear program-ming problems and solved to optimality using a convex piecewise linear riskmeasure such as absolute deviation instead of variance. A similar approachis also used in a second class of problems related to “maximal predictabilityportfolio optimization” and a solution algorithm is given. The third class ofproblems is related to attribute selection in discriminant analysis for failureprediction.
The third paper, by Hall and Satchell, considers the trade-off betweenportfolio return and portfolio downside risk that has arisen because of in-adequacies of the mean-variance framework and regulatory requirements tocalculate value at risk and related measures by banks and other financial in-stitutions. Analytical results are given that allow one to better understandthe form of mean-risk frontiers. The authors show that the set of minimumrisk portfolios are essentially the same under ellipticity for a wide class of riskmeasures. The authors also derive explicit expressions for mean-value at risk,mean-expected loss and mean-semivariance frontiers under normality and pro-pose extensions for portfolio simulation and for the analysis of fairly arbitraryrisk measures with arbitrary return distributions.
In the fourth chapter of Part I, Deville provides a complete overview ofexchange traded funds (ETFs), which have emerged as major financial innova-tion since the early 1990s. The chapter begins with the history of ETFs, fromtheir creation in North American markets to their more recent developmentsin the U.S. and European markets. The mechanics of ETFs are then presentedalong with the current status of the ETF industry. The chapter also coversseveral important aspects of ETFs, including their pricing efficiency comparedto closed-end funds, the relative performance of ETFs over conventional indexmutual funds, the impact of ETFs on the market quality of the stock compo-nents of the underlying indices, as well as the efficiency of index derivativesmarkets and the pricing discovery process for index prices.
In the final chapter of Part I, Chen, Kuo, and Hoi investigate the devel-opment of technical trading rules using a computational intelligence method-ology. Technical analysis is widely used by practitioners in securities trading,but the development of proper trading rules in a dynamic and evolving envi-ronment is cumbersome. Genetic programming (GP) techniques is a promisingmethodology that can be used for this purpose. The chapter presents a thor-ough examination of the applicability and performance of GP in this contextusing data from different markets. This extensive study enriches our under-standing of the behavior of GP in financial markets, and the robustness oftheir results.
The second part of the book is devoted to risk management, which is anintegral part of financial engineering. In the first chapter of this part, Ioannidis,
X Preface
Miao, and Williams provide a review of interest rate models. Interest ratemodeling has been a major research topic in financial engineering with directapplications in the pricing of rate-sensitive instruments. This review addressesthree general approaches to interest rate modeling, namely single and multi-factor models of the short rate, models of forward rates, and finally LIBORmodels. The chapter focuses on key results and pertinent pricing formulas anddiscusses several practical approaches to implementing short rate models.
In the next chapter, Dash and Kajiji illustrate the contribution of an arti-ficial intelligence methodology in modeling volatility spillovers. The analysisis implemented in two stages. The first stage focuses on the development ofa radial basis function neural network mapping of government bond excessreturns. The second stage establishes the overall effectiveness of the model tocontrol for the known conditional volatility properties that define transmis-sion linkages among government bond excess returns. The developed networkmodel provides helpful policy inferences and research findings and it proves tobe extremely efficient in the separation of global, regional and local volatilityeffects.
In the third chapter of Part II, MacLean, Zhao, Consigli, and Ziembadevelop a model of market returns that, under certain conditions, determinesthe emergence of a speculative bubble in the economy and drives bond andequity returns more generally. The model has diffusion parameters, which arerandom variables plus shock/jump terms with random coefficients. The modelincorporates both over-and under-valuation of stocks, and an algorithm isproposed for the estimation of its parameters. Empirical results indicate thatthe procedures are able to accurately estimate the parameters and that thereis a dependence of shock intensity on the state of returns.
The last chapter of Part II, by Topaloglou, Vladimirou, and Zenios, an-alyzes alternative means for controlling currency risk exposure in activelymanaged international portfolios. Multistage stochastic programming modelsare extended to incorporate decisions for optimal selection of forward con-tracts or currency options for hedging purposes, and a valuation procedureto price currency options is presented with discrete distributions of exchangerates. The authors also provide an empirical analysis of the effectiveness ofalternative decision strategies through extensive numerical tests. Individualput options strategies as well as combinations of options are considered andcompared to optimal choices of forward contracts, using static tests and dy-namic backtesting. The results show that optimally selected currency forwardcontracts yield superior results in comparison to single protective puts. More-over, it is shown that a multistage stochastic programming model consistentlyoutperforms its single-stage counterpart and yields incremental benefits.
The third part of the book is devoted to the applications of operations re-search methods in financial engineering. This part consists of three chapters. Inthe first one, Kosmidou and Zopounidis give an overview of the main method-ologies that have been used for asset liability management, focusing on bank-ing institutions. Different types of models are covered, which are categorized
Preface XI
into two major groups: deterministic mathematical programming models andstochastic models. An example of a deterministic model is also given, in theform of a goal programming formulation, which uses Monte Carlo simulationfor handling the interest rate risk.
The next chapter, by Kunsch, is devoted to capital budgeting. Kunschgives a detailed tutorial overview of modern operations research methods ap-plied in this field. The chapter begins with an introduction to the traditionalcapital budgeting process and then presents several extensions, including theapplication of multicriteria decision aid methods, the treatment of uncertaintyin the context of the fuzzy sets theory (e.g., fuzzy arithmetic and fuzzy rulesystems), and the use of real options in the investment process. All these issuesare discussed in a unified context and their connections are highlighted.
In the last chapter of Part III, Nagurney overviews some of the major de-velopments in financial engineering in the context of financial networks. Thechapter begins with a discussion of financial optimization problems within anetwork context. Then, financial network equilibrium problems that involvemore than a single decision maker are analyzed. The presentation is based onthe extension of the classical mean-variance portfolio optimization to multiplesectors. The dynamics of the financial economy are also explored with the dis-cussion of dynamic financial networks with intermediation and the integrationof social networks with financial networks is explored. Optimality conditions,solution algorithms, and examples are also presented.
The last part of the handbook includes three chapters on mergers/acquisi-tions and credit rating models. The first paper, by Chevalier and Redor, sur-veys the theories on the choice of the payment method in mergers and acquisi-tions and the empirical studies on this topic. Initially, asymmetric informationmodels are discussed, which assume that both sides (i.e., the target and thebidder) have private information on their own value. Then, the impact of taxa-tion is reviewed, followed by the presentation of theories related to managerialownership and outside control. Additional issues discussed include past per-formances, investment opportunities, business cycles, capital structure, thedelay of completion theory, as well as acquisitions for non-public firms.
The next chapter, by Pasiouras, Gaganis, Tanna, and Zopounidis, is alsorelated to mergers and acquisitions. The authors present empirical results onthe potential of developing reliable models for identifying acquisition targets,focusing on the European banking industry. The relevant literature on thistopic is reviewed and a methodology is developed based on nonparametricpattern recognition approach, namely support vector machines. The method-ology is applied to a sample of European commercial banks and issues suchas the selection of proper explanatory variables and the performance of theresulting models are discussed.
The last chapter of the handbook, by Papageorgiou, Doumpos, Zopounidis,and Pardalos, is devoted to the development of credit rating systems, whichhave become an integral part of the risk management process under the newBasel capital adequacy accord. The authors discuss the requirements of the
XII Preface
new regulatory environment, the role of credit rating systems as well as theirspecifications and development procedure, along with their use for estimatingthe minimum capital requirements. A review of the current rating systemsand methodologies is also presented together with a survey of comparativestudies. On the empirical side, the chapter presents detailed results on therelative performance of several methodologies for the development of creditrating systems, covering issues such as variable and sample selection as wellas model stability.
Sincere thanks must be expressed to all the authors, whose contributionshave been essential in creating this high-quality volume. We hope that thisvolume will be of great help to financial engineers/analysts, bank managers,risk analysts, investment managers, pension fund managers, and of course tofinancial engineering researchers and graduate students, as reference materialto the recent advances in the different aspects of financial engineering and theexisting methodologies in this field.
Constantin ZopounidisMichael Doumpos
Panos M. PardalosMay 2008
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . VII
Part I Portfolio Management and Trading
Portfolio Selection in the Presence of Multiple CriteriaRalph E. Steuer, Yue Qi, Markus Hirschberger . . . . . . . . . . . . . . . . . . . . . . . 3
Applications of Integer Programming to FinancialOptimizationHiroshi Konno, Rei Yamamoto . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Computing Mean/Downside Risk Frontiers: The Roleof EllipticityAntony D. Hall, Steve E. Satchell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Exchange Traded Funds: History, Trading, and ResearchLaurent Deville . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Genetic Programming and Financial Trading: How MuchAbout “What We Know”Shu-Heng Chen, Tzu-Wen Kuo, Kong-Mui Hoi . . . . . . . . . . . . . . . . . . . . . . 99
Part II Risk Management
Interest Rate Models: A ReviewChristos Ioannidis, Rong Hui Miao, Julian M. Williams . . . . . . . . . . . . . . 157
Engineering a Generalized Neural Network Mappingof Volatility Spillovers in European Government BondMarketsGordon H. Dash, Jr., Nina Kajiji . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
XIV Contents
Estimating Parameters in a Pricing Modelwith State-Dependent ShocksLeonard MacLean, Yonggan Zhao, Giorgio Consigli, William Ziemba . . . 231
Controlling Currency Risk with Options or ForwardsNikolas Topaloglou, Hercules Vladimirou, Stavros A. Zenios . . . . . . . . . . . 245
Part III Operations Research Methods in Financial Engineering
Asset Liability Management TechniquesKyriaki Kosmidou, Constantin Zopounidis . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Advanced Operations Research Techniques in CapitalBudgetingPierre L. Kunsch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
Financial NetworksAnna Nagurney . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Part IV Mergers, Acquisitions, and Credit Risk Ratings
The Choice of the Payment Method in Mergersand AcquisitionsAlain Chevalier, Etienne Redor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
An Application of Support Vector Machines in the Predictionof Acquisition Targets: Evidence from the EU Banking SectorFotios Pasiouras, Chrysovalantis Gaganis, Sailesh Tanna,Constantin Zopounidis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
Credit Rating Systems: Regulatory Frameworkand Comparative Evaluation of Existing MethodsDimitris Papageorgiou, Michael Doumpos, Constantin Zopounidis,Panos M. Pardalos . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
List of Contributors
Shu-Heng ChenAI-ECON Research CenterDepartment of EconomicsNational Chengchi UniversityTaipei, Taiwan [email protected]
Alain ChevalierESCP EAP79 Avenue de la Republique75543 Paris Cedex 11, [email protected]
Giorgio ConsigliUniversity of BergamoVia Salvecchio 1924129, Bergamo, [email protected]
Gordon H. Dash, Jr.777 Smith StreetProvidence, RI 02908, [email protected]
Laurent DevilleParis-Dauphine UniversityCNRS, DRM-CEREGParis, [email protected]
Michael DoumposTechnical University of CreteDepartment of ProductionEngineering and ManagementFinancial Engineering LaboratoryUniversity Campus73100 Chania, [email protected]
Chrysovalantis GaganisTechnical University of CreteDepartment of ProductionEngineering and ManagementFinancial Engineering LaboratoryUniversity Campus73100 Chania, [email protected]
Antony D. HallUniversity of Technology SydneySchool of Finance and EconomicsSydney, [email protected]
Markus HirschbergerDepartment of MathematicsUniversity of Eichstatt-IngolstadtEichstatt, Germany
Kong-Mui HoiAI-ECON Research CenterDepartment of Economics
XVI List of Contributors
National Chengchi UniversityTaipei, Taiwan [email protected]
Christos IoannidisSchool of ManagementUniversity of BathBath, BA2 7AY, [email protected]
Nina KajijiNational Center on Public Educationand Social PolicyUniversity of Rhode Island80 Washington StreetProvidence, RI 02903, [email protected]
Hiroshi KonnoDepartment of Industrial andSystems EngineeringChuo UniversityTokyo, [email protected]
Kyriaki KosmidouTechnical University of CreteDepartment of ProductionEngineering and ManagementFinancial Engineering LaboratoryUniversity Campus73100 Chania, [email protected]
Pierre L. KunschVrije Universiteit BrusselMOSI DepartmentPleinlaan 2BE-1050 Brussels, [email protected]
Tzu-Wen KuoDepartment of Financeand BankingAletheia UniversityTamsui, Taipei, Taiwan [email protected]
Leonard MacLeanSchool of Business AdministrationDalhousie UniversityHalifax, Nova Scotia, B3H [email protected]
Rong Hui MiaoSchool of ManagementUniversity of BathBath, BA2 7AY, UK
Anna NagurneyDepartment of Finance andOperations ManagementIsenberg School of ManagementUniversity of Massachusetts atAmherstAmherst, MA 01003, [email protected]
Dimitris PapageorgiouTechnical University of CreteDepartment of ProductionEngineering and ManagementFinancial Engineering LaboratoryUniversity Campus73100 Chania, [email protected]
Panos M. PardalosDepartment of Industrial andSystems EngineeringCenter for Applied OptimizationUniversity of Florida303 Weil HallPO Box 116595Gainesville, FL 32611-6595, [email protected]
Fotios PasiourasSchool of ManagementUniversity of BathClaverton DownBath, BA2 7AY, [email protected]
List of Contributors XVII
Yue QiHedge Fund Research InstituteInternational University of MonacoPrincipality of Monaco
Etienne RedorUESCP EAP79 Avenue de la Republique75543 Paris Cedex 11, [email protected]
Steve E. SatchellUniversity of CambridgeFaculty of EconomicsSidgwick AvenueCambridge, CB3 9DD, [email protected]
Ralph E. SteuerTerry College of BusinessUniversity of GeorgiaAthens, GA 30602-6253, [email protected]
Sailesh TannaDepartment of Economics, Financeand AccountingFaculty of Business, Environmentand SocietyCoventry UniversityPriory StreetCoventry, CV1 5FB, [email protected]
Nikolas TopaloglouHERMES European Center ofExcellence on ComputationalFinance and EconomicsSchool of Economics andManagementUniversity of CyprusPO Box 20537CY-1678 Nicosia, Cyprus
Hercules VladimirouHERMES European Center ofExcellence on ComputationalFinance and EconomicsSchool of Economics andManagement
University of CyprusPO Box 20537CY-1678 Nicosia, [email protected]
Julian M. WilliamsSchool of ManagementUniversity of BathBath, BA2 7AY, UK
Rei YamamotoDepartment of Industrial andSystems EngineeringChuo UniversityTokyo, [email protected]
Stavros A. ZeniosHERMES European Center ofExcellence on ComputationalFinance and EconomicsSchool of Economics andManagementUniversity of CyprusPO Box 20537CY-1678 Nicosia, Cyprus
Yonggan ZhaoRBC Centre for Risk ManagementFaculty of ManagementDalhousie UniversityHalifax, Nova Scotia, B3H 3J5,[email protected]
William ZiembaSauder School of BusinessUniversity of British ColumbiaVancouver, BC, V6T 1Z2, [email protected]
Constantin ZopounidisTechnical University of CreteDepartment of ProductionEngineering and ManagementFinancial Engineering LaboratoryUniversity Campus73100 Chania, [email protected]
