Book value optimisation, risk and redistribution

Abstract

Across three different settings, we show that if classical metrics are key to understanding behaviours of financial actors, it is necessary to also examine others, generally considered as secondary, to comprehend actions taken by decision-makers. Firstly, while managers of public companies maximize investors’ utility first, they also use redistribution to manage the company’s earnings-per-share ratio, stock price, and their own managerial stock options’ valuation. We prove that in a frictionless setting, share repurchases and dividends are equivalent in analogy to the classical Modigliani-Miller theorem. We further exhibit extensions in which the utility equivalence of dividends and repurchases is broken. Our analytical differentiation of redistribution methods provides grounding towards explaining the various empirical redistribution behaviours observed in markets. Secondly, we prove and display empirically that typical risk metrics such as Value-at-Risk and Expected Shortfall mechanically grow as the number market observations is reduced. Modern international regulation assumes the opposite and in turn implies the double counting of risk over illiquid assets. We argue that this accounting methodology specification has considerable ramifications, altering the global structure through which banks calibrate their risk limits: regulated banks are now opting for the “Standardised Approach” instead of the “Internal Model Approach”. Finally we present a novel sovereign credit grades prediction model, which beats Nomura’s previous internal implementations as well as, to our knowledge, all previously published ones. It is the first to attain a sufficient level of accuracy satisfactory to financial institutions. In particular, better modelling of credit grades entails a more precise calibration of credit risk. Not linked to material adjustments in P&L or positions, improved credit grades’ modelling can reduce portfolios’ uncertainty: changes to the predictions of purely indicative sovereign credit grades have meaningful repercussions over the haircuts and spreads observed in sovereign bond markets.