New Economics Papers
on Financial Markets
Issue of 2005‒11‒19
fifty-five papers chosen by

  1. International Capital Flows in a World of Greater Financial Integration By Viktoria Hnatkovska; Martin Evans
  2. Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations By Guenter Franke; Jan Pieter Krahnen
  3. Bank finance versus bond finance - what explains the differences between US and Europe? By Fiorella De Fiore; Harald Uhlig
  4. Extreme Value Theory and Fat Tails in Equity Markets By Ritirupa Samanta; Blake LeBaron
  5. The link between interest rates and exchange rates - do contractionary depreciations make a difference? By Marcelo Sánchez
  6. Financial Development and Property Valuation By Sikandar Hussain; M. Shahid Ebrahim
  7. Current Account Balances, Financial Development and Institutions: Assaying the World "Savings Glut" By Menzie D. Chinn; Hiro Ito
  8. European Union enlargement and equity markets in accession countries By Tomas Dvorak; Richard Podpiera
  9. The Behavior of Banks under the Deposit Insurance and Capital Requirements By Xiaozhong Liang
  10. European Stock Market Dynamics Before and After the Introduction of the Euro By Joseph Friedman; Yochanan Shachmurove
  11. Degree of Internationalization and Performance: An Analysis of Canadian Banks By Walid Hejazi; Eric Santor
  12. Consumption Volatility and Financial Openness By Claudia M. Buch; Serkan Yener
  13. Return Predictability and the Implied Intertemporal Hedging Demands for Stocks and Bonds: International Evidence By Mark E. Wohar; David E. Rapach
  14. Global bond portfolios and EMU By Philip R. Lane
  15. Implicit regimes for the Spanish Peseta/Deutschmark exchange rate By Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñezr; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
  16. Extracting expectations from currency option prices: a comparison of methods By Marian Micu
  17. Proprietary Income, Entrepreneurial Risk and the Predictability of U.S. Stock Returns By Mathias Hoffmann
  18. Underpricing and Index Excess Returns By Peter Nippel; Christian Pierdzioch; Andrea Schertler
  19. What Defines %u2018News%u2019 in Foreign Exchange Markets? By Kathryn Dominguez; Freyan Panthaki
  20. Exchange-rate pass-through to import prices in the euro area By Campa, Jose M.; Goldberg, Linda S.; Gonzalez-Minguez, Jose M.
  21. Does Financial Structure Matter for the Information Content of Financial Indicators? By Ramdane Djoudad; Jack Selody; Carolyn Wilkins
  22. Optimal Interest Rate Rules, Asset Prices and Credit Frictions By Tommaso Monacelli; Ester Faia
  23. Roughing it Up: Including Jump Components in the Measurement, Modeling and Forecasting of Return Volatility By Torben G. Andersen; Tim Bollerslev; Francis X. Diebold
  24. Predicting the Daily Covariance Matrix for S&P 100 Stocks Using Intraday Data - But Which Frequency to Use? By Michiel de Pooter; Martin Martens; Dick van Dijk
  25. China's capital account convertibility and financial stability By James Laurenceson; Kam Ki Tang
  26. Credit Card Debt Puzzles By Michael Haliassos; Michael Reiter
  27. Option Pricing and the Implied Tail Index with the Generalized Extreme Value (GEV) Distribution By Sheri Markose; Amadeo Alentorn
  28. Shareholder value maximisation, stock market and new technology: should the US corporate model be the universal standard By Ajit Singh; Jack Glen; Ann Zammitt; Rafael De-Hoyas; Alaka Singh; Bruce Weisse
  29. Underwriter competition and gross spreads in the eurobond market By Michael G. Kollo
  30. Agency Conflicts, Investment, and Asset Pricing By Neng Wang; Rui Albuquerque
  31. Framing Effects in Stock Market Forecasts: The Difference Between Asking for Prices and Asking for Returns By Glaser, Markus; Langer, Thomas; Reynders, Jens; Weber, Martin
  32. The Futures Pricing Puzzle By Shafiqur Rahman; M. Shahid Ebrahim
  33. Which Past Returns Affect Trading Volume? By Glaser, Markus; Weber, Martin
  34. Bayesian Estimation of a DSGE Model with Financial Frictions for the U.S. and the Euro Area By Virginia Queijo
  35. Operational risk management and new computational needs in banks By Duc PHAM-HI
  36. The US Current Account Deficit: A Re-examination of the Role of Private Saving By Charles Engel
  37. The Fed and the Stock Market By Paolo Surico; Antonello D'Agostino; Luca Sala
  38. Interest Rates, Exchange Rates and International Adjustment By Michael P. Dooley; David Folkerts-Landau; Peter M. Garber
  39. Interbank market under the currency board: Case of Lithuania By Marius Jurgilas
  40. Banks and Innovation: Microeconometric Evidence on Italian Firms By Luigi Benfratello; Fabio Schiantarelli; Alessandro Sembenelli
  41. Limited Participation, Income Distribution and Capital Account Liberalization By Eva de Francisco
  42. A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance By Matt Pritsker
  43. Capital Accumulation in the Presence of Informal Credit Contract: Does Incentive Mechanism Work Better than Credit Rationing Under Asymmetric Information? By basab dasgupta
  44. Computational Efficiency and Macroeconomic Stability under Centralized Exchange: Evidence from Swiss and US Exchange Data By James Stodder
  45. Optimal Timing of Mark-to-Market for Contingent Credit Risk Control By Jiali Liao; Theodore V. Theodosopoulos
  46. Ex Ante Versus Ex Post Regulation of Bank Capital By Arup Daripa; Simone Varotto
  47. Asset Diversion, Input Allocation and Trade Credit By Daniela Fabbri; Anna Maria Cristina Menichini
  48. How (Not) to Sell Money By Arup Daripa
  49. Yes, Libor Models can capture Interest Rate Derivatives Skew : A Simple Modelling Approach By Eymen Errais; Fabio Mercurio
  50. Financing Technology: An Assessment of Theory and Practice By Pasquale Lucio Scandizzo
  51. Option-Pricing in Incomplete Markets: The Hedging Portfolio plus a Risk Premium-Based Recursive Approach By Alfredo Ibáñez
  52. Asset Pricing and Loss Aversion By Willi Semmler; Lars Grüne
  53. Wavelet Optimized Finite-Difference Approach to Solve Jump-Diffusion type Partial Differential Equation for Option Pricing By Mohammad R. Rahman; Ruppa K. Thulasiram; Parimala Thulasiraman
  54. Pricing American-style Derivatives under the Heston Model Dynamics: A Fast Fourier Transformation in the Geske–Johnson Scheme By Oleksandr Zhylyevskyy
  55. Information Quality and Stock Returns Revisited By Frode Brevik; Stefano d'Addona

  1. By: Viktoria Hnatkovska; Martin Evans (Economics Georgetown University)
    Abstract: International capital flows have increased dramatically since the 1980s, with much of the increase being due to trade in equity and debt markets. Such developments are often attributed to the increased integration of world financial markets. We present a model that allows us to examine how greater integration in world financial markets affects the structure of asset ownership and the behavior of international capital flows. Our model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows fall dramatically but continue to exceed the size and volatility of international equity flows. We also find that variations in the equity risk premia account for almost all of the international portfolio flows in bonds and equities. We argue that both effects arise naturally as a result of increased risk sharing facilitated by greater financial integration. The paper also makes a methodological contribution to the literature on dynamic general equilibrium asset-pricing. We present a new technique for solving a dynamic general equilibrium model with production, portfolio choice and incomplete markets
    Keywords: Portfolio Choice; Financial Integration; Incomplete Markets
    JEL: D52 F36 G11
    Date: 2005–11–11
  2. By: Guenter Franke; Jan Pieter Krahnen
    Abstract: This paper contributes to the economics of financial institutions risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to expand its loan business, thereby affecting systematic risk. For a sample of European CDO issues, we find an increase of the banks’ betas, but no significant stock price effect around the announcement of a CDO issue.
    JEL: D82 G21 D74
    Date: 2005–11
  3. By: Fiorella De Fiore (Directorate General Research, European Central Bank, Postfach 160319, 60066 Frankfurt am Main, Germany); Harald Uhlig (School of Business and Economics,WiPol 1, Humboldt University, Spandauer Str. 1, 10178 Berlin, Germany)
    Abstract: We present a dynamic general equilibrium model with agency costs, where heterogeneous firms choose among two alternative instruments of external finance - corporate bonds and bank loans. We characterize the financing choice of firms and the endogenous financial structure of the economy. The calibrated model is used to address questions such as - What explains differences in the financial structure of the US and the euro area? What are the implications of these differences for allocations? We find that a higher share of bank finance in the euro area relative to the US is due to lower availability of public information about firms'credit worthiness and to higher efficiency of banks in acquiring this information. We also quantify the effect of differences in the financial structure on per-capita GDP.
    Keywords: Financial structure; agency costs; heterogeneity.
    JEL: E20 E44 C68
    Date: 2005–11
  4. By: Ritirupa Samanta; Blake LeBaron
    Abstract: Equity market crashes or booms are extreme realizations of the underlying return distribution. This paper questions whether booms are more or less likely than crashes and whether emerging markets crash more frequently than developed equity markets. We apply Extreme Value Theory (EVT) to construct statistical tests of both of these questions. EVT elegantly frames the problem of extreme events in the context of the limiting distributions of sample maxima and minima. This paper applies generalized extreme value theory to understand the probability of extreme events and estimate the level of �fatness� in the tails of emerging and developed markets. We disentangle the major �tail index� estimators in the literature and evaluate their small sample properties and sensitivities to the number of extreme observations. We choose to use the Hill index to measure the shape of the distribution in the tail. We then apply nonparametric techniques to assess the significance of differences in tail thickness between the positive and negative tails of a given market and in the tail behavior of the developed and emerging region. We construct Monte Carlo and Wild Bootstrap tests of the null of tail symmetry and find that negative tails are statistically significantly fatter than positive tails for a subset of markets in both regions. We frame group bootstrap tests of universal tail behavior for each region and show that the tail index is statistically similar across countries within the same region. This allows us to pool returns and estimate region wide tail behavior. We form bootstrapping tests of pooled returns and document evidence that emerging markets have fatter negative tails than the developed region. Our findings are consistent with prevalent notions of crashes being more in the emerging region than among developed markets. However our results of asymmetry in several markets in both regions, suggest that the risk of market crashes varies significantly within the region. This has important implications for any international portfolio allocation decisions made with a regional view
    Keywords: Extreme value theory, fat tails, emerging markets
    JEL: G12 G15
    Date: 2005–11–11
  5. By: Marcelo Sánchez (Correspondence to: European Central Bank, Postfach 160319, 60066 Frankfurt am Main, Germany)
    Abstract: The link between exchange rates and interest rates features prominently in the theoretical and empirical literature on small open economies. This paper revisits this relationship using a simple model that incorporates the role of exchange rate pass-through into domestic prices and distinguishes between cases of expansionary and contractionary depreciations. The model results show that the correlation between exchange rates and interest rates, conditional on an adverse risk premium shock, is negative for expansionary depreciations and positive for contractionary ones. For this type of shock, interest rates are found to be raised to prevent the contractionary effect of a depreciation regardless of whether the latter effect is strong or mild. Interest rates are predicted to also rise in response to an adverse net export shock in contractionary depreciation cases, and to be lowered in the case of expansionary ones.
    Keywords: Transmission mechanism; Emerging market economies; Exchange rate; Monetary policy.
    JEL: E52 E58 F31 F41
    Date: 2005–11
  6. By: Sikandar Hussain; M. Shahid Ebrahim
    Abstract: This paper investigates the impact of financial development on property valuation in a rational expectations framework by modeling the agency theoretic perspective of risk averse investors (property owners) and financiers (banks/ capital markets). In contrast to previous research, we consider a setting in which financiers possess no inherent information processing or monitoring advantages. We demonstrate that property financing is undertaken in a pecking order of increasing pareto-efficiency (with reduction in its overall costs and a subsequent increase in the value of the underlying collateral) in a three staged process as financial architecture advances from a partially liberalized bank to the developed stage of capital markets. The primary solution is obtained in the rudimentary stage of commercial banks (in a specialized banking system), where the default-free mortgages are pareto-optimal to defaulting mortgages in accordance with the prognosis of Scott (1976) and Stulz and Johnson (1985). A pareto-improvement of the first solution is obtained by removing the restriction on ownership of property for financiers such as universal banks and pension funds, insurance companies, etc. This solution resolves the real estate version of the asset location puzzle (see Geltner and Miller, 2001). A further pareto-enhancement of this equilibrium is obtained under financial innovation by embedding the above default-free mortgage with options (in the form of a participating mortgage) in accordance with the prognosis of Green (1984), Haugen and Senbet (1981, 1987) and Schnabel (1993). Our results yield implications for financial system development. Our analysis predicts that an optimal financial system will configure itself skewed towards capital markets irrespective of the source of its origination (from specialized banking system or universal banking system). We also rationalize the co-existence of banks and financial markets in a well-developed financial system
    Keywords: Financial Deepening; Financial Innovation; Financial Liberalization; Pareto-optimal Mortgage Design; Risk Management.
    JEL: D58 G12 G2 G32
    Date: 2005–11–11
  7. By: Menzie D. Chinn; Hiro Ito
    Abstract: We investigate the medium-term determinants of the current account using a model that controls for factors related to institutional development, with a goal of informing the recent debate over the existence and relevance of the "savings glut." The economic environmental factors that we consider are the degree of financial openness and the extent of legal development. We find that for industrial countries, the government budget balance is an important determinant of the current account balance; the budget balance coefficient is 0.21 in a specification controlling for institutional variables. More interestingly, our empirical findings are not consistent with the argument that the more developed financial markets are, the less saving a country undertakes. We find that this posited relationship is applicable only for countries with highly developed legal systems and open financial markets. For less developed countries and emerging market countries we usually find the reverse correlation; greater financial development leads to higher savings. Furthermore, there is no evidence of "excess domestic saving" in the Asian emerging market countries; rather they seem to have suffered from depressed investment in the wake of the 1997 financial crises. We also find evidence that the more developed equity markets are, the more likely countries are to run current account deficits.
    JEL: F32 F41
    Date: 2005–11
  8. By: Tomas Dvorak (Union College, Schenectady, NY 12308, USA); Richard Podpiera (International Monetary Fund,Washington, D.C. 20431, USA)
    Abstract: The announcement of European Union enlargement coincided with a dramatic rise in stock prices in accession countries. This paper investigates the hypothesis that the rise in stock prices was a result of the repricing of systematic risk due to the integration of accession countries into the world market. We find that firm-level stock price changes are positively related to the difference between a firm’s local and world market betas. This result is robust to controlling for changes in expected earnings, country effects and other controls, although the magnitude of the effect is not very large. The differences between local and world betas explain nearly 22% of the stock price increase.
    Keywords: Asset pricing; international financial integration; EU enlargement.
    JEL: F36 G15 G12
    Date: 2005–11
  9. By: Xiaozhong Liang (Economics University of Connecticut)
    Abstract: Deposit insurance and capital requirements are two focuses in banking literature. Many researchers criticize these two important schemes using moral hazard theory: Under the protection of the deposit insurance, banks have incentive to take deposits as much as they can for some debt-favor reasons such as tax deduction on interest payment, and let the FDIC pay for the deposits if it turns out banks do not have enough capital to pay the deposits back. One the other hand, banks also have incentive to take riskier investment in hope of having higher returns. When capital requirements are imposed, insured banks may shift priced risks to unpriced risks. Therefore, capital requirements actually will lead banks to take more risks, and hence lead to higher probability of bank failure. However, this criticism does not consider the implicit costs of bankruptcy. If a bank is bankrupt, it will lose the benefit of deposit insurance. Moreover, it will lose the possible future earnings. In this paper, I take into account the implicit costs of bankruptcy, and investigate how banks react to the fixed and risk-based capital requirements under deposit insurance. In my basic model, I adopt one factor option pricing model and find a closed-form solution for bank equity in terms of asset-to-debt ratio. In my extension model, I relax the assumption of constant interest rate in the basic model. Thus, the uncertainty of bank equity comes from two sources: capital ratio and interest rate. I adopt a general form of term structure and find the numerical solution for the bank equity value as a function of both asset-to-debt ratio and interest rate. Through the stochastic term structure, interest rate risk is also involved. The results show that banks actually prefer to use more capital even there are no capital requirements. Moreover, banks tend to take lower risk instead of high risk no matter there are capital requirements or not, if they are solvent. However, for insolvent banks, they may take riskier investment. Under the risk-based capital requirements, banks would prefer lower capital requirements by taking lower risk. Lastly, capital requirements only have impact on banks with low capital. For those well capitalized banks, capital requirements will not affect their behavior too much.
    Keywords: numerical analysis, capital ratio, risk-taking, interest rate risk, deposit insurance, capital requirements
    JEL: G21
    Date: 2005–11–11
  10. By: Joseph Friedman (Department of Economics, Temple University); Yochanan Shachmurove (Department of Economics, University of Pennsylvania)
    Abstract: This paper addresses the following questions: Are the major European stock markets more integrated after the introduction of the Euro? How much of the change in the stock indices in different European countries can be attributed to innovations in other markets? How fast are events occurring in one European market transmitted to other markets? Vector Auto Regression models, impulses responses and variance decomposition are used to ascertain the stock market dynamics before and after the introduction of the Euro. The paper presents evidence of further integration of the European stock markets after the introduction of the Euro.
    Keywords: Euro, Vector Auto Regression Models, Co-movements of Stock Markets, Impulse Response, Variance Decomposition
    JEL: F G C1 C3 C5 E44
    Date: 2005–10–01
  11. By: Walid Hejazi; Eric Santor
    Abstract: The international business literature measures the link between the degree of internationalization (DOI) of a firm's activities and its performance. The results of this literature are mixed. The authors extend the analysis to Canadian bank-level data, but they also take into account the riskiness of each bank's foreign-asset exposure. The results establish a positive, but weak, relationship between DOI and performance—one that is dependent on each bank's risk profile. The authors discuss the policy implications of their analysis.
    Keywords: Financial institutions
    JEL: F23 G21
    Date: 2005
  12. By: Claudia M. Buch; Serkan Yener
    Abstract: Economic theory predicts that the integration of financial markets lowers the volatility of consumption. In this paper, we study long-term trends in the consumption volatility of the G7 countries. Using different measures of financial openness, we find that greater financial openness has been associated with lower consumption volatility in Canada and Italy. In France, Germany, Japan, and the UK, consumption volatility has declined following equity market liberalization but not following capital account liberalization as such.
    Keywords: Consumption volatility, financial integration, G7 countries
    JEL: F36 F41
    Date: 2005–07
  13. By: Mark E. Wohar; David E. Rapach
    Abstract: We investigate return predictability and the implied intertemporal hedging demands for stocks and bonds in the U.S., Australia, Canada, France, Germany, Italy, and U.K. We first estimate predictive regression models for domestic bill, stock, and bond returns in each country, where returns depend on the nominal bill yield, dividend yield, and term spread. Employing the recently developed methodology of Campbell, Chan, and Viceira (2003), we calculate the implied optimal asset demands, including their myopic and intertemporal hedging components, for domestic bills, stocks, and bonds for an investor with an infinite horizon and Epstein-Zin-Weil utility in each country. We find that return predictability generates sizable positive intertemporal hedging demands for domestic stocks in the U.S. and U.K., while the intertemporal hedging demands for domestic stocks are decidedly smaller in Australia, Canada, and Germany and essentially zero in France and Italy. The intertemporal hedging demands for domestic bonds are negative and reasonably large in magnitude in the U.S., France, Germany, and Italy, while they are considerably smaller in magnitude in Australia, Canada, and the U.K. We also calculate optimal asset demands for an investor in the U.S. who, in addition to domestic bills, stocks, and bonds, has access to foreign stocks and bonds. We continue to find a sizable positive intertemporal hedging demand for U.S. stocks, and an important positive intertemporal hedging demand for U.K. stocks emerges. In another exercise, we find that investors in Australia, Canada, France, Germany, Italy, and the U.K. who have access to U.S. stocks and bonds all display sizable positive intertemporal hedging demands for U.S. stocks. Overall, we discover interesting similarities and differences in the implied intertemporal hedging demands for stocks and bonds across countries, and our results indicate that return predictability implies especially strong intertemporal hedging demands for U.S. and U.K. stocks
    JEL: C32 G11
    Date: 2005–11–11
  14. By: Philip R. Lane (IIIS,Trinity College Dublin and CEPR)
    Abstract: We examine the bilateral composition of international bond portfolios for the euro area and the individual EMU member countries. We find considerable support for “euro area bias” - EMU member countries disproportionately invest in one another relative to other country pairs. Another striking pattern is the positive connection between trade linkages and financial linkages in explaining asymmetries across EMU member countries in terms of their outward and inward bond investments vis-à-vis external counterparties. At the aggregate level, it is those countries physically closest to the euro area that are both the most important destinations and sources for external bond investment vis-à-vis the euro area. Our empirical results support the notion that financial regionalization is the leading force underlying financial globalization.
    Keywords: EMU; bond portfolios; financial integration.
    JEL: E4 F2 F3 F4
    Date: 2005–11
  15. By: Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñezr; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
    Abstract: The objective of this paper is to identify implicit exchange rate regimes for the Spanish peseta/Deutschmark exchange rate. To this end, several statistical approaches, proposed by previous studies, are applied to the period 1965-1998. The results indicate the existence of implicit regimes other than a free-floating one.
  16. By: Marian Micu (Research and Policy Analysis Bank for International Settlements)
    Abstract: This paper compares the goodness-of-fit and the stability of six methods used to extract risk-neutral probability density functions from currency option prices. We first compare five existing methods commonly employed to recover risk-neutral density functions from option prices. Specifically, we compare the methods introduced by Shimko (1993), Madan and Milne (1994), Malz (1996), Melick and Thomas (1997) and Bliss and Panigirtzoglou (2002). In addition, we propose a new method based on the piecewise cubic Hermite interpolation of the implied volatility function. We use data on 12 emerging market currencies against the US dollar and find that the piecewise cubic Hermite interpolation method is by far the method with the best accuracy in fitting observed option prices. We also find that there is a relative tradeoff between the goodness-of-fit and the stability of the methods. Thus, methods which have a better accuracy in fitting observed option prices appear to be more sensitive to option pricing errors, while the most stable methods have a fairly disappointing fitting. However, for the first two PDF moments as well as the quartiles of the risk-neutral distributions we find that the estimates do not differ significantly across methods. This suggests that there is a large scope for selection between these methods without essentially sacrificing the accuracy of the analysis. Nonetheless, depending on the particular use of these PDFs, some methods may be more suitable than others
    Keywords: Risk-neutral probability density functions, option pricing, exchange rate expectations
    JEL: C52 F31 G13
    Date: 2005–11–11
  17. By: Mathias Hoffmann (Economics University of Dortmund)
    Abstract: The paper contributes to a recent empirical and theoretical literature that suggests that proprietors are an important group of stockholders and that entrepreneurial risk could therefore help explain time-varying risk premia on the aggregate stock market. I use the intertemporal budget constraint of the average U.S. household to derive a cointegrating relationship between consumption and income from proprietary and non-proprietary wealth. I call this cointegrating relationship the cpy -residual. I interpret cpy as an entrepreneurial risk factor, because it mainly reflects cyclical fluctuations in proprietary income and because it is highly correlated with cross-sectional measures of idiosyncratic entrepreneurial risk. The cpy residual turns out to be a potent predictor of excess returns on the aggregate stock market in postwar U.S. data. However, this predictive power has started to decline since the beginning of the 1980s as stock market participation has widened with the advent of tax-deferable employer-sponsored pension plans and as proprietary income risk has become more easily diversifiable in the wake of state level bank deregulation
    Keywords: Non-insurable background risk, entrepreneurial income, equity premium, long-horizon predictability, consumption risk sharing
    JEL: E32 G12
    Date: 2005–11–11
  18. By: Peter Nippel; Christian Pierdzioch; Andrea Schertler
    Abstract: We study the link between underpricing of initial public offerings (IPOs) and index excess returns in secondary markets. We use a theoretical model to argue that underpricing of IPOs raises investors’ attention and, thereby, triggers investments in secondary markets. Our theoretical model implies that such investments should give rise to positive index excess returns in secondary markets. The results of our empirical tests, based on a dataset of stocks from the Neuer Markt and the Nouveau Marché, are in line with the implication of our theoretical model.
    Keywords: underpricing, index excess returns, IT firms
    JEL: G14 N24
    Date: 2005–10
  19. By: Kathryn Dominguez; Freyan Panthaki
    Abstract: This paper examines whether the traditional sets of macro surprises, that most of the literature considers, are the only sorts of news that can explain exchange rate movements. We examine the intra-daily influence of a broad set of news reports, including variables which are not typically considered "fundamentals" in the context of standard models of exchange rate determination, and ask whether they too help predict exchange rate behavior. We also examine whether "news" not only impacts exchange rates directly, but also influences exchange rates via order flow (signed trade volume). Our results indicate that along with the standard fundamentals, both non-fundamental news and order flow matter, suggesting that future models of exchange rate determination ought to include all three types of explanatory variables.
    JEL: F31 G15
    Date: 2005–11
  20. By: Campa, Jose M. (IESE Business School); Goldberg, Linda S. (Federal Reserve Bank of New York); Gonzalez-Minguez, Jose M. (Banco de España)
    Abstract: This paper presents an empirical analysis of transmission rates from exchange rate movements to import prices, across countries and product categories, in the euro area over the last fifteen years. Our results show that the transmission of exchange rate changes to import prices in the short run is high, although incomplete, and that it differs across industries and countries; in the long run, exchange rate pass-through is higher and close to one. We find no strong statistical evidence that the introduction of the euro caused a structural change in this transmission. Although estimated point elasticities seem to have declined since the introduction of the euro, we find little evidence of a structural break in the transmission of exchange rate movements except in the case of some manufacturing industries. And since the euro was introduced, industries producing differentiated goods have been more likely to experience reduced rates of exchange rate pass-through to import prices. Exchange rate changes continue to lead to large changes in import prices across euro-area countries.
    Keywords: Currency; invoicing; pass-through; exchange rate; producer currency pricing; local currency pricing;
    Date: 2005–09–18
  21. By: Ramdane Djoudad; Jack Selody; Carolyn Wilkins
    Abstract: Of particular concern to monetary policy-makers is the considerable unreliability of financial variables for predicting GDP growth and inflation. As Stock and Watson (2003) find, some financial variables work well in some countries or over some time periods and forecast horizons, but the results do not show any clear pattern. This may be caused by the changing nature of financial structures within countries across time, or the differing types of financial structures across countries. The authors assess the extent to which financial structure across countries influences the information content of financial variables for predicting real GDP growth and inflation. Their assumption is that financial asset prices will dominate financial quantities in economies with highly developed market-based financial systems. The authors use standard methods to determine the predictive content of common financial asset prices and quantities for 29 countries. They find no systematic pattern between financial structure and whether financial asset prices or quantities are the best financial indicators for monetary policy. Importantly, financial quantities are sometimes the best financial indicator, even in economies with highly developed market-based financial systems. The authors conclude that it would be difficult to tell, a priori, whether a financial asset price or quantity would be the best indicator for monetary policy for a particular country at a particular point in time.
    Keywords: Inflation and prices; Business fluctuations and cycles; Credit and credit aggregates; Monetary aggregates; Interest rates
    JEL: E31 E32
    Date: 2005
  22. By: Tommaso Monacelli; Ester Faia
    Abstract: We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the "financial markup" (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behavior of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy
    JEL: E52 F41
    Date: 2005–11–11
  23. By: Torben G. Andersen; Tim Bollerslev; Francis X. Diebold
    Abstract: A rapidly growing literature has documented important improvements in financial return volatility measurement and forecasting via use of realized variation measures constructed from high-frequency returns coupled with simple modeling procedures. Building on recent theoretical results in Barndorff-Nielsen and Shephard (2004a, 2005) for related bi-power variation measures, the present paper provides a practical and robust framework for non-parametrically measuring the jump component in asset return volatility. In an application to the DM/$ exchange rate, the S&P500 market index, and the 30-year U.S. Treasury bond yield, we find that jumps are both highly prevalent and distinctly less persistent than the continuous sample path variation process. Moreover, many jumps appear directly associated with specific macroeconomic news announcements. Separating jump from non-jump movements in a simple but sophisticated volatility forecasting model, we find that almost all of the predictability in daily, weekly, and monthly return volatilities comes from the non-jump component. Our results thus set the stage for a number of interesting future econometric developments and important financial applications by separately modeling, forecasting, and pricing the continuous and jump components of the total return variation process.
    JEL: C1 G1
    Date: 2005–11
  24. By: Michiel de Pooter (Faculty of Economics, Erasmus Universiteit Rotterdam); Martin Martens (Faculty of Economics, Erasmus Universiteit Rotterdam); Dick van Dijk (Faculty of Economics, Erasmus Universiteit Rotterdam)
    Abstract: This paper investigates the merits of high-frequency intraday data when forming minimum variance portfolios and minimum tracking error portfolios with daily rebalancing from the individual constituents of the S&P 100 index. We focus on the issue of determining the optimal sampling frequency, which strikes a balance between variance and bias in covariance matrix estimates due to market microstructure effects such as non-synchronous trading and bid-ask bounce. The optimal sampling frequency typically ranges between 30- and 65-minutes, considerably lower than the popular five-minute frequency. We also examine how bias-correction procedures, based on the addition of leads and lags and on scaling, and a variance-reduction technique, based on subsampling, affect the performance.
    Keywords: realized volatility; high-frequency data; volatility timing; mean-variance analysis; tracking error
    JEL: G11
    Date: 2005–10–12
  25. By: James Laurenceson; Kam Ki Tang (EAERG - School of Economics, The University of Queensland)
    Abstract: Capital account convertibility in China is on the rise. Some see the process as a means of circumventing domestic financial sector inefficiency while others view it as potentially exposing China to financial crises. In considering these different viewpoints, this paper attempts to quantify the impact that opening the capital account will have on the volume of China’s international capital flows. It is found that were China to fully open its capital account, gross non-FDI capital flows are predicted to rise by around 4.6 percent of GDP. While an increase of this magnitude would present a prudential challenge for China’s monetary authorities, it does not appear to be large enough to seriously call into question financial sector stability, either in China or abroad.
  26. By: Michael Haliassos; Michael Reiter
    Abstract: Most US credit card holders revolve high-interest debt, often combined with substantial (i) asset accumulation by retirement, and (ii) low-rate liquid assets. Hyperbolic discounting can resolve only the former puzzle (Laibson et al., 2003). Bertaut and Haliassos (2002) proposed an 'accountant-shopper'framework for the latter. The current paper builds, solves, and simulates a fully-specified accountant-shopper model, to show that this framework can actually generate both types of co-existence, as well as target credit card utilization rates consistent with Gross and Souleles (2002). The benchmark model is compared to setups without self-control problems, with alternative mechanisms, and with impatient but fully rational shoppers.
    Keywords: Credit cards, debt, self control, household portfolios
    JEL: E21 G11
    Date: 2005–11
  27. By: Sheri Markose; Amadeo Alentorn
    Abstract: The 1987 stock market crash, the LTCM debacle, the Asian Crisis, the bursting of the high technology Dot-Com bubble of 2001-2 with 30% losses of equity values, events such as 9/11 and sudden corporate collapses of the magnitude of Enron - have radically changed the view that extreme events have negligible probability. The well known drawback of the Black-Scholes model is that it cannot account for the negative skewness and the excess kurtosis of asset returns. Since the work of Jackwerth and Rubinstein (1996) which demonstrated the discontinuity in the implied skewness and kurtosis across the divide of the 1987 stock market crash - a large literature has developed, which aims to extract the risk neutral probability density function from traded option prices so that the skewness and fat tail properties of the distribution are better captured than in the case of lognormal models. This paper argues that the use of the Generalized Extreme Value Distribution (GEV) for asset returns provides not just a flexible framework that subsumes as special cases a number of classes of distributions that have been assumed to date in more restrictive settings – but also delivers the market implied tail index for the assets returns. Under the postulation of the GEV distribution in the Risk Neutral Density (RND) function for the asset returns, we obtain an original analytical closed form solution for the Harrison and Pliska (1981) no arbitrage equilibrium price for the European call option. The implied GEV parameters and RND are estimated from traded option prices for the period from 1997 to 2003. The pricing performance of the GEV option pricing model is compared to the benchmark Black-Scholes model and found to be superior at all time horizons and at all levels of moneyness. We explain how the implied tail index extracted from traded put prices are efficacious at identifying the fat tailed behaviour of losses or negative returns and hence of the skew in the left tail of the RND function for the underlying price. The GEV implied RNDs before and after special events such as the Asian Crisis, the LTCM crisis and 9/11 are also analyzed
    Keywords: Risk neutral probability density function; Generalized Extreme Value Distribution; Implied Tail Index.
    JEL: G13 G14
    Date: 2005–11–11
  28. By: Ajit Singh; Jack Glen; Ann Zammitt; Rafael De-Hoyas; Alaka Singh; Bruce Weisse
    Abstract: In 1992 a blue-ribbon group of US economists led by Michael Porter concluded that the US stock market-based corporate model was misallocating resources and jeopardising US competitiveness. The faster growth of US economy since then and the supposed US lead in the spread of information technology has brought new legitimacy to the stock market and the corporate model, which is being hailed as the universal standard. Two main conclusions of the analysis presented here are: (a) there is no warrant for revising the blue-ribbon groupÕs conclusion; and (b) even US corporations let alone developing country ones would be better off not having stock market valuation as a corporate goal.
    Keywords: Shareholder wealth, Information technology, Stock-market efficiency
    JEL: G1 G3
  29. By: Michael G. Kollo (Financial Markets Group, London School of Economics, London, WC2A 2AE, United Kingdom)
    Abstract: We investigate the competitive landscape of underwriting services in the Eurobond market including the choice of underwriter and underwriter gross spread. We find a significant but declining association between the home market of the Eurobond’s currency of denomination and that of the lead underwriter. These bonds underwritten by underwriters ‘local’ to the currency also carry significantly lower underwriter gross spreads vis-à-vis other Eurobonds. The amalgamation of the European currencies into the Euro resulted in a significant shift in the competitive landscape for underwriting services. We find a significant portion of market shares shifted from the ‘local’ European underwriters to non-‘local’ U.S. underwriters with the introduction of the Euro. Moreover, the volume of new issues rose and the gross underwriter spread declined significantly. Our empirical results suggest that Eurozone underwriters responded to the increased entry of U.S. and other Eurozone underwriters with aggressive discounting of the underwriter gross spread.
    Keywords: Underwriter competition; Underwriter spreads; Eurobond market.
    JEL: G15 G24
    Date: 2005–11
  30. By: Neng Wang; Rui Albuquerque (Finance and Economics Columbia Business School)
    Abstract: Corporations in most countries are run by controlling shareholders whose cash flow rights are substantially smaller than their control rights in the firm. This separation of ownership and control allows the controlling shareholders to pursue private benefits at the cost of outside minority investors by diverting resources away from the firm and distorting corporate investment and payout policies. We develop a dynamic stochastic general equilibrium asset pricing model that acknowledges the implications of agency conflicts through imperfect investor protection on security prices. We show that countries with weaker investor protection have more overinvestment, lower market-to-book equity values, larger expected equity returns and return volatility, higher dividend yields, and higher interest rates. These predictions are consistent with empirical findings. We develop new predictions: countries with high investment-capital ratios have both higher variance of GDP growth and higher variance of stock returns. We provide evidence consistent with these hypotheses. Finally, we show that weak investor protection causes significant wealth redistribution from outside shareholders to controlling shareholders
    Keywords: investment, asset pricing, investor protection
    JEL: G12
    Date: 2005–11–11
  31. By: Glaser, Markus (Sonderforschungsbereich 504); Langer, Thomas (Westfälischen Wilhelms-Universität Münster Lehrstuhl für BWL, insbesondere Finanzierung); Reynders, Jens; Weber, Martin (Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre)
    Abstract: In this study, we analyze whether individual expectations of stock returns are influenced by the specific elicitation mode (i.e. whether forecasters have to state future price levels or directly future returns). We thus examine whether there are framing effects in stock market forecasts. We present questionnaire responses of about 250 students from two German universities. Participants were asked to state median forecasts as well as confidence intervals for seven stock market time series. Using a between subject design, one half of the subjects was asked to state future price levels, the other group was directly asked for returns. The main results of our study can be summarized as follows. There is a highly significant framing effect. For upward sloping time series, the return forecasts given by investors who are asked directly for returns are significantly higher than those stated by investors who are asked for prices. For downward sloping time series, the return forecasts given by investors who are asked directly for returns are significantly lower than those stated by investors who are asked for prices. Furthermore, our data shows that subjects underestimate the volatility of stock returns, indicating overconfidence. As a new insight, we find that the strength of the overconfidence effect in stock market forecasts is highly significantly affected by the fact whether subjects provide price or return forecasts. Volatility estimates are lower (and the overconfidence bias is thus stronger) when subjects are asked for returns compared to price forecasts. Moreover, we find that financial education improves answers of subjects. The observed framing effect and the overconfidence bias are less pronounced for subjects with higher financial education.
    Date: 2005–11–03
  32. By: Shafiqur Rahman; M. Shahid Ebrahim
    Abstract: This paper models commodity futures in a rational expectations equilibrium specifically (i) incorporating the conflict of interests between Hedgers (Producers-Consumers) and Speculators and (ii) superimposing constraints to immunize the real sector of the economy from shocks of excessive futures contracting. We extend the framework of Newbery and Stiglitz (1981), Anderson and Danthine (1983) and Britto (1984) to attribute the conflicting and puzzling results in the empirical literature to the presence of multiple equilibria ranked in a pecking order of decreasing pareto-efficiency. Thus, we caution empirical researchers on making inferences on data embedded with moving equilibria, as it can render their analysis of asset pricing mechanism incomprehensible. Finally, we rationalize the imposition of position limits by policy makers to help steer the equilibria to pareto-inferior ones, which make the real sector of the economy more resilient to shocks from the financial sector
    Keywords: Contango, Expectations, Normal Backwardations
    JEL: D58 D74 D91 G12
    Date: 2005–11–11
  33. By: Glaser, Markus (Sonderforschungsbereich 504); Weber, Martin (Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre)
    Abstract: Anecdotal evidence and recent theoretical models argue that past stock returns affect subsequent stock trading volume. We study 3,000 individual investors over a 51 month period to test this prediction using linear panel regressions as well as negative binomial panel regressions and Logit panel regressions. We find that both past market returns as well as past portfolio returns affect trading activity of individual investors (as measured by stock portfolio turnover, the number of stock transactions, and the probability to trade stocks in a given month) and are thus able to confirm predictions of overconfidence models. However, contrary to intuition, the effect of market returns on subsequent trading volume is stronger for the whole group of investors. Using survey data of our investor sample, we present evidence that individual investors, on average, are unable to give a correct estimate of their own past realized stock portfolio performance. The correlation between return estimates and past realized returns is insignificant. For the subgroup of respondents, we are able to analyze the link between the ability to correctly estimate the past realized stock portfolio performance on the one hand and the dependence of trading volume on past returns on the other hand. We find that for the subgroup of investors that is better able to estimate the own past realized stock portfolio performance, the effect of past portfolio returns on trading volume is stronger. We argue that this finding might explain our results concerning the relation between past returns and subsequent trading volume.
    Date: 2005–08–06
  34. By: Virginia Queijo
    Abstract: This paper aims to evaluate the importance of frictions in credit markets for business cycles in the U.S. and the Euro area. For this purpose, I modify the DSGE financial accelerator model developed by Bernanke, Gertler and Gilchrist (1999) and estimate it using Bayesian methods. The model is augmented with frictions such as price indexation to past inflation, sticky wages, consumption habits and variable capital utilization. My results indicate that financial frictions are relevant in both areas. Using the Bayes factor as criterion, the data favors the model with financial frictions both in the U.S. and the Euro area in five different specifications of the model. Moreover, the size of the financial frictions is larger in the Euro area
    Keywords: DSGE models; Bayesian estimation; financial accelerator
    JEL: E3 E4 E5
    Date: 2005–11–11
  35. By: Duc PHAM-HI (Systemes Informations & Finance Ecole Centrale Electronique)
    Abstract: Basel II banking regulation introduces new needs for computational schemes. They involve both optimal stochastic control, and large scale simulations of decision processes of preventing low-frequency high loss-impact events. This paper will first state the problem and present its parameters. It then spells out the equations that represent a rational risk management behavior and link together the variables: Levy processes are used to model operational risk losses, where calibration by historical loss databases is possible ; where it is not the case, qualitative variables such as quality of business environment and internal controls can provide both costs-side and profits-side impacts. Among other control variables are business growth rate, and efficiency of risk mitigation. The economic value of a policy is maximized by resolving the resulting Hamilton-Jacobi-Bellman type equation. Computational complexity arises from embedded interactions between 3 levels: * Programming global optimal dynamic expenditures budget in Basel II context, * Arbitraging between the cost of risk-reduction policies (as measured by organizational qualitative scorecards and insurance buying) and the impact of incurred losses themselves. This implies modeling the efficiency of the process through which forward-looking measures of threats minimization, can actually reduce stochastic losses, * And optimal allocation according to profitability across subsidiaries and business lines. The paper next reviews the different types of approaches that can be envisaged in deriving a sound budgetary policy solution for operational risk management, based on this HJB equation. It is argued that while this complex, high dimensional problem can be resolved by taking some usual simplifications (Galerkin approach, imposing Merton form solutions, viscosity approach, ad hoc utility functions that provide closed form solutions, etc.) , the main interest of this model lies in exploring the scenarios in an adaptive learning framework ( MDP, partially observed MDP, Q-learning, neuro-dynamic programming, greedy algorithm, etc.). This makes more sense from a management point of view, and solutions are more easily communicated to, and accepted by, the operational level staff in banks through the explicit scenarios that can be derived. This kind of approach combines different computational techniques such as POMDP, stochastic control theory and learning algorithms under uncertainty and incomplete information. The paper concludes by presenting the benefits of such a consistent computational approach to managing budgets, as opposed to a policy of operational risk management made up from disconnected expenditures. Such consistency satisfies the qualifying criteria for banks to apply for the AMA (Advanced Measurement Approach) that will allow large economies of regulatory capital charge under Basel II Accord.
    Keywords: REGULAR - Operational risk management, HJB equation, Levy processes, budget optimization, capital allocation
    JEL: G21
    Date: 2005–11–11
  36. By: Charles Engel (University of Wisconsin)
    Abstract: The large recent US current account deficits have been the subject of an enormous amount of study in academia, among government and central bank economists, in business economic reports, and in the press. Many different explanations of the cause of the deficit have been offered, and to varying degrees we believe that all may have played a role: low private saving in the US; large public-sector budget deficits; a ‘glut’ of savings in the rest of world; and, perhaps even a misalignment of nominal exchange rates. In this paper we explore the role of one other factor that also has been mentioned prominently: private saving in the US is low because income growth is expected to be strong. We rework the standard neoclassical two-country model to show how a country will be a net borrower when its future share of world GDP is expected to increase above its current share. Our research ultimately is motivated by the question of whether the US current account is ‘sustainable’. The way we approach the question is to see whether the high level of US spending currently is compatible with an optimal path of borrowing. In particular, what assumptions about expected future growth of the US’s share of world output could justify its current account deficit? We show that if the deficit can be explained by higher future income shares, then the size of the real depreciation, that may otherwise be required to reduce the deficit, may be quite small.
    Keywords: current account adjustment; saving
    JEL: F21 F32 F41
    Date: 2005–11
  37. By: Paolo Surico; Antonello D'Agostino; Luca Sala
    Abstract: The Fed closely monitors the stock market and the stock market continuously forms expectations about the Fed decisions. What does this imply for the relation between the fed funds rate and the S&P500? We find that the answer depends on the conditions prevailing on the financial market. During periods of high (low) volatility in asset price inflation an unexpected 5 fall in the stock market index implies that the Fed cuts the interest rate by 19 ($6$) basis points while an unanticipated policy tightening of 50 basis points causes a 4.7 (2.3) decline in the S&P500. The Fed reaction to asset price return is however statistically different from zero only in the high volatility regime, whereas the fall in asset price return following an interest rate rise is highly significant during normal times only
    Keywords: asset price volatility, nonlinear policy, threshold SVAR, system GMM.
    JEL: E44 E52 E58
    Date: 2005–11–11
  38. By: Michael P. Dooley; David Folkerts-Landau; Peter M. Garber
    Abstract: In this paper we examine the behavior of interest rates and exchange rates following a variety of shocks to the international monetary system. Our analysis suggests that real interest rates in the US and Europe will remain low relative to historical experience for an extended period but converge slowly toward normal levels. During this adjustment interval, the US absorbs a disproportionate share of world savings. After a substantial initial appreciation of floating currencies relative to the dollar, the dollar and other floating currencies remain constant relative to each other. An improvement in the investment climate in Europe during the adjustment period would generate an immediate depreciation of the euro relative to the dollar. In real terms, the dollar and the floating currencies will eventually have to depreciate relative to the managed currencies. But most of the adjustment in the US trade account will come as US absorption responds to increases in real interest rates.
    JEL: F02 F32 F33
    Date: 2005–11
  39. By: Marius Jurgilas (Economics University of Connecticut)
    Abstract: This paper studies the liquidity effect in the environment of a currency board. Under such an environment, the endogeneity issue common to other monetary regimes does not arise, thereby allowing for a straightforward analysis. Using daily data from the interbank market in Lithuania, we estimate the liquidity effect and show that, contrarily to the existent literature, overnight interest rates tend to fall at the end of reserve holding period while being higher at the beginning. Thus the martingale hypothesis of the interest rates is rejected. It is also shown that banks do not utilize aggregate liquidity information provided by the Central Bank of Lithuania due to the structural impediments of the market
    Keywords: interbank market, liquidity effect, currency board, Lithuania
    JEL: E52 E58
    Date: 2005–11–11
  40. By: Luigi Benfratello (Università di Torino); Fabio Schiantarelli (Boston College); Alessandro Sembenelli (Università di Torino)
    Abstract: This paper contains a detailed empirical investigation of the effect of local banking development on firms' innovative activities, using a rich data set on innovation at the firm level for a large number of Italian firms over the 90's. There is evidence that banking development affects the probability of process innovation, particularly for small firms and for firms in high(er) tech sectors and in sectors more dependent upon external finance. There is also some evidence that banking development reduces the cash flow sensitivity of fixed investment spending, particularly for small firms, and that it increases the probability they will engage in R&D.
    Keywords: Banks, Financial Development, Innovation, R&D, Investment
    JEL: D24 G21 G38
    Date: 2005–10–30
  41. By: Eva de Francisco (Macroanalysis CBO)
    Abstract: This paper examines theoretically, using a two-country real-business-cycle model, the effects of capital-market liberalization when there is limited participation in national financial markets. It is assumed that workers cannot smooth consumption as well as do stockholders, and therefore, liberalization may hurt workers. This dynamic model evaluates some claims---made particularly by the "anti-globalization" movement---that capital movements hurt workers, while benefitting stockholders. Quantitatively, liberalization makes workers better off in the long run, since the new capital allocation and increased insurance foster capital accumulation, raising wages that offset the output fluctuations due to capital flows. However, transitional effects may overturn these long-run benefits
    Keywords: Capital Account Liberalization, Globalization and Limited Participation
    JEL: E20 F20 F30
    Date: 2005–11–11
  42. By: Matt Pritsker
    Abstract: I present a fully-rational symmetric-information model of an IPO, as well as a dynamic imperfectly competitive model of the aftermarket trading that follows. The model helps explain why IPO share allocations favor large institutional investors. It also helps to explain IPO underpricing, and underperformance, and the large fees charged by underwriters. The critical assumption in the model is that underwriters need to sell a fixed number of shares at the IPO or soon thereafter in the aftermarket, but they want to avoid selling in the aftermarket because there are some aftermarket investors who have market power and can affect the prices received by the underwriter. To maximize revenue and avoid unnecessary aftermarket sales, the underwriter distorts share allocations toward those those investors who have market power, and he sets the offer price at the IPO below the aftermarket price that will prevail shortly after the IPO. In the aftermarket model, I show that there are share allocations that can generate arbitrarily high levels of return underperformance for very long periods of time. In some simulations, the distorted share allocations at the IPO generate return underperformance that persists for more than one year. The underwriter can dilute investor's market power by participating for longer periods of time in the aftermarket. By doing so, he sometimes substantially increase the revenue that is raised by the IPO issuer
    Keywords: IPO, Asset Pricing, Market Microstructure, Liquidity
    JEL: G12
    Date: 2005–11–11
  43. By: basab dasgupta (economics university of connecticut)
    Abstract: Credit markets with asymmetric information often prefer credit rationing as a profit maximizing device. This paper asks whether the presence of informal credit markets reduces the cost of credit rationing, that is, whether it can alleviate the impact of asymmetric information based on the available information. We used a dynamic general equilibrium model with heterogenous agents to assess this. Using Indian credit market data our study shows that the presence of informal credit market can reduce the cost of credit rationing by separating high risk firms from the low risk firms in the informal market. But even after this improvement, the steady state capital accumulation is still much lower as compared to incentive based market clearing rates. Through self revelation of each firm's type, based on the incentive mechanism, banks can diversify their risk by achieving a separating equilibrium in the loan market. Incentive mechanism helps banks to increase capital accumulation in the long run by charging lower rates and lending relatively higher amount to the less risky firms. Another important finding of this study is that self revelation leads to very significant welfare improvement, as measured by consumption equivalence
    Keywords: informal credit and capital accumulation
    JEL: O16 O17
    Date: 2005–11–11
  44. By: James Stodder
    Abstract: Centralized exchange has a worst-case size-complexity many orders of magnitude lower than decentralized monetary exchange for the same number of agents and goods. A more rapid approach to competitive equilibrium may therefore be possible through centralized exchange. An additional benefit of centralized exchanges is macroeconomic stability: their volume of financial activity can be shown to vary inversely with the business cycle. This counter-cyclical tendency is shown by error-correction models, based on twenty-five years of data from a US exchange (the International Reciprocal Trade Association) and fifty-five years of data from a Swiss bank (WIR). This combination of computational efficiency and counter-cyclical activity suggests that the forms of exchange and credit enabled by these centralized exchanges may promote both microeconomic efficiency and macroeconomic stability. The financial activities of such exchanges, therefore, can complement a central bank’s monetary policy, although they do diminish its direct control of the money supply itself.
    Keywords: size-complexity, centralized exchange, countercyclical policy
    JEL: D83 E52 G14
    Date: 2005–11–11
  45. By: Jiali Liao; Theodore V. Theodosopoulos
    Abstract: Collateral is one of the most important and widespread credit risk mitigation techniques used by practitioners. This paper studies the effect of mark-to-market (MTM) timing in collateral agreements on the contingent credit risk exposure. We measure contingent credit risk exposure using Potential Future Exposure (PFE), the maximum amount of exposure expected to occur at a specified confidence during the remaining duration of the underlying contract. The parameters of a collateral agreement that can affect the contingent credit risk exposure include the frequency and timing of marking-to-market, trigger level for margin calls and the level of collateralization. However, these decisions are often made in an ad-hoc manner, without reference to an analytical framework. While the frequency of mark-to-market and collateral level has been studied, very little academic research has addressed the quantitative analysis of mark-to-market timing. The goal of this research is to fill this theoretical gap and propose a framework for optimizing the timing of mark-to-market in collateral agreements to minimize potential future exposure. Our framework computes the probability of maximum risk exposure of the underlying contract above a specified level during its remaining time until maturity using one or two MTMs whose timing is decided simultaneously at the contract initiation, or in a sequential manner. This probability is expressed as a function of the parameters of the underlying contract which is assumed to follow a Brownian motion and the decision variables in collateralization, including initial margin, trigger level and variation margin. Numerical examples are investigated with different values of volatility and duration of the underlying contract. Sensitivity analysis and numerical results reveal the optimal timing of MTM that minimizes PFE. Simulations are used to test preliminary conclusions from numerical analysis
    Keywords: Mark-to-Market. Potential Future Exposure, Contingent Credit Risk
    JEL: C69
    Date: 2005–11–11
  46. By: Arup Daripa (Birkbeck College, London University); Simone Varotto (ICMA Centre, University of Reading)
    Abstract: The current debate on the new Basel Accord gives rise to a natural question about the appropriate form of capital regulation.We construct a simple framework to analyze this issue. In our model the risk carried by a bank as well as managerial risk preference are a bank's private information. We show that ex ante constraints waste the superior risk information of a bank, while an ex post regime makes full use of it. However, the latter is more vulnerable to the problem of unknown managerial risk-aversion. The results imply that the two regimes are complements, rather than substitutes. Further, under plausible conditions, an ex post regime emerges as the dominant element of the optimal combination. We use the results to shed light on current policy concerns. In particular, our results provides theoretical underpinning for the inclusion of pillar 2 alongside pillar 1 in Basel II.
    Keywords: Ex Ante Regulation, Ex Post Regulation, Asymmetric Information, Safety Loss, Overprotection Loss, Safety Bias, Basel II.
    JEL: G28 D82 L51
    Date: 2005–11–17
  47. By: Daniela Fabbri (Université de Lausanne); Anna Maria Cristina Menichini (University of Salerno, CELPE and CSEF)
    Abstract: We study a general equilibrium model where agents’ preferences, productivity and labor endowments depend on their health status, and occupational choices affect individual health distributions. Efficiency typically requires agents of the same type to obtain different expected utilities if assigned to di¤erent occupations. Under mild assumptions, workers with riskier jobs must get higher expected utilities if health a¤ects production capabilities. The same holds if health affects preferences and health enhancing consumption activities are sufficiently effective, so that income and health are substitutes. The converse obtains when health a¤ects preferences, but health enhancing consumption activities are not very effective, and hence income and health are complements. Competitive equilibria are first-best if lottery contracts are enforceable, but typically not if only assets with deterministic payoffs are traded. Compensating wage differentials which equalize the utilities of workers in different jobs are incompatible with ex-ante efficiency. Finally, absent asymmetric information, there exist deterministic cross-jobs transfers leading to ex-ante efficiency.
    Keywords: Creditor Rights, Trade Credit, Banking Credit, Financial Constraints, Asset Tangibilityy
    JEL: G32
    Date: 2005–11–01
  48. By: Arup Daripa (Birkbeck College)
    Abstract: A repo auction is a multi-unit common value auction in which bidders submit demand functions. Such auctions are used by the Bundesbank as well as the European Central Bank as the principal instrument for implementing monetary policy. In this paper, we analyze a repo auction with a uniform pricing rule. We show that under a uniform pricing rule, the usual intuition about the value of exclusive information can be violated, and implies free riding by uninformed bidders on the information of the informed bidders, lowering payoff of the latter. Further, free riding can distort the information content of auction prices, in turn distorting the policy signals, hindering the conduct of monetary policy. The results agree with evidence from repo auctions, and clarifies the reason behind the Bundesbank's decision to switch away from the uniform price format. Our results also shed some light on the rationale behind the contrasting switch to the uniform price format in US Treasury auctions.
    Keywords: Repo auction, Informational Free Riding, Monetary Policy Signals
    JEL: D44 E50
    Date: 2005–11–17
  49. By: Eymen Errais (Managment Science and Engineering Stanford University); Fabio Mercurio
    Abstract: We introduce a simple extension of a shifted geometric Brownian motion for modelling forward LIBOR rates under their canonical measures. The extension is based on a parameter uncertainty modelled through a random variable whose value is drawn at an in¯nitesimal time after zero. The shift in the proposed model captures the skew commonly seen in the cap market, whereas the uncertain volatility component allows us to obtain more symmetric implied volatility structures. We show how this model can be calibrated to cap prices. We also propose an analytical approximated formula to price swaptions from the cap calibrated model. Finally, we build the bridge between caps and swaptions market by calibrating the correlation structure to swaption prices, and analysing some implications of the calibrated model parameters
    Keywords: Libor Models, Volatility Skew, Interest Rate Derivatives
    JEL: C6 G12
    Date: 2005–11–11
  50. By: Pasquale Lucio Scandizzo (University of Rome II)
    Abstract: Financing technology poses a special challenge to economic institutions for several reasons. First, the uncertainty surrounding all the investment decisions is particularly acute and pervasive in the case of R&D, as well as developing and testing process and product innovation. Second, while the banks appear to have an important role to play, for many types of innovative businesses, they cannot be the sole source of financing. Third, technology ventures appear to face a basic trade off between profit and growth, which may be exacerbated by a difficult relationship with a credit institution. The paper examines these questions both theoretically and empirically, focusing on the US market as the leading financial center capable of providing imaginative solutions and on the Arab countries as a case study of developing economies facing a financial and institutional constraints.
    Keywords: Innovation, finance; growth, new economy, risk evaluation, credit supply, Arab countries, government policies, science and technology parks
    Date: 2004–01–16
  51. By: Alfredo Ibáñez
    Abstract: Consider a non-spanned security C_{T} in an incomplete market. We study the risk/return trade-offs generated if this security is sold for an arbitrage-free price C₀ and then hedged. We consider recursive "one-period optimal" self-financing hedging strategies, a simple but tractable criterion. For continuous trading, diffusion processes, the one-period minimum variance portfolio is optimal. Let C₀(0) be its price. Self-financing implies that the residual risk is equal to the sum of the one-period orthogonal hedging errors, ∑_{t≤T}Y_{t}(0)e^{r(T-t)}. To compensate the residual risk, a risk premium y_{t}Δt is associated with every Y_{t}. Now let C₀(y) be the price of the hedging portfolio, and ∑_{t≤T}(Y_{t}(y)+y_{t}Δt)e^{r(T-t)} is the total residual risk. Although not the same, the one-period hedging errors Y_{t}(0) and Y_{t}(y) are orthogonal to the trading assets, and are perfectly correlated. This implies that the spanned option payoff does not depend on y. Let C₀=C₀(y). A main result follows. Any arbitrage-free price, C₀, is just the price of a hedging portfolio (such as in a complete market), C₀(0), plus a premium, C₀-C₀(0). That is, C₀(0) is the price of the option's payoff which can be spanned, and C₀-C₀(0) is the premium associated with the option's payoff which cannot be spanned (and yields a contingent risk premium of ∑y_{t}Δte^{r(T-t)} at maturity). We study other applications of option-pricing theory as well
    Keywords: Option Pricing; Incomplete Markets
    JEL: G13
    Date: 2005–11–11
  52. By: Willi Semmler; Lars Grüne (Economics New School University)
    Abstract: Using standard preferences for asset pricing has not been very successful to match asset price characteristics such as the risk-free interest rate, equity premium and the Sharpe ratio to time series data. Behavioral finance has recently proposed more realistic preferences such as preferences with loss aversion to model asset pricing. Research has now started to explore the implications of behaviorally founded preferences for asset price characteristics. Yet the solution to those models is intricate and depends on the solution techniques employed. In this paper a stochastic version of a dynamic programming method with adaptive grid scheme is applied to compute the above mentioned asset price characteristics of a model with loss aversion in preferences. Since, as shown in Grüne and Semmler (2004), our method produces only negligible errors it is suitable to be used as solution technique for such models with more intricate decision structure.
    Keywords: asset pricing, preferences with loss aversion, behavioral finance, equity premium, dynamic programming
    JEL: G1 G12
    Date: 2005–11–11
  53. By: Mohammad R. Rahman; Ruppa K. Thulasiram (Computer Science University of Manitoba); Parimala Thulasiraman
    Abstract: The sine and cosine functions used as the bases in Fourier analysis are very smooth (infinitely differentiable) and very broad (nonzero almost everywhere on the real line), and hence they are not effective for representing functions that change abruptly (jumps) or have highly localized support (diffusive). In response to this shortcoming, there has been intense interest in recent years in a new type of basis functions called wavelets. A given wavelet basis is generated from a single function, called a mother wavelet or scaling function, by dilation and translation. By replicating the mother wavelet at many different scales, it is possible to mimic the behavior of any function; this property of wavelets is called multiresolution. Wavelet is a powerful integral transform technique for studying many problems including financial derivatives such as options. Moreover, the approximation error is much smaller than that of the truncated Fourier expansion. Therefore, one can get better approximation of a function at jump discontinuity with the use of wavelet expansion rather than Fourier expansion. In the current study, we employ wavelet analysis to option pricing problem manifested as partial differential equation (PDE) with jump characteristics. We have used wavelets to develop an optimum finite differencing of the differential equations manifested by complex financial models. In particular, we apply wavelet optimized finite-difference (WOFD) technique on the partial differential equation. We describe how Lagrangian polynomial is used to approximate the partial derivatives on an irregular grid. We then describe how to determine sparse and dense grid with wavelets. Further work on implementation is going on.
    Keywords: options; wavelets; jump-diffusion; finite-difference;
    JEL: C
    Date: 2005–11–11
  54. By: Oleksandr Zhylyevskyy
    Abstract: Theoretical research on option valuation tends to focus on pricing the plain-vanilla European-style derivatives. Duffie, Pan, and Singleton (Econometrica, 2000) have recently developed a general transform method to determine the value of European options for a broad class of the underlying price dynamics. Contrastingly, no universal and analytically attractive approach to pricing of American-style derivatives is yet available. When the underlying price follows simple dynamics, literature suggests using finite difference methods. Simulation methods are often applied in more complicated cases. This paper addresses the valuation of American-style derivatives when the price of an underlying asset follows the Heston model dynamics (Rev.Fin.S., 1993). The model belongs to the class of stochastic volatility models, which have been proposed in the hope of remedying the strike-price biases of the Black–Scholes formula. Option values are obtained by a variant of the Geske–Johnson scheme (JF, 1984), which has been devised in the context of the Black–Scholes model. The scheme exploits the fact that an American option is the limit of a sequence of “Bermudan†derivatives. The latter ones can be priced recursively according to a simple formula, and iterations start from valuing a corresponding European-style security. To implement the recursion, one needs to obtain the expected value of “Bermudan†prices in the joint measure of the state variables of the model. Since the joint density must be, in turn, recovered by inverting the joint characteristic function, an unmodified Geske–Johnson algorithm implies a computationally unfeasible multiple integration. To drastically reduce the cost of numerical integration, I suggest applying a kernel-smoothed bivariate fast Fourier transformation to obtain the density function. Numerical accuracy of the method is assessed by predicting option prices of the S&P 100 index options
    Keywords: American-style option, stochastic volatility model, Geske–Johnson scheme, characteristic function inversion, fast Fourier transform
    JEL: G13
    Date: 2005–11–11
  55. By: Frode Brevik (St. Gallen University); Stefano d'Addona (University of Rome III & Columbia Business School)
    Abstract: Building on Veronesi (2000), we investigate the relationship between the quality of information on the state of the economy and equity risk premium. We show how his results stems from the strict relationship between investors' elasticity of intertemporal substitution and their degree of risk aversion embedded in a power utility function. By extending Veronesi's setting, allowing the investors to have a more general recursive utility function, we show how his result is a special case and that, for realistic model parameters, it is reversed.
    JEL: G
    Date: 2005–11–16

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NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.