Endogeneity of Return Parameters and Portfolio Selection: An Analysis on Implied Covariances1. (9th October 2017)

• Record Type: Journal Article
• Authors: Park, Koohyun; Rhee, Thomas
• Is Part Of: Asia-Pacific journal of financial studies. Volume 46:Number 5(2017:Oct.)
• Page Start: 760
• Page End: 789
• Publication Date: 2017-10-09
• Subjects: Endogeneity of return parameters -- Option implied covariance -- Option implied volatility -- Forward‐looking volatility -- Forward‐looking covariance -- Risk‐neutral probability -- Portfolio selection -- Quadratic programming; Pacific Area -- Economic conditions -- Periodicals; Finance -- Asia -- Periodicals; Finance -- Pacific Area -- Periodicals; Asia -- Economic conditions -- Periodicals; 332.09505
• DOI: 10.1111/ajfs.12187
• Languages: English
• ISSNs: 2041-9945

Abstract

Abstract: The paper presents a method to measure forward‐looking covariance risk for any two assets even when the explicit market for barter trades does not exist. We argue that the terms of trade in any barter exchanges also follow a martingale process with no arbitrage. We then compute various bivariate martingale probabilities for different assets to value all possible pseudo exchange options. This makes it possible for one to compute implied covariances embedded in the value of any exchange options as in Margrabe (1978). The paper also discusses how these "recoverable" implied return distribution parameters can impact portfolio choice.