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Endogeneity of Return Parameters and Portfolio Selection: An Analysis on Implied Covariances
Author(s) -
Park Koohyun,
Rhee Thomas
Publication year - 2017
Publication title -
asia‐pacific journal of financial studies
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.375
H-Index - 15
eISSN - 2041-6156
pISSN - 2041-9945
DOI - 10.1111/ajfs.12187
Subject(s) - econometrics , portfolio , economics , martingale (probability theory) , bivariate analysis , index arbitrage , arbitrage , mathematics , financial economics , arbitrage pricing theory , capital asset pricing model , statistics , risk arbitrage
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.