New Economics Papers
on Financial Markets
Issue of 2004‒12‒12
27 papers chosen by

  1. Modelling the Evolution of Credit Spreads in the United States By Stuart M. Turnbull; Jun Yang
  2. Equilibrium in a dynamic limit order market By ronald l goettler; christine a parlour; uday rajan
  3. Financial Intermediation and the Costs of Trading in an Opaque Market By Richard C. Green; Burton Hollifield; Norman Schurhoff
  4. Liquidity Discovery and Asset Pricing By Michael Gallmeyer; Burton Hollifield; Duane Seppi
  5. Imperfect Competition in Financial Markets: ISLAND vs. NASDAQ By Bruno Biais; Christophe Bisiere; Chester Spatt
  6. Information Acquisition in a Limit Order Market By Ronald Goettler; Christine Parlour; Uday Rajan
  7. The Equilibrium Allocation of Diffusive and Jump Risks with Heterogeneous Agents By Stephan Dieckmann; Michael Gallmeyer
  9. 'Is it the weather?' By Jacobsen, B.; Marquering, W.
  10. Dynamic behavior of value and growth stocks By Wouters, T.; Plantinga, A.
  11. Monetary transmission and equity markets in the EU By Elbourne, A.; Salomons, R.
  12. Shareholder lockup agreements in French nouveau marche and German neuer markt IPOs By Goergen,M.; Renneboog,L.; Khursed,A.
  13. Arbitrage Possibilities in Russian Spot and Future Markets By Victor Chetverikov
  14. Modeling Feedback Effects with Stochastic Liquidity By Angelika Esser; Burkart Mönch
  15. Tractable Hedging - An Implementation of Robust Hedging Strategies By Nicole Branger; Antje Mahayni
  16. Is Jump Risk Priced? - What We Can (and Cannot) Learn From Option Hedging Errors By Nicole Branger; Christian Schlag
  17. Can Tests Based on Option Hedging Errors Correctly Identify Volatility Risk Premia? By Nicole Branger; Christian Schlag
  18. Modelling the Dynamics of Cross-Sectional Price Functions: an Econometric Analysis of the Bid and Ask Curves of an Automated Exchange By Clive G. Bowsher
  19. Non-stationarities in stock returns By Catalin Starica; Clive Granger
  20. Threshold Cointegration between Stock Returns : An application of STECM Models By Jawadi Fredj; Koubaa Yousra
  21. Is it really long memory we see in financial returns? By Thomas Mikosch
  22. Rational Investors' Performance Versus Momentum Traders By Kirby Adam J.R. Faciane
  23. Do Individual Investors Drive Post-Earnings Announcement Drift? Direct Evidence from Personal Trades By David Hirshleifer; James N. Myers; Linda A. Myers; Siew Hong Teoh
  24. International Financial Markets Integration or Segmentation: A Case Study of Equity Markets By Puja Guha; Shivani Daga; Richa Gulati; Ganita Bhupal; Hena Oak
  25. Why VAR Fails: Long Memory and Extreme Events in Financial Markets By Cornelis A. Los
  26. Market structure and insider trading By Wassim Daher; Leonard J. Mirman
  27. Cournot duopoly and insider trading with two insiders By Wassim Daher; Leonard J. Mirman

  1. By: Stuart M. Turnbull; Jun Yang
    Abstract: The authors use Jarrow and Turnbull's (1995) reduced-form methodology to model the evolution of the term structure of interest rates in the United States for different credit classes and different industries. The authors also estimate a liquidity function for each credit class and industry. Using data from individual firms, the authors estimate the probability of default under the natural measure and compare it with the estimated default frequencies produced by KMV.
    Keywords: Financial markets; Market structure and pricing
    JEL: G12 G13
    Date: 2004
  2. By: ronald l goettler; christine a parlour; uday rajan
    Abstract: We provide an algorithm for solving for equilibrium in a dynamic limit order market. Our model relaxes many of the restrictive assumptions in the prior literature, leading to a more realistic framework for policy experiments on market design. We formulate a limit order market as a stochastic sequential game and use a simulation technique based on Pakes and McGuire (2001) to find a stationary equilibrium. Given the stationary equilibrium, we generate artificial time series and perform comparative dynamics. We explicitly determine investor welfare in our numerical solution. We find that the effective spread is {\it negatively} correlated with transactions costs and uncorrelated with welfare. As one policy experiment, we evaluate the effect of changing tick size.
    Date: 2003–10
  3. By: Richard C. Green; Burton Hollifield; Norman Schurhoff
    Abstract: Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to study because data in such markets is generally not centrally recorded. We analyze a comprehensive database of all trades between broker-dealers in municipal bonds and their customers. The data is only released to the public with a substantial lag, and thus the market was relatively opaque to the traders themselves during our sample period. We use our sample to estimate the cross-sectional determinants of the dealer markups. We find that dealers earn lower average markups on larger trades with customers, even though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple structural bargaining model that allows us to estimate measures of leader bargaining power and relate it to characteristics of the trades. The results suggest dealers exercise substantial market power in their trades with customers. Our measures of market power decrease in trade size and in variables that indicate the complexity of the trade for the dealer.
  4. By: Michael Gallmeyer; Burton Hollifield; Duane Seppi
    Abstract: Asset prices are risky, in part, because of uncertainty about the preferences of potential counterparties and the terms-of-trade at which they will be willing to provide liquidity in the future. We call such randomness liquidity risk. We argue that liquidity risk is an important source of asymmetric information in addition to private information about future cash flows. We model the endogenous dynamics of liquidity risk, the risk premisum for bearing liquidity risk, and the role of market trading in the liquidity discovery process through which investors learn about their counterparties' preferences and their future demands for securities. We show that market liquidity is a forward-looking predictor of future risk and, as such, is prices. Our model also provides rational explanations for "prices support levels" and "flights to quality."
  5. By: Bruno Biais; Christophe Bisiere; Chester Spatt
    Date: 2002–10
  6. By: Ronald Goettler; Christine Parlour; Uday Rajan
    Abstract: We model an infinite horizon trading game of a limit order market with informed traders. Agents with a private and common value motive for trade randomly arrive in a market and may either post prices (submit limit orders) or accept posted prices (submit market orders). If their orders have not executed, traders may reenter the market and thus solve a dynamic problem. We consider agents incentive to acquire information. We characterize how information acquisition changes agents strategies and demonstrate the effect of this on the e±ciency of market prices. We demonstrate that for some costs of acquiring information, there are multiple equilibria in the information acquisition game. Finally, we demonstrate that information acquisition can make all agents worse off.
  7. By: Stephan Dieckmann; Michael Gallmeyer
  8. By: Alberto Mora-Galan; Ana Perez; Esther Ruiz
    Abstract: It has been often empirically observed that the sample autocorrelations of absolute financial returns are larger than those of squared returns. This property, know as Taylor effect, is analysed in this paper in the Stochastic Volatility (SV) model framework. We show that the stationary autoregressive SV model is able to generate this property for realistic parameter specifications. On the other hand, the Taylor effect is shown not to be a sampling phenomena due to estimation biases of the sample autocorrelations. Therefore, financial models that aims to explain the behaviour of financial returns should take account of this property.
    Date: 2004–11
  9. By: Jacobsen, B.; Marquering, W. (Erasmus Research Institute of Management (ERIM), Erasmus University Rotterdam)
    Abstract: We show that results in the recent strand of the literature that tries to explain stock returns by weather induced mood shifts of investors might be data-driven inference. More specifically, we consider two recent studies (Kamstra, Kramer and Levi, 2003a and Cao and Wei, 2004) that claim that a seasonal anomaly in stock returns is caused by mood changes of investors due to lack of daylight and temperature variations, respectively. We confirm earlier results in the literature that there is indeed a strong seasonal effect in stock returns in many countries: stock market returns tend to be significantly lower during summer and fall months than during winter and spring months. However, we also show that at best, these two studies offer two of many possible explanations for the observed seasonal effect. As an illustration we link ice cream production and airline travel to the stock market seasonality using similar reasoning. Our results suggest that without any further evidence the correlation between weather variables and stock returns might be spurious and the conclusion that weather affects stock returns through mood changes of investors is premature.
    Keywords: Stock market seasonality;Sell in May;Seasonal Affective Disorder;temperature;spurious correlations;
    Date: 2004–12–03
  10. By: Wouters, T.; Plantinga, A. (Groningen University)
    Abstract: The difference between the performance of growth and value portfolios presents an interesting puzzle for researchers in finance. Most studies showed that value stocks outperform growth stocks. This is the so-called value premium. In this article, we try to find an answer to the question as to why value stocks generate superior returns to growth stocks by dividing growth and value stocks into switching- and fixed-style stocks. We show that the difference in returns between value and growth stocks is caused by frequently rebalancing portfolios and find a value premium for the switching-style stocks and a growth premium for the fixed-style stocks. We will try to find an explanation for this phenomenon using the behavioral finance explanation that investors are unable to process information correctly. We use earnings announcement return data to test whether expectations of investors about future growth are too extreme.
    Date: 2004
  11. By: Elbourne, A.; Salomons, R. (Groningen University)
    Abstract: We assess the role of equity markets in the transmission of monetary policy in the EU. We use a structural VAR model based upon the models of Kim and Roubini [2000] and Brischetto and Voss [1999] and we find that there are differences in monetary policy transmission across our sample of countries. The largest output losses following a monetary shock are seen in a core of euro area countries: Austria, Belgium, Finland, France, and Germany. Germany also displays the largest response of prices and is followed by Austria and Finland. Variance decompositions also suggest that the bank based core euro area countries are different from market based countries. As regards the channels of transmission we find no evidence to suggest an equity wealth effect channel in the euro area and only circumstantial evidence for the UK. We do, however, find that those countries that use equity finance (the UK and the Netherlands) suffer smaller output losses following a monetary shock indicating that a bank lending channel is less likely to be present in these countries.
    Keywords: monetary policy, equity markets, VAR modelling. JEL Classifications: E44, E52, G15
    Date: 2004
  12. By: Goergen,M.; Renneboog,L.; Khursed,A. (TILEC (Tilburg Law and Economics Center))
    Date: 2004
  13. By: Victor Chetverikov
    Abstract: The authors apply the single-index Sharp model and construct the effective Markowitz set for the most liquid stocks of Russian companies listed in the Russian Trading System. Their stability during 1996-98 is studied for various investment horizons.
    Date: 2000–04–05
  14. By: Angelika Esser; Burkart Mönch
    Date: 2002
  15. By: Nicole Branger; Antje Mahayni
    Date: 2003–03
  16. By: Nicole Branger; Christian Schlag
    Date: 2004–05
  17. By: Nicole Branger; Christian Schlag
    Date: 2003
  18. By: Clive G. Bowsher (Nuffield College, Oxford University, UK)
    Abstract: Functional Signal plus Noise (FSN) time series models are introduced for the econometric analysis of the dynamics of a large cross-section of prices in which contemporaneous observations are functionally related. A semiparametric FSN model is developed in which a smooth, cubic spline signal function is used to approximate the price curve data. Estimation may then be performed using quasi-maximum likelihood methods based on the Kalman filter. The model is used to provide one of the first studies of the dynamics of the bid and ask curves of an electronic limit order book and enables the comprehensive measurement of the dynamic determinants of traders execution costs. It is found that the differences between the bid and ask curves and their intercepts (i.e. the immediate price impacts of market orders) are well described by covariance stationary processes. The in-sample, 1-step ahead point predictions for these curves perform well and motivate the development of parametric FSN models that take into account the monotonicity of the price curves and can be used to form predictive distributions.
    Keywords: functional time series, bid and ask curves, liquidity, electronic limit order book, cubic spline, state space form, Kalman filter, quasi-maximum likelihood.
    JEL: C14 C32 C33 C51 G12
    Date: 2004–09–22
  19. By: Catalin Starica (Dept. Mathematical Statistics, Chalmers University of Technology); Clive Granger (Dept. Economics, UCSD)
    Abstract: The paper outlines a methodology for analyzing daily stock returns that relinquishes the assumption of global stationarity. Giving up this common working hypothesis reflects our belief that fundamental features of the financial markets are continuously and significantly changing. Our approach approximates locally the non-stationary data by stationary models. The methodology is applied to the S&P 500 series of returns covering a period of over seventy years of market activity. We find most of the dynamics of this time series to be concentrated in shifts of the unconditional variance. The forecasts based on our non-stationary unconditional modeling were found to be superior to those obtained in a stationary long memory framework or to those based on a stationary Garch(1,1) data generating process.
    Keywords: stock returns, non-stationarities, locally stationary processes, volatility, sample autocorrelation, long range dependence, Garch(1,1) data generating process.
    JEL: C14 C22 C52 C53
    Date: 2004–11–22
  20. By: Jawadi Fredj (Université de Paris10-Nanterre MODEM-CNRS); Koubaa Yousra (Université de Paris10-Nanterre MODEM-CNRS)
    Abstract: The aim of this paper is to study the efficient capital market hypothesis by using recent developments in nonlinear econometrics. In such a context, we estimate a Smooth Transition Error Correction Model (STECM). We introduce the DowJones as an explanatory variable of the dynamics of the other stock indexes. The error correction term takes into account of the structural changes that occured progressively from both the endogenous and the DowJones series. We note that the Smooth Transition Error Correction Model, for which the dynamics of adjustment is of ESTAR type, is more adequate than the linear ECM model to represent the adjustment of the stock price to the long term equilibrium price. Estimation results reveal the nonlinearity inherent to the adjustment process. In particular, we note that the adjustment is not continuous and that the speed of convergence toward price of equilibrium is not constant but rather function of the size of the disequilibrium.
    Keywords: Efficiency, Regime-Switching Models, Threshold Cointegration, STECM.
    JEL: C1 C2 C3 C4 C5 C8
    Date: 2004–12–02
  21. By: Thomas Mikosch (Dept. Actuarial Mathematics, University of Copenhagen)
    Abstract: Our study supports the hypothesis of global non-stationarity of the return time series. We bring forth both theoretical and empirical evidence that the long range dependence (LRD) type behavior of the sample ACF and the periodogram of absolute return series and the IGARCH effect documented in the econometrics literature could be due to the impact of non-stationarity on sta- tistical instruments and estimation procedures. In particular, contrary to the common-hold belief that the LRD characteristic and the IGARCH phenomena carry meaningful information about the price generating process, these so-called stylized facts could be just artifacts due to structural changes in the data. The effect that the switch to a different regime has on the sample ACF and the periodogram is theoretically explained and empirically documented using time series that were the object of LRD modeling efforts (S&P500, DEM/USD FX) in various publications.
    Keywords: sample autocorrelation, change point, GARCH process, long range dependence.
    JEL: C22 C52 C53
    Date: 2004–12–06
  22. By: Kirby Adam J.R. Faciane (Kirby Faciane / KAJR Faciane)
    Abstract: Through a formalization of the intuition of De Long, Shieifer, Summers & Waldmann (1990a), this paper first shows that the presence of irrational investors of any type who behave differently from rational investors always drives a wedge between the equity premium and the covariance of aggregate consumption growth and stock returns because only rational investors satisfy the Euler equations. By analyzing the case where the stock positions of rational investors and irrational investors sum to 0, I demonstrate that the extra equity premium of 2% ~ 4% that positive feedback traders generate in the simulation can come about without any increase in the covariance of aggregate consumption growth and stock returns. I show that in this case irrational investors change the equity premium from the efficient market level through the effect from market inefficiency while they do not change the covariance of aggregate consumption growth and stock returns from the efficient market level because the stock positions of different agents always sum to the fixed supply of stocks and the covariance of aggregate consumption growth and stock returns is determined only by the aggregate stock position. This paper then demonstrates that in the situation where the conditional variance of rate of returns is constant along the fundamentals path, any transitory component in prices increases the conditional variance when prices fall below fundamentals and decreases it when prices rise above fundamentals. Moreover, the persistence of return volatility is actually identical to the persistence of the transitory component. As positive feedback traders with extended knowledge make prices deviate widely and persistently from fundamentals, the increase of volatility when stock prices fall can be dramatic and the volatility shows an extreme persistence. This paper further determines that the deviation follows approximately another MA process of a very high order when the memory horizon is very long. This extreme persistence of the deviation is the source of the extreme persistence of volatility. Positive feedback traders with extended knowledge make the stock market a seemingly paradoxical place where their infinitesimal forecast error causes prices to deviate widely from fundamentals. However, although positive feedback traders are not rational, they hardly lose to rational investors.
    Keywords: inventory; stock trades; prices; informed traders; positive feedback traders; market makers; irrational traders; momentum traders
    JEL: G G0
    Date: 2004–11–29
  23. By: David Hirshleifer (Fisher College of Business, Ohio State University); James N. Myers (University of Illinois at Urbana- Champaign); Linda A. Myers (University of Illinois at Urbana- Champaign - Department of Accountancy); Siew Hong Teoh (Fisher College of Business, Ohio State University)
    Abstract: This study examines whether individual investors are the source of post- earnings announcement drift (PEAD). We provide evidence on how individual investors trade in response to extreme quarterly earnings surprises and on the relation between individual investors' trades and subsequent abnormal returns. We find no evidence that either individuals or any sub-category of individuals in our sample cause PEAD. Individuals are significant net buyers after both negative and positive earnings surprises. There is no indication that trading by any of our investor sub-categories explains the concentration of drift at subsequent earnings announcement dates. While post-announcement individual net buying is a significant negative predictor of stock returns over the next three quarters, individual investor trading fails to subsume any of the power of extreme earnings surprises to predict future abnormal returns.
    Keywords: post earnings-announcement drift, trading activity, individual investors, market efficiency
    JEL: G
    Date: 2004–12–04
  24. By: Puja Guha (Delhi School of Economics); Shivani Daga (Delhi School of Economics); Richa Gulati (Delhi School of Economics); Ganita Bhupal (Delhi School of Economics); Hena Oak (Delhi School of Economics)
    Abstract: Over the past 15 years, financial markets have become increasingly global. The relationship among the equity markets of the developed and the emerging countries has been examined extensively in the literature. This paper studies the interdependence among the major stock markets of the world. Using the monthly data from January 1993 to September 2003, we examine the stock market indices of India (Sensex), Hong Kong (Hang Seng), the USA (DJIA) and the UK (FTSE-100). Co-integration technique has been employed to study the long-term linkages among the markets. We found that the equity markets of India and Hong Kong are co-integrated with the other markets whereas the markets of the USA and UK are not.
    Keywords: Direct financial integration, segmentation, co-integration
    JEL: G
    Date: 2004–12–08
  25. By: Cornelis A. Los
    Abstract: The Value-at-Risk (VAR) measure is based on only the second moment of a rates of return distribution. It is an insufficient risk performance measure, since it ignores both the higher moments of the pricing distributions, like skewness and kurtosis, and all the fractional moments resulting from the long - term dependencies (long memory) of dynamic market pricing. Not coincidentally, the VaR methodology also devotes insufficient attention to the truly extreme financial events, i.e., those events that are catastrophic and that are clustering because of this long memory. Since the usual stationarity and i.i.d. assumptions of classical asset returns theory are not satisfied in reality, more attention should be paid to the measurement of the degree of dependence to determine the true risks to which any investment portfolio is exposed: the return distributions are time-varying and skewness and kurtosis occur and change over time. Conventional mean-variance diversification does not apply when the tails of the return distributions ate too fat, i.e., when many more than normal extreme events occur. Regrettably, also, Extreme Value Theory is empirically not valid, because it is based on the uncorroborated i.i.d. assumption.
    Keywords: Long memory, Value at Risk, Extreme Value Theory, Portfolio Management, Degrees of Persistence
    JEL: C33 G13 G14 G18 G19 G24
    Date: 2004–12–08
  26. By: Wassim Daher (CERMSEM); Leonard J. Mirman (University of Virginia)
    Abstract: In this paper we examine the real and financial effects of two insiders trading in a static Jain-Mirman model (Henceforth JM). The first insider is the manager of the firm. The second insider is the owner. First, we study the change of the linear-equilibrium variables, in the presence of two insiders. Specifically, we show that the trading order and the real output of the manager are less in this model than in JM model. Secondly, we show that the stock price reveals more information than in Cournot duopoly and monopoly models studied by Jain-Mirman. Finally, we analyze the comparative statics (insiders' profits) of this model, when the market maker receives one or two signals.
    Keywords: Insider trading, stock prices, correlated signals, Kyle model
    JEL: G14 D82
    Date: 2004–03
  27. By: Wassim Daher (CERMSEM); Leonard J. Mirman (University of Virginia)
    Abstract: In this paper, we study a version of the static Jain-Mirman (2002) model in which competition in the real sector is introduced. In this paper, we add competition in the stock sector to the Jain-Mirman (2002) paper. We show that the linear equilibrium structure is affected by this competition in the financial sector. Specifically, we show that the stock price set by the market maker reveals more information and that the behavior of the profits of the manager depends on the parameters of the model. Moreover, we prove that the level of output produced by the manager is less than in Jain-Mirman (2002). Finally, we also study the case in which the market maker receives only one signal and analyze the comparative statics of this model when the market maker receives either one or two signals.
    Keywords: Insider trading, stock prices, correlated signals, Kyle model
    JEL: G14 D82
    Date: 2004–09

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