nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒01‒23
twelve papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Stress Testing the Czech Banking System: Where Are We? Where Are We Going? By Martin Cihak; Jaroslav Hermanek
  2. Dependence Structure and Portfolio Diversification on Central European Stock Markets By Filip Žikeš
  3. The Nontradable Share Reform in the Chinese Stock Market By Bernardo Bortolotti; Andrea Beltratti
  4. Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold By Dirk G. Baur; Brian M. Lucey
  5. Multivariate ARCH with spatial effects for stock sector and size By Caporin Massimiliano; Paruolo Paolo
  6. Structural breaks in the interest rate pass-through and the euro. A cross-country study in the euro area and the UK By Giuseppe Marotta
  7. Do U.S. Firms Have the Best Corporate Governance? A Cross-Country Examination of the Relation between Corporate Governance and Shareholder Wealth By Reena Aggarwal; Isil Erel; Rene M. Stulz; Rohan Williamson
  8. Why are Buyouts Levered: The Financial Structure of Private Equity Funds By Ulf Axelson; Per Stromberg; Michael S. Weisbach
  9. Spot and forward interest rates: Why practically homogeneous bonds of different maturities have different interest rates? By Govori, Fadil
  10. Fixed-income instrument pricing. By ilya, gikhman
  11. The term structure and risk structure of interest rates By Govori, Fadil
  12. Some critical comments on credit risk modeling. By ilya, gikhman

  1. By: Martin Cihak; Jaroslav Hermanek
    Abstract: This note summarizes the various outputs from the CNB research project Stress Testing for Banking Supervision. Previous research notes in this project presented the key stress testing concepts and discussed the design of stress tests in general terms. Since then, the project has generated outputs that were presented, for example, in the CNB's first Financial Stability Report. The note describes the current status of the project by presenting the latest stress test results and by comparing the methodology of these tests with those presented by other central banks. Finally, the note suggests further steps to improve the stress testing program at the CNB, such as strengthening credit risk modeling, including by engaging commercial banks in the exercise. The note is accompanied by an appendix presenting one of the project's outputs, namely a survey of stress testing practices in commercial banks.
    Keywords: Banking system, stress tests
    JEL: G21 G28 E44
    Date: 2005–02
  2. By: Filip Žikeš (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic)
    Abstract: This paper studies the dependence structure on Central European, German and UK stock markets within the framework of a semiparametric copula model for weekly stock index return pairs. Although the linear correlation is much lower, we find similar degree of lower tail dependence as between returns on stocks indices representing developed markets. We show in a simulation exercise that the implications of the estimated nonlinear dependencies for portfolio selection and risk management may be not only statisticaly but also economicaly important.
    Keywords: dependence structure; tail dependence; portfolio selection; risk measures
    JEL: G11 G15 C46
    Date: 2007–01
  3. By: Bernardo Bortolotti (University of Torino and Fondazione Eni Enrico Mattei); Andrea Beltratti (Bocconi University)
    Abstract: Nontradable shares (NTS) are an unparalleled feature of the ownership structure of Chinese listed companies and represented a major hurdle to domestic financial market development. After some failed attempts, in 2005 the Chinese authorities have launched a structural reform program aiming at eliminating NTS. In this paper, we evaluate the stock price effects of the actual implementation of this reform in 368 firms. The NTS reform generated a statistically significant 8 percent positive abnormal return over the event window, adjusting prices for the compensation requested by tradable shareholders. Results are consistent with the expectation of improved economic fundamentals such as better corporate governance and enhanced liquidity.
    Keywords: Chinese Equity Market, Financial Market Development, Split-Share Structure
    JEL: G14 G28 G32
    Date: 2006–11
  4. By: Dirk G. Baur; Brian M. Lucey
    Abstract: This paper addresses two questions. First, we investigate whether gold is a hedge against stocks and/or bonds and second, we investigate whether gold is a safe haven for investors if either stocks or bonds fall. A safe haven is defined as a security that loses none of its value in case of a market crash. This is counterpoised against a hedge, defined as a security that does not co-move with stocks or bonds on average. We study constant and time-varying relationships between stocks, bonds and gold in order to investigate the existence of a hedge and a safe haven. The empirical analysis examines US, UK and German stock and bond prices and returns and their relationship with the Gold price. We find that (i) Gold is a hedge against stocks, (ii) Gold is a safe haven in extreme stock market conditions and (iii) Gold is a safe haven for stocks only for 15 trading days after an extreme shock occurred.
    Keywords: Safe haven, gold, stock-bond correlation, flight-to-quality
    Date: 2007–01–17
  5. By: Caporin Massimiliano (Department of Economics, University of Padova, Italy); Paruolo Paolo (Department of Economics, University of Insubria, Italy)
    Abstract: This paper applies a new spatial approach for the specfication of multivariate GARCH models, called Spatial Effects in ARCH, SEARCH. We consider spatial dependence associated with industrial sectors and capitalization size. This parametrization extends current feasible specifications for large scale GARCH models, keeping the numbers of parameters linear as a function of the number of assets. An application to daily returns on 150 stocks from the NYSE for the period January 1994 to June 2001 shows the benefits of the present specification when compared to alternative specifications.
    Keywords: Spatial models, GARCH, Volatility, Large scale models, Portfolio allocation.
    JEL: C32 C51 C52
    Date: 2005–12
  6. By: Giuseppe Marotta
    Abstract: We search for multiple unknown structural breaks in the short term business lending rate pass-through in euro countries, possibly associated with the introduction of the single currency. One break is detected in five EMU countries, two are found in other four, and in the UK as well. The last break occurs much before the event for France, several quarters later for Austria, Germany, Italy and Portugal, and the UK, hinting at best at a loose link with the inception of EMU. Long run pass-throughs decrease (except for France), becoming even more incomplete (except for the Netherlands and the UK); though the adjustment to equilibrium has become faster, cross-country heterogeneity in the euro area has barely changed. An incomplete lending rate pass-through, even in the long run, for the least sticky bank rate and the persistence of cross-country heterogeneity make tougher for the ECB to realize an effective area-wide monetary policy.
    Keywords: Interest rates; Monetary policy; Economic and Monetary Union (EMU); Cointegration analysis; Structural breaks
    JEL: E43 E52 E58 F36
    Date: 2006–12
  7. By: Reena Aggarwal; Isil Erel; Rene M. Stulz; Rohan Williamson
    Abstract: We compare the governance of foreign firms to the governance of similar U.S. firms. Using an index of firm governance attributes, we find that, on average, foreign firms have worse governance than matching U.S. firms. Roughly 8% of foreign firms have better governance than comparable U.S. firms. The majority of these firms are either in the U.K. or in Canada. When we define a firm's governance gap as the difference between the quality of its governance and the governance of a comparable U.S. firm, we find that the value of foreign firms increases with the governance gap. This result suggests that firms are rewarded by the markets for having better governance than their U.S. peers. It is therefore not the case that foreign firms are better off simply mimicking the governance of comparable U.S. firms. Among the individual governance attributes considered, we find that firms with board and audit committee independence are valued more. In contrast, other attributes, such as the separation of the chairman of the board and of the CEO functions, do not appear to be associated with higher shareholder wealth.
    JEL: G30 G32 G34 G38 K22
    Date: 2007–01
  8. By: Ulf Axelson; Per Stromberg; Michael S. Weisbach
    Abstract: This paper presents a model of the financial structure of private equity firms. In the model, the general partner of the firm encounters a sequence of deals over time where the exact quality of each deal cannot be credibly communicated to investors. We show that the optimal financing arrangement is consistent with a number of characteristics of the private equity industry. First, the firm should be financed by a combination of fund capital raised before deals are encountered, and capital that is raised to finance a specific deal. Second, the fund investors' claim on fund cash flow is a combination of debt and levered equity, while the general partner receives a claim similar to the carry contracts received by real-world practitioners. Third, the fund will be set up in a manner similar to that observed in practice, with investments pooled within a fund, decision rights over investments held by the general partner, and limits set in partnership agreements on the size of particular investments. Fourth, the model suggests that incentives will lead to overinvestment in good states of the world and underinvestment in bad states, so that the natural industry cycles will be multiplied. Fifth, investments made in recessions will on average outperform investments made in booms.
    JEL: G31 G32
    Date: 2007–01
  9. By: Govori, Fadil
    Abstract: The term structure of interest rates is a widely discussed topic in the economic literature. One of the main questions in these discussions is why practically homogeneous bonds of different maturities have different interest rates. The discussion of present value and interest rates assumes an abstract world of frictionless (or perfect) financial markets. In practice, markets are not frictionless, that is, there are no perfect financial markets. However, frictionless markets are a necessary starting point. Borrowers are faced with the choice to borrow short-term or long-term. Short-term borrowing runs the risk of refinancing at higher interest rates. Long-term borrowing runs the risk of locking-in a higher interest rate. In an unrestricted shortsale, the shortseller can use the proceeds from the sale. In practice, most shortsellers are not able to use the proceeds because of the possibility of a shortseller absconding with the funds. In addition, shortsellers usually have to post collateral to guarantee against default. Because of the time value of money, one euro received at a future date has a present value of less than one euro. The pattern of spot interest rates for different maturities is called the term structure of interest rates. One possible term structure pattern is for all spot interest rates to be the same; this is called a flat term structure. If the spot interest rates increase with maturity, the term structure is rising. Rising term structures are the most common pattern in practice; longer maturity interest rates are typically higher than short maturity interest rates. Spot interest rates decreasing with maturity are called a declining (or inverted) term structure. One of the most important concepts in finance is the concept of arbitrage, also called the law of one price. In frictionless markets, the same asset must have one price at a particular instant in time, no matter where it is traded. The arbitrage operations drive prices toward their equilibrium values. That is, purchase of one-period bond by the arbitrager drives its price up; sale of the two-period bond forces its price down. Arbitrage provides the fundamental link between the spot and forward markets. Arbitrage forces a precise relationship between forward and spot rates of interest. Forward transactions involve a contract signed in the present to do something in the future. The parties agree right now to exchange securities in the future at a price agreed upon right now. If securities are exchanged in the forward market, the buyer, called the long, contracts right now to purchase the bond at some future date, called the delivery date, at a specified price. Futures markets are very similar to forward markets.
    Keywords: Interest Rates; Spot Interest Rates; Forward Interest Rates; Term Structure of the Interest Rates; Maturity Structure of the Interest Rates
    JEL: G31 G11 G12 G10 G14 G13
    Date: 2007–01
  10. By: ilya, gikhman
    Abstract: In this article we discuss the fundamentals of pricing of the popular financial instruments. The basic point of our approach is to extend the present value benchmark concept. The present value valuation approach plays the similar role as The Newton Laws in the Classic Mechanics. Thus our primary goal is to present a new outlook on valuation of the debt securities and its derivatives. We also, demonstrate why the present value is not a complete method of pricing either securities or derivatives. Then, as illustration we present a valuation of the floating rate, callable and convertible bonds. Next we discuss major drawbacks of the risk neutral interpretation of the derivatives pricing. At the end of the article we discuss interest rate swap and derivative valuation of some classes of the fixed income securities.
    Keywords: Bond; coupon bond; present value; floating rate bond; convertible; callable bond; interest rate swap; options valuation; risk neutral probabilities; interest rate derivatives.
    JEL: G12
    Date: 2006–10
  11. By: Govori, Fadil
    Abstract: The relationship that exists at a given point in time between the length of time to maturity and the yield on a security is known as the term structure of interest rates. Another important factor that also has significant bearing impact on both nominal and real interest rates of a financial instrument is its default risk, that is, the risk that the lender may not recover the original principal. Both nominal and real interest rates differ by maturity, or term. A schedule of spot interest rates by maturity is called the term structure of interest rates. The term structure can be rising, flat, declining, or humped. The yield curve: a set of points plotted corresponding to the yields existing on a given day on various maturities of a particular type of instrument. A yield curve shows the relationship between interest rates and maturity for coupon-bearing bonds. Historically, upward-sloping, or ascending, yield curves have been much more common than downward-sloping, or descending, patterns. Downward-sloping yield curves have occurred at the end of the expansion phase of business cycle. To answer what determines the shape of the yield curve, we must examine four different theories of the term structure of interest rates. All these theories seek to account for the shape of the yield curve at any point in time and for changes in its shape over time. Term structure theories include the segmented markets theory, the increasing liquidity premium theory, the preferred habitat theory, the money substitute theory, and the pure expectations theory. There are enormous numbers of securities on which the interest rates can and differ. The relationship among these interest rates is called the risk structure of interest rates. A default risk is a failure to meet the terms of a contractual agreement in full amount. In the case of a debt instrument such as a bond, default may refer to the borrower’s failure to make the full interest payment as agreed or to the failure to redeem the bond at face value at maturity. The spread between the interest rates on bonds with default risk and default-free bonds, is called the risk premium, and indicates how much additional interest bond buyer must earn in order to be willing to hold a risky bond. U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes or even print money to pay off its obligations. Bonds like these with no default risk are called default-free bonds. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. For this reason there exist many investment advisory firms, that provide default risk information by rating the quality of corporate and municipal bonds in terms of the probability of default.
    Keywords: Interest Rates; Term Structure of Interest Rates; Risk Structure of Interest Rates; Yield to Maturity; Yield Curve; Term Structure Theories
    JEL: G0 G11 G24 G12 G32 G14 G13 G15
    Date: 2007–01
  12. By: ilya, gikhman
    Abstract: In this notice we are comment popular approaches to the credit risk modeling.
    Keywords: Credit risk; credit derivatives; risk neutral world; risk neutral probability; structural model; reduced form.
    JEL: G12 G13 C63 C6
    Date: 2006–07

This nep-fmk issue is ©2007 by Kwang Soo Cheong. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
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