APPLICATIONSINFINANCE, INVESTMENTS,AND BANKING Advances in Computational Economics VOLUME9 SERIESEDITORS HansAmman, UniversityofAmsterdam,TheNetherlands AnnaNagurney,University ofMassachusettsatAmherst,USA EDITORIALBOARD Anantha K.Duraiappah,European University Institute lohnGeweke,UniversityofMinnesota Manfred GilIi,University ofGeneva KennethL. ludd,StanfordUniversity DavidKendriek,UniversityofTexasatAustin DanielMeFadden, UniversityofCaliforniaatBerkeley EllenMeGrattan,DukeUniversity Reinhard Neck, UniversityofKlagenfurt Adrian R.Pagan,AustralianNationalUniversity lohnRust,UniversityofWisconsin BereRustern, UniversityofLondon HaiR.Varian,UniversityofMichigan The titlespublishedinthisseriesarelistedattheendofthisvolume. Applications in Finance, Investments, and Banking Editedby Diem Ho IBMManagement TechnologiesConsutting Group-Europe and Thomas Schneeweis CISDM,School0/Management, University0/Massachusetts Springer Seience-Business Media, LLC AC.!.P.Cataloguerecord forthisbook isavailable from theLibrary ofCongress. ISBN978-1-4419-5062-8 ISBN978-1-4757-3007-4(eBook) DOI 10.1007/978-1-4757-3007-4 Printedonacid-free paper AllRights Reserved ©1999 SpringerSeiences-BusinessMediaNewYork OriginallypublishedbyKluwerAcademicPublishersin1999. Softcoverreprintofthehardcover1stedition1999 No partofthematerialprotectedbythiscopyrightnotice maybereproduced or utilizedinanyform orbyanymeans, electronicormechanical, includingphotocopying,recordingorbyanyinformationstorage and retrieval systern,without written permissionfrom thecopyrightowner Table ofContents Part I. Finance Overview 1. Advanced ApplicationsinFinance:AnOverviewofProblemsand Solution Techniques DiemHo PartH.Issues inFinancialManagementforFinancialInstitutions 2. Principlesfor theControlofAssetLiabilityManagementStrategiesinBanksand 21 InsuranceCompanies GorenBergendahl [acques[anssen 3. Asset & Liability Management:RegulatoryGuidelinesonInterestRateRisk 63 ControlandTheirImpactson FinancialInstitution ElisabettaGualandri 4. OTCDerivativesand the 'CompetitivePaymentsSystem' Debate:TheLessons 93 from Historyand ImplicationsforaSupervisoryFramework GeorgeA. Martin PartIII.Issues inAssetManagement 5. AUnified ApproachtoPerformanceAttribution 159 ThomasK.Philips 6. Volatility 197 RonaldC.Heynen HarryM.Kat vi PartIV.IssuesinInvestmentManagement 7. Diversifying EarningsForecastErrorsvia CompositesofMarket-based, 257 AnalystandTime-SeriesPredictions PieterEIgers MayLo DennisMurray 8. The ValuationofCross-CurrencyInterest-SensitiveClaimswithApplicationto 285 "Diff"Swaps SimonH. Babbs PrefaceandSummary Financialinnovationshave historically beendriven by economic changes as well as technological progress. Today, advances in trading technology and regulatory changes, affecting banks as well as the corporate and investment community, have led to dramatic and rapid changes. Similarly, the applications of quantitative investment and computer technologies have given us a new array of tools and techniques with whichto manageriskand returnin assetmanagement. The paperscontained in this volumeconcentrate on research and applications in three areas:mathematics and optimization in portfolio management, regulatory issues in financial productmanagement, and investmentmanagementissues in bothdomestic and international markets. Each article offers a unique understanding to various issues confronting investors in the international marketplace. In"Advanced Applications in Finance: An Overview of Problems and Solution Techniques", Diem Ho offers a wide rangingsurvey ofthe stateof the art in financial applications ofquantitative methods.In this article, Ho gives us asense ofthe rangeofareaswhich havemade use ofquantitative methods, as well as the power of such methods in formulating and solving problems whichhad beenheretoforeimpossibleto address--orotherwiseaddressableonly byafew institutions possessing the necessary physical and human resources, such as supercomputersandspecialiststrainedinboth financial andquantitativeproblemsolving. In so doing, Ho explains how changes in the nature of financial markets (globalization vii viii and deregulation) and technological advance (the widespread availability of extensive computing resources-inc1uding software as well as hardware) have combined with advancesinfinancial theoryand practice,toyield the presentenvironment.He focuses on six specific areas: Portfolio Optimization, Asset Pricing, Risk Assessment, Securitization, Asset-LiabilityManagement,and DataVisualization,and providesuswithadiscussionof boththe mathematicalandcomputingtechniquesthatmakeuptheseapplicationareas,as well as how those techniques haveenhanced financial practice. The reader mayalso find the chapterasaquickrefreshercourseinsomeareasoffinance and mathematics.Assuch, itservesausefulprefacetomanyofthe otherchapterscontained inthis book. In their paper on asset-liability management (ALM), "Principles for the Control of Asset Liability Management Strategies in Banks and Insurance Companies," Goran Bergendahland JacquesJanssengive us a detailed discussion of sophisticated techniques for insurance companies, banks and other financial institutions to effectively and simultaneously manage risk and return, focusing in particular on the consequences associatedwithinterestraterisk,liquidityrisk and defaultrisk. Theyexplainmanyofthe short-comings of traditional approaches to ALM, which do not thoroughly address the fact that risk and returns are jointly determined, and provide a detailed framework of their ownapproach which directly remedies sucha gap.In particular, drawing upon the mathematics of stochastic calculus, the authors give us an methodology for evaluating and selecting ALM strategies. Many explicit examples are provide to both illustrate the conceptualissuesinvolvedas well as facilitate the readers understandingofhowfinancial institutions might actuaIly operationalize their approach to ALM. Further, Bergendahl ix and Janssen do not neglect to provide us with their own specific recommendations on organizational and managerial elements that must be integrated into any firrn's ALM system. In her article, "Asset & Liability Management: Regulatory Guidelines On Interest RateRiskControlandTheirImpactson FinancialInstitutions,"ElisabettaGualandrioffers us a broad discussion of the many regulatory issues that confront financial institutions, paying particular attention to the problem of Interest Rate Risk (IRR). Such issues have become even more acute in recent years, with increases in volatility of interest (and exchange rates), as weIl as the potential for financial institution missteps afforded by an international market for derivatives comprised of OTC interest rate contracts with a notional value of 28 irillion dollars.Gualandriemphasizes the need for both supervisory authoritiesand financial institutionsto confrontmatters of prudential regulationwith an intimate and holistic conception of actual and evolving asset and Iiability management practices of the financial institutions themselves-a natural and essential complement to the discussion presented in the paper by Janssen and Bergendahl. Optimal enterprise strategyhas and will necessarilycontinueto be affected by the regulations in place, both at the national, and at supranational level (e.g., as established by the G-IO central banks through the Bank for International Settlements and associated institutions), as weIl as those due to be implemented, such as the BIS provisions on Market Risk. Gualandri providesus with some specific ways-at practical, (i.e.operational) as weIl as conceptual levels-that this may be done, as weIl as providing us with discussion of many related concerns.