Published in the Journal of Derivatives & Hedge Funds 19, 278-294 (November 2013).

We find that leverage in exchange traded funds (ETFs) can affect the “crookedness” of volatility smiles. This observation is consistent with the intuition that return shocks are inversely correlated with volatility shocks – resulting in more expensive out-of-the-money put options and less expensive out-of-the-money call options. We show that the prices of options on leveraged and inverse ETFs can be used to better calibrate models of stochastic volatility. In particular, we study a sextet of leveraged and inverse ETFs based on the S&P 500 index. We show that the Heston model (Heston , 1993) can reproduce the crooked smiles observed in the market price of options on leveraged and inverse leveraged ETFs. We show further that the model predicts a leverage dependent moneyness, consistent with empirical data, at which options on positively and negatively leveraged ETFs have the same price. Finally, by analyzing the asymptotic behavior for the implied variances at extreme strikes, we observe an approximate symmetry between pairs of LETF smiles empirically consistent with the predictions of the Heston model.

Recent actions by the New York State Attorney General have highlighted abusive personal trading practices by mutual fund portfolio managers. In this paper, Dr. McCann explains how abusive personal trading practices, including those most recently identified, can be detected in a simple, cost effective manner.

Twenty years ago, we evaluated brokerage firms’ recommendation that investors should diversify a concentrated stock position by buying additional stocks on margin[McCann and Luo, 2003]
Twenty years later, some brokers and advisors continue to recklessly recommend that their clients borrow against concentrated stock positions and purchase additional stocks to diversify. In this note, we use recent stock market returns to update our previous work which used data from the 1990s. We also extend the analysis to cover a larger universe of stocks and employ more sophisticated simulations. Our updates and enhancements show that this “hold, borrow, and buy some more” strategy remains inconsistent with basic principles of prudent investment management; leveraged diversification perversely increases risk and or lowers expected returns.