nep-fmk New Economics Papers
on Financial Markets
Issue of 2005‒02‒13
thirty-one papers chosen by
Erik Schloegl
School of Mathematical Sciences University of Technology

  1. Interest Rate Determination in the Interbank Market By Gaspar, Vítor; Pérez-Quirós, Gabriel; Rodriguez, Hugo
  2. Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows and Exchange Rates? By Hau, Harald; Rey, Hélène
  3. Performance and Behaviour of Family Firms: Evidence from the French Stock Market By Sraer, David; Thesmar, David
  4. A Guided Tour of the Market Microstructure Approach to Exchange Rate Determination By Vitale, Paolo
  5. An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates By Breedon, Francis; Vitale, Paolo
  6. Predatory Trading By Brunnermeier, Markus K; Pedersen, Lasse Heje
  7. Information Sales and Insider Trading By Cespa, Giovanni
  8. Can Venture Capital Funds Pick Winners? Evidence from Pre-IPO Survival Rates and Post-IPO Performance By Ber, Hedva; Yafeh, Yishay
  9. Equilibrium of Real Financial Markets: Theory and Experimental Evidence By Bossaerts, Peter
  10. The Comovement of Credit Default Swap, Bond and Stock Markets: An Empirical Analysis By Norden, Lars; Weber, Martin
  11. Estimating the Expected Marginal Rate of Substitution: Exploiting Idiosyncratic Risk By Flood, Robert P; Rose, Andrew K
  12. Asset Pricing with Liquidity Risk By Acharya, Viral V; Pedersen, Lasse Heje
  13. A Variance Ratio Related Prediction Tool with Application to the NYSE Index 1825-2002 By Kandel, Shmuel; Zilca, Shlomo
  14. On the design of Artificial Stockmarkets By Boer-Sorban, K.; Bruin, A. de; Kaymak, U.
  15. The Profitability of Block Trades in Auction and Dealer Markets By Andy Snell; Ian Tonks
  16. Intraday stock price effects of ad hoc disclosures: The German case By Jan Muntermann; André Güttler
  17. On the Predictability of Global Stock Returns By Hjalmarsson, Erik
  18. Valutation, Liquidity and Risk in Government Bond Markets By Carlo Favero; Marco Pagano; Ernst-Ludwig von Thadden
  19. Understanding the Stock Market's Response to Monetary Policy Shocks By Johann Scharler
  20. Multiple time scales in volatility and leverage correlation: A stochastic volatility model By Jean-Philippe Bouchaud; Josep Perello; Jaume Masoliver
  21. Stock market crashes, precursors and replicas By Jean-Philippe Bouchaud; Didier Sornette; Anders Johansen
  22. Comment on: "Two-phase behaviour of financial markets" By Marc Potters; Jean-Philippe Bouchaud
  23. Self-referential behaviour, overreaction and conventions in financial markets By Jean-Philippe Bouchaud; Matthieu Wyart
  24. Bubbles, crashes and intermittency in agent based market models By Jean-Philippe Bouchaud; Irene Giardina
  25. Power-laws in economics and finance: some ideas from physics By Jean-Philippe Bouchaud
  26. Microscopic models for long ranged volatility correlations By Jean-Philippe Bouchaud; Marc Mezard; Irene Giardina
  27. A Langevin approach to stock market fluctuations and crashes By Jean-Philippe Bouchaud; Rama Cont
  28. Herd behavior and aggregate fluctuations in financial markets By Jean-Philippe Bouchaud; Rama Cont
  29. Financial markets as adaptative systems By Marc Potters; Jean-Philippe Bouchaud; Rama Cont
  30. Phenomenology of the interest rate curve By Marc Potters; Jean-Philippe Bouchaud; Rama Cont; Nicolas Sagna; Nicole El-Karoui
  31. Momentum and Mean Reversion Across National Equity Markets By Ronald J. Balvers; Yangru Wu

  1. By: Gaspar, Vítor; Pérez-Quirós, Gabriel; Rodriguez, Hugo
    Abstract: The purpose of this Paper is to study the determinants of equilibrium in the market for daily funds. We use the EONIA panel database which includes daily information on the lending rates applied by contributing commercial banks. The data clearly shows an increase in both the time series volatility and the cross-section dispersion of rates towards the end of the reserve maintenance period. These increases are highly correlated. With respect to quantities, we find that the volume of trade as well as the use of the standing facilities is also larger at the end of the maintenance period. Our theoretical model shows how the operational framework of monetary policy causes a reduction in the elasticity of the supply of funds by banks throughout the reserve maintenance period. This reduction in the elasticity together with market segmentation and heterogeneity are able to generate distributions for the interest rates and quantities traded with the same properties as in the data.
    Keywords: Eonia panel; monetary policy instruments; overnight interest rate
    JEL: E52 E58
    Date: 2004–08
  2. By: Hau, Harald; Rey, Hélène
    Abstract: We explore whether the pattern of international equity returns, equity portfolio flows, and exchange rate returns are consistent with the hypothesis that (unhedged) global investors rebalance their portfolio in order to limit their exchange rate exposure when there are (1) relative equity return; and (2) exchange rate shocks. We also explore whether (3) equity flow shocks influence the exchange rates and relative equity prices. In the estimation of the VAR system we do not impose any causal ordering upon the primitive shocks, but instead identify the system based on theoretical priors about the contemporaneous conditional correlations between the three variables. International data for the five largest equity markets are consistent with a theory in which equity returns and portfolio rebalancing are an important source of exchange rate dynamics.
    Keywords: F37; international finance
    JEL: F30 F31
    Date: 2004–08
  3. By: Sraer, David; Thesmar, David
    Abstract: We look at the corporate performance of family firms listed on the French stock exchange between 1994 and 2000. On the French stock market, approximately one third of the firms are widely held, another third are founder controlled and the remaining third are heir-controlled family firms. We find that, in cross section, family firms largely outperform widely held corporations. This result holds for founder-controlled firms, but more surprisingly also for heir-managed firms. To explain this, we provide evidence consistent with the fact that, because of their different time horizons, heir-managed corporations have a comparative advantage when enforcing implicit insurance contracts with their labour force. More specifically, we find that: (1) employment in heir-managed firms is less sensitive to industry shocks; and (2) heirs pay lower wages. Finally, we discuss issues related to the endogeneity of performance/family regressions looking both at delisting and transitions from family to non-family status. We conclude that these issues may lead us to overestimate the performance of heirs compared to professionally-managed firms, but to underestimate the performance of heirs when compared to widely held firms.
    Keywords: corporate performance; family firms; management style
    JEL: D21 G32 L21
    Date: 2004–08
  4. By: Vitale, Paolo
    Abstract: We propose a critical review of recent developments in exchange rate economics. This new strand of research is motivated by some very stark empirical evidence, relating exchange rate returns to order flow. Plenty of empirical evidence shows that order flow, i.e. the imbalance in the sequence of purchases and sales of foreign currencies in the markets for foreign exchange, is an extremely powerful determinant of short-run exchange rate movements. With a simplified analytical framework we see how, according to the rational expectation paradigm of asset pricing, such a relation reflects liquidity and information effects of portfolios shifts.
    Keywords: exchange rate dynamics; foreign exchange microstructure; order flow
    JEL: D82 G14 G15
    Date: 2004–08
  5. By: Breedon, Francis; Vitale, Paolo
    Abstract: We propose a simple structural model of exchange rate determination that draws from the analytical framework recently proposed by Bacchetta and van Wincoop (2003) and allows us to disentangle the liquidity and information effects of order flow on exchange rates. We estimate this model employing an innovative transaction data-set that covers all direct foreign exchange transactions completed in the USD/EUR market via EBS and Reuters between August 2000 and January 2001. Our results indicate that the strong contemporaneous correlation between order flow and exchange rates is mostly due to liquidity effects. This result also appears to carry through to the four FX intervention events that appear in our sample.
    Keywords: exchange rate dynamics; foreign exchange mirror structure; order flow
    JEL: D82 G14 G15
    Date: 2004–08
  6. By: Brunnermeier, Markus K; Pedersen, Lasse Heje
    Abstract: This Paper studies predatory trading: trading that induces and/or exploits other investors’ need to reduce their positions. We show that if one trader needs to sell, others also sell and subsequently buy back the asset. This leads to price overshooting and a reduced liquidation value for the distressed trader. Hence, the market is illiquid when liquidity is most needed. Further, a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.
    Keywords: dealer exit stress test; liquidity; liquidity crisis; predation; risk management; systemic risk; valuation
    JEL: G10 G12 G23 G24
    Date: 2004–09
  7. By: Cespa, Giovanni
    Abstract: Fundamental information resembles in many respects a durable good. Hence, the effects of its incorporation into stock prices depend on who is the agent controlling its flow. Similarly to a durable goods monopolist, a monopolistic analyst selling information intertemporally competes against themself. This forces them to partially relinquish control over the information flow to traders. Conversely, an insider solves the intertemporal competition problem through vertical integration, thus exerting a tighter control over the flow of information. Comparing market patterns I show that a dynamic market where information is provided by an analyst is thicker and more informative than one where an insider trades.
    Keywords: analysts; durable goods monopolist; information sales; insider trading
    JEL: G10 G12 G14 L12
    Date: 2004–10
  8. By: Ber, Hedva; Yafeh, Yishay
    Abstract: This Paper evaluates the ability of venture capital funds to identify and bring to market successful high-tech Israeli companies during the period 1991 to 2000. Using a newly constructed and highly detailed database we find that: (1) The probability of survival until the IPO stage is higher for venture-backed companies. (2) According to several different measures, conditional on making an IPO, the post-listing performance of venture-backed companies is not statistically different from that of non-venture companies throughout the 1990s. We interpret this as evidence that an important contribution of the venture capital industry may be in increasing the survival rates of young technology-intensive firms, rather than in identifying high performers.
    Keywords: IPO; long-run performance; survival rate; venture capital
    JEL: G20 G30
    Date: 2004–10
  9. By: Bossaerts, Peter
    Abstract: The theory and the data in this Paper challenge the view that there is no structure in prices and allocations when markets are off equilibrium. Starting from the observation that price-taking usually applies only to small orders, a theory of equilibration is derived based on the assumption that orders are optimal only locally. Prices adjust in the direction of the order imbalance. In the context of mean-variance preferences, the theory predicts that a security’s price will correlate with excess demands in other securities, and the sign of this correlation is the same as that of the covariance of the final payoffs. In the short run, prices tend to a local equilibrium where the risk-aversion weighted endowment portfolio (RAWE) is mean-variance optimal. Relative to the market portfolio, RAWE overweighs securities that are held disproportionally by more risk averse agents; RAWE puts less weight on securities that are held primarily by more risk tolerant agents. Throughout equilibration, portfolio separation is violated generically, and violations are more extreme when payoff covariances are positive. For a variety of patterns of initial allocations (including identical initial holdings), the equity premium is larger at the outset than at (CAPM) equilibrium. Experimental evidence confirms the predictions conclusively.
    Keywords: CAPM; Equilibration; experimental finance; financial markets; optimal portfolios; portfolio separation
    JEL: C92 D50 G12
    Date: 2004–10
  10. By: Norden, Lars; Weber, Martin
    Abstract: This Paper analyses the empirical relationship between credit default swap, bond and stock markets during the period 2000-02. Focusing on the intertemporal comovement, we examine weekly and daily lead-lag relationships in a vector autoregressive model and the adjustment between markets caused by cointegration. First, we find that stock returns lead CDS and bond spread changes. Second, CDS spread changes Granger cause bond spread changes for a higher number of firms than vice versa. Third, the CDS market is significantly more sensitive to the stock market than the bond market and the magnitude of this sensitivity increases when credit quality becomes worse. Finally, the CDS market plays a more important role for price discovery than the corporate bond market.
    Keywords: credit derivatives; credit risk; credit spreads; lead-lag relationship
    JEL: C32 G10 G14
    Date: 2004–10
  11. By: Flood, Robert P; Rose, Andrew K
    Abstract: This Paper develops a simple but general methodology to estimate the expected intertemporal marginal rate of substitution or ‘EMRS’, using only data on asset prices and returns. Our empirical strategy is general, and allows the EMRS to vary arbitrarily over time. A novel feature of our technique is that it relies upon exploiting idiosyncratic risk, since theory dictates that idiosyncratic shocks earn the EMRS. We apply our methodology to two different datasets: monthly data from 1994 through 2003, and daily data for 2003. Both datasets include assets from three different markets: the New York Stock Exchange, the NASDAQ, and the Toronto Stock Exchange. For both monthly and daily frequencies, we find plausible estimates of EMRS with considerable precision and time-series volatility. We then use these estimates to test for asset integration, both within and between stock markets. We find that all three markets seem to be internally integrated in the sense that different assets traded on a given market share the same EMRS. The technique is also powerful enough to reject integration between the three stock markets, and between stock and money markets.
    Keywords: asset; discount; factor; intertemporal integration; market; price; stochastic; stock
    JEL: G14
    Date: 2004–10
  12. By: Acharya, Viral V; Pedersen, Lasse Heje
    Abstract: This Paper solves explicitly a simple equilibrium asset pricing model with liquidity risk – the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security’s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity. In addition, the model shows how a negative shock to a security’s liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns. The model provides a simple, unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels.
    Keywords: asset pricing; frictions; liquidity; liquidity risk; transaction costs
    JEL: G00 G10 G12
    Date: 2004–10
  13. By: Kandel, Shmuel; Zilca, Shlomo
    Abstract: Cochrane’s variance ratio is a leading tool for detection of deviations from random walks in financial asset prices. This Paper develops a variance ratio related regression model that can be used for prediction. We suggest a comprehensive framework for our model, including model identification, model estimation and selection, bias correction, model diagnostic check, and an inference procedure. We use our model to study and model mean reversion in the NYSE index in the period 1825-2002. We demonstrate that in addition to mean reversion, our model can generate other characteristic properties of financial asset prices, such as short-term persistence and volatility clustering of unconditional returns.
    Keywords: mean reversion; persistence; variance ratio
    Date: 2004–11
  14. By: Boer-Sorban, K.; Bruin, A. de; Kaymak, U. (Erasmus Research Institute of Management (ERIM), Erasmus University Rotterdam)
    Abstract: Artificial stock markets are designed with the aim to study and understand market dynamics by representing (part of) real stock markets. Since there is a large variety of real stock markets with several partially observable elements and hidden processes, artificial markets differ regarding their structure and implementation. In this paper we analyze to what degree current artificial stock markets reflect the workings of real stock markets. In order to conduct this analysis we set up a list of factors which influence market dynamics and are as a consequence important to consider for designing market models. We differentiate two categories of factors: general, well-defined aspects that characterize the organization of a market and hidden aspects that characterize the functioning of the markets and the behaviour of the traders.
    Keywords: market microstructure;financial markets;agent-based computational economics;artificial stock markets;uncertainty modeling;
    Date: 2005–02–01
  15. By: Andy Snell; Ian Tonks
    Abstract: The paper compares the trading costs for institutional investors who are subject to liquidity shocks, of trading in auction and dealer markets. The batch auction restricts the institutions’ ability to exploit informational advantages because of competition between institutions when they simultaneously submit their orders. This competition lowers aggregate trading costs. In the dealership market, competition between traders is absent but trades occur in sequence so that private information is revealed by observing the flow of successive orders. This information revelation reduces trading costs in aggregate. We analyse the relative effects on profits of competition in one system and information revelation in the other and identify the circumstances under which dealership markets have lower trading costs than auction markets and vice versa.
    Keywords: Market microstructure, Auction market, Dealer markets.
    JEL: G10 G15 G19
  16. By: Jan Muntermann; André Güttler
    Abstract: This paper examines intraday stock price effects and trading activity caused by ad hoc disclosures in Germany. The evidence suggests that the observed stock prices react within 90 minutes after the ad hoc disclosures. Trading volumes take even longer to adjust. We find no evidence for abnormal price reactions or abnormal trading volume before announcements. The bigger the company that announces an ad hoc disclosure, the less severe is the abnormal price effect following the announcement. The number of analysts is negatively correlated to the trading volume effect before the ad hoc disclosure. The higher the trading volume on the last trading day before the announcement, the greater is the price effect after the ad hoc disclosures and the greater the trading volume effect.
    JEL: G14 K22
    Date: 2005
  17. By: Hjalmarsson, Erik (Department of Economics)
    Abstract: Stock return predictability is a central issue in empirical finance. Yet no comprehensive study of international data has been performed to test the predictive ability of lagged explanatory variables. In fact, most stylized facts are based on U.S. stock-market data. In this paper, I test for stock return predictability in the largest and most comprehensive data set analyzed so far, using four common forecasting variables: the dividend- and earnings-price ratios, the short interest rate, and the term spread. The data contain over 20,000 monthly observations from 40 international markets, including markets in 22 of the 24 OECD countries. <p> I also develop new asymptotic results for long-run regressions with overlapping observations. I show that rather than using auto-correlation robust standard errors, the standard t-statistic can simply be divided by the square root of the forecasting horizon to correct for the effects of the overlap in the data. Further, when the regressors are persistent and endogenous, the long-run OLS estimator suffers from the same problems as does the short-run OLS estimator, and similar corrections and test procedures as those proposed by Campbell and Yogo (2003) for the short-run case should also be used in the long-run; again, the resulting test statistics should be scaled due to the overlap. <p> The empirical analysis conducts time-series regressions for individual countries as well as pooled regressions. The results indicate that the short interest rate and the term spread are fairly robust predictors of stock returns in OECD countries. The predictive abilities of both the short rate and the term spread are short-run phenomena; in particular, there is only evidence of predictability at one and 12-month horizons. In contrast to the interest rate variables, no strong or consistent evidence of predictability is found when considering the earnings- and dividend-price ratios as predictors. Any evidence that is found is primarily seen at the long-run horizon of 60 months. Neither of these predictors yields any consistent predictive power for the OECD countries. <p> The interest rate variables also have out-of-sample predictive power that is economically significant; the welfare gains to a log-utility investor who uses the predictive ability of these variables to make portfolio decisions are substantial. <p>
    Keywords: Predictive regressions; long-horizon regressions; panel data; stock return predictability
    JEL: C22 C23 G12 G15
    Date: 2005–02–02
  18. By: Carlo Favero; Marco Pagano; Ernst-Ludwig von Thadden
    Abstract: We explore the determinants of yield differentials between sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of the international risk factor. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We present a model that predicts that yield differentials should increase in both liquidity and risk, with an interaction term whose magnitude and sign depends on the size of the liquidity differential with respect to the reference country. Testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced only for a subset of countries and their interaction with the risk factor is crucial to detect their effect.
  19. By: Johann Scharler (Oesterreichische Nationalbank, Economic Analysis Division)
    Abstract: This paper explores whether a limited participation model of the monetary transmission mechanism can account for the observed re- sponse of stock market returns to monetary policy shocks. It is found that the model generates responses that broadly match the empiri- cal counterparts, although the magnitudes are somewhat too small. Moreover, the results suggest that the increased exposure of bank- dependent ¯rms to liquidity shocks cannot fully account for the het- erogenous responses of returns that are observed across ¯rms.
    Keywords: limited participation, asset pricing, stock market
    JEL: E4 E5 G1
    Date: 2004–12–29
  20. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Josep Perello; Jaume Masoliver
    Abstract: Financial time series exhibit two different type of non linear correlations: (i) volatility autocorrelations that have a very long range memory, on the order of years, and (ii) asymmetric return-volatility (or `leverage') correlations that are much shorter ranged. Different stochastic volatility models have been proposed in the past to account for both these correlations. However, in these models, the decay of the correlations is exponential, with a single time scale for both the volatility and the leverage correlations, at variance with observations. We extend the linear Ornstein-Uhlenbeck stochastic volatility model by assuming that the mean reverting level is itself random. We find that the resulting three-dimensional diffusion process can account for different correlation time scales. We show that the results are in good agreement with a century of the Dow Jones index daily returns (1900-2000), with the exception of crash days.
    JEL: G10
  21. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Didier Sornette (UCLA; Science & Finance, Capital Fund Management); Anders Johansen
    Abstract: We present an analysis of the time behavior of the S&P 500 (Standard and Poors) New York stock exchange index before and after the October 1987 market crash and identify precursory patterns as well as aftershock signatures and characteristic oscillations of relaxation. Combined, they all suggest a picture of a kind of dynamical critical point, with characteristic log-periodic signatures, similar to what has been found recently for earthquakes. These observations are confirmed on other smaller crashes, and strengthen the view of the stockmarket as an example of a self-organizing cooperative system.
    JEL: G10
  22. By: Marc Potters (Science & Finance, Capital Fund Management); Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;)
    Abstract: In a recent article [Nature 421, 130 (2003)], Plerou, Gopikrishnan and Stanley report some evidence for an intriguing two-phase behavior of financial markets when studying the distribution of volume imbalance conditional to the local intensity of its fluctuations. We show here that this apparent phase transition is a generic consequence of the conditioning and exists even in the absence of any non trivial collective phenomenon.
    JEL: G10
  23. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Matthieu Wyart (CEA Saclay;)
    Abstract: We study a generic model for self-referential behaviour in financial markets, where agents attempt to use some (possibly fictitious) causal correlations between a certain quantitative information and the price itself. This correlation is estimated using the past history itself, and is used by a fraction of agents to devise active trading strategies. The impact of these strategies on the price modify the observed correlations. A potentially unstable feedback loop appears and destabilizes the market from an efficient behaviour. For large enough feedbacks, we find a `phase transition' beyond which non trivial correlations spontaneously set in and where the market switches between two long lived states, that we call conventions. This mechanism leads to overreaction and excess volatility, which may be considerable in the convention phase. A particularly relevant case is when the source of information is the price itself. The two conventions then correspond then to either a trend following regime or to a contrarian (mean reverting) regime. We provide some empirical evidence for the existence of these conventions in real markets, that can last for several decades.
    JEL: G10
  24. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Irene Giardina
    Abstract: We define and study a rather complex market model, inspired from the Santa Fe artificial market and the Minority Game. Agents have different strategies among which they can choose, according to their relative profitability, with the possibility of not participating to the market. The price is updated according to the excess demand, and the wealth of the agents is properly accounted for. Only two parameters play a significant role: one describes the impact of trading on the price, and the other describes the propensity of agents to be trend following or contrarian. We observe three different regimes, depending on the value of these two parameters: an oscillating phase with bubbles and crashes, an intermittent phase and a stable `rational' market phase. The statistics of price changes in the intermittent phase resembles that of real price changes, with small linear correlations, fat tails and long range volatility clustering. We discuss how the time dependence of these two parameters spontaneously drives the system in the intermittent region. We analyze quantitatively the temporal correlation of activity in the intermittent phase, and show that the `random time strategy shift' mechanism that we proposed earlier allows one to understand the observed long ranged correlations. Other mechanisms leading to long ranged correlations are also reviewed. We discuss several other issues, such as the formation of bubbles and crashes, the influence of transaction costs and the distribution of agents wealth.
    JEL: G10
  25. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;)
    Abstract: We discuss several models in order to shed light on the origin of power-law distributions and power-law correlations in financial time series. From an empirical point of view, the exponents describing the tails of the price increments distribution and the decay of the volatility correlations are rather robust and suggest universality. However, many of the models that appear naturally (for example, to account for the distribution of wealth) contain some multiplicative noise, which generically leads to *non universal exponents*. Recent progress in the empirical study of the volatility suggests that the volatility results from some sort of multiplicative cascade. A convincing `microscopic' (i.e. trader based) model that explains this observation is however not yet available. It would be particularly important to understand the relevance of the pseudo-geometric progression of natural human time scales on the long range nature of the volatility correlations.
    JEL: G10
  26. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Marc Mezard (Universite Paris Sud (Orsay)); Irene Giardina
    Abstract: We propose a general interpretation for long-range correlation effects in the activity and volatility of financial markets. This interpretation is based on the fact that the choice between `active' and `inactive' strategies is subordinated to random-walk like processes. We numerically demonstrate our scenario in the framework of simplified market models, such as the Minority Game model with an inactive strategy, or a more sophisticated version that includes some price dynamics. We show that real market data can be surprisingly well accounted for by these simple models.
    JEL: G10
  27. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Rama Cont (Science & Finance, Capital Fund Management)
    Abstract: We propose a non linear Langevin equation as a model for stock market fluctuations and crashes. This equation is based on an identification of the different processes influencing the demand and supply, and their mathematical transcription. We emphasize the importance of feedback effects of price variations onto themselves. Risk aversion, in particular, leads to an up-down symmetry breaking term which is responsible for crashes, where `panic' is self reinforcing. It is also responsible for the sudden collapse of speculative bubbles. Interestingly, these crashes appear as rare, `activated' events, and have an exponentially small probability of occurence. We predict that the shape of the falldown of the price during a crash should be logarithmic. The normal regime, where the stock price exhibits behavior similar to that of a random walk, however reveals non trivial correlations on different time scales, in particular on the time scale over which operators perceive a change of trend.
    JEL: G10
  28. By: Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Rama Cont (Science & Finance, Capital Fund Management)
    Abstract: We present a simple model of a stock market where a random communication structure between agents gives rise to a heavy tails in the distribution of stock price variations in the form of an exponentially truncated power-law, similar to distributions observed in recent empirical studies of high frequency market data. Our model provides a link between two well-known market phenomena: the heavy tails observed in the distribution of stock market returns on one hand and 'herding' behavior in financial markets on the other hand. In particular, our study suggests a relation between the excess kurtosis observed in asset returns, the market order flow and the tendency of market participants to imitate each other.
    JEL: G10
  29. By: Marc Potters (Science & Finance, Capital Fund Management); Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Rama Cont (Science & Finance, Capital Fund Management)
    Abstract: We show, by studying in detail the market prices of options on liquid markets, that the market has empirically corrected the simple, but inadequate Black-Scholes formula to account for two important statistical features of asset fluctuations: `fat tails' and correlations in the scale of fluctuations. These aspects, although not included in the pricing models, are very precisely reflected in the price fixed by the market as a whole. Financial markets thus behave as rather efficient adaptive systems.
    JEL: G10
  30. By: Marc Potters (Science & Finance, Capital Fund Management); Jean-Philippe Bouchaud (Science & Finance, Capital Fund Management; CEA Saclay;); Rama Cont (Science & Finance, Capital Fund Management); Nicolas Sagna; Nicole El-Karoui
    Abstract: This paper contains a phenomenological description of the whole U.S. forward rate curve (FRC), based on an data in the period 1990-1996. We find that the average FRC (measured from the spot rate) grows as the square-root of the maturity, with a prefactor which is comparable to the spot rate volatility. This suggests that forward rate market prices include a risk premium, comparable to the probable changes of the spot rate between now and maturity, which can be understood as a `Value-at-Risk' type of pricing. The instantaneous FRC however departs form a simple square-root law. The distortion is maximum around one year, and reflects the market anticipation of a local trend on the spot rate. This anticipated trend is shown to be calibrated on the past behaviour of the spot itself. We show that this is consistent with the volatility `hump' around one year found by several authors (and which we confirm). Finally, the number of independent components needed to interpret most of the FRC fluctuations is found to be small. We rationalize this by showing that the dynamical evolution of the FRC contains a stabilizing second derivative (line tension) term, which tends to suppress short scale distortions of the FRC. This shape dependent term could lead, in principle, to arbitrage. However, this arbitrage cannot be implemented in practice because of transaction costs. We suggest that the presence of transaction costs (or other market `imperfections') is crucial for model building, for a much wider class of models becomes eligible to represent reality.
    JEL: G10
  31. By: Ronald J. Balvers (Division of Economics and Finance, West Virginia University); Yangru Wu (Department of Finance and Economics, Rutgers University)
    Abstract: A number of studies have separately identified mean reversion and momentum, but this paper considers these effects jointly: Potential for mean reversion and momentum is combined optimally into one indicator, interpretable as a risk-adjusted expected return. Combination momentum-contrarian strategies, used to select from among 18 developed equity markets at a monthly frequency, outperform both pure momentum and pure contrarian strategies. A key assumption is that, among developed markets, only global equity price index shocks can have permanent components, as would be reasonable in a production-based asset-pricing context, given that production levels converge across developed countries. The results hold with basic risk corrections and continue to hold after transactions costs are included. They reveal that it is important to control for mean reversion in exploiting momentum and vice versa.
    Keywords: Mean Reversion, Momentum, International Asset Pricing, Investment Strategies
    JEL: G10 G15

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