nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒02‒10
nine papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Information Loss in Volatility Measurement with Flat Price Trading By Phillips C.B. Peter; Jun Yu
  2. Term Structure Modeling for Pension Funds:What to do in Practice? By Peter Vlaar
  3. Interest Rates: The Behavior, the Term Structure, and the Risk Structure By Govori, Fadil
  4. A Yield Curve Perspective on Uncovered Interest Parity By Leo Krippner
  5. The effect of lenders’ credit risk transfer activities on borrowing firms’ equity returns By Marsh , Ian W
  6. The Demand for Treasury Debt By Arvind Krishnamurthy; Annette Vissing-Jorgensen
  7. Liquidity and Risk Management By Nicolae B. Garleanu; Lasse H. Pedersen
  8. Asymmetric Information and Dividends Payment at Bovespa By Iquiapaza, Robert; Lamounier, Wagner; Amaral, Hudson
  9. Volatility Spillover Between the Stock Market and the Foreign Exchange Market in Pakistan By Qayyum, Abdul; Kemal, A. R.

  1. By: Phillips C.B. Peter; Jun Yu
    Date: 2007–01–26
  2. By: Peter Vlaar
    Abstract: With the increased emphasis on market valuation in accounting rules and solvency regulation, the proper modeling of interest rate dynamics has become increasingly important for pension funds. A number of pension fund characteristics make these models particularly demanding. First, as the obligations of pension funds stretch far into the future, the model should be reasonable both for short rates and very long term rates. Second, as the value of liabilities increases enormously if interest rates approach zero, especially the probability of very low rates should be modeled correctly. Third, as pension rights are usually indexed, the interaction between interest rates and inflation should be addressed. Fourth, in order to allow for long term analysis, the simulation results should preferably be stationary. Fifth, account has to be taken to possible structural breaks in the inflation and interest rate dynamics, if only to comply with maximum return assumptions of supervisors. In this paper we present a new affine discrete-time, three-factor model of the term structure of interest rates that meets these criteria. The factors are the short term rate, expected inflation and stochastic risk aversion. The model is applied to an unbalanced panel of German/euro area zero-coupon yields for maturities of one to sixty years, and estimated using the extended Kalman filter.
    Keywords: Discrete time; no-arbitrage; expected inflation; stochastic risk aversion; stochastic volatility; generalized essentially a_ne model.
    JEL: G13
    Date: 2007–01
  3. By: Govori, Fadil
    Abstract: From the financial markets point of view the interest rate can be considered as the price of money. This makes the interest rate a very important instrument for efficient financial markets performance and a vital tool of the government's economic management. The control of interest rates is passed over to the Central Bank. There are many different interest rates. Interest rates will vary according to the amount of time money is tied up for and the riskiness of the investment. The actual interest rate will depend on a number of factors. These include: The length of time for which the money is borrowed (or saved); the security of the loan (or investment); the nature of the financial institution the money is borrowed from (or lent to); the amount of competition between financial institutions Monetary policy and the alteration of interest rates are important tool in the government's economic management. When the Central Bank feels that inflationary pressures are rising in the economy then it increases the rate of interest to dampen down the growth of aggregate demand. Demand falls when interest rates are raised through their effect on the components of aggregate demand. Consumption will fall when interest rates are raised. The rise in interest rates will therefore reduce the level of investment. The amount investment falls by depends on the interest elasticity of demand for investment. Changes in interest rates affects on different aspects of the economy (growth, prices, employment, spending, etc.). That is the interest rate transmission mechanism: One of the peculiarities of the money market is its way of quoting interest rates. Some money market instruments (Treasury bills, commercial paper, and bankers’ acceptances) are quoted on a discount basis. Other rates (fed funds, Federal Reserve discount rate, and repo rates) are quoted on an add-on basis. Each of these rates is different from the yield to maturity, the rate generally used for comparing coupon-bearing bonds. There are at least five different money market rates: The discount rate, the add-on rate, the bond equivalent yield, and the semiannual and annual yields to maturity. 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. Bonds and other debt instruments have varying degrees of default risk, and the yields on these instruments reflect the market’s assessment of this default risk. The relationship among these interest rates is called the risk structure of interest rates.
    Keywords: Interest Rates; Behavior of Interest Rate; Term Structure; Risk Structure
    JEL: E51 G13 E52 E44 E58 E43 E41 G12
    Date: 2007–01
  4. By: Leo Krippner (AMP Capital Investors and University of Waikato)
    Abstract: This article uses a dynamic multi-factor model of the yield curve with a rational-expectations, general-equilibrium-economy foundation to investigate the uncovered interest parity hypothesis(UIPH). The yield curve model is used to decompose the interest rate data used in the UIPH regressions into components that reflect rationally-based expectations of the cyclical and fundamental components of the underlying economy. The UIPH is not rejected based on the fundamental components of interest rates, but is soundly rejected based on the cyclical components. These results provide empirical support for suggestions in the existing theoretical literature that rationally-based interest rate and exchange rate dynamics associated with cyclical inter-linkages between the economy and financial markets may contribute materially to the UIPH puzzle.
    Keywords: uncovered interest parity; forward rate unbiasedness hypothesis; yield curve; term structure of interest rates; ANS model; Nelson and Siegel model
    JEL: E43 F31
    Date: 2006–12–21
  5. By: Marsh , Ian W (Cass Business School, London, and Bank of Finland)
    Abstract: Although innovative credit risk transfer techniques help to allocate risk more optimally, policymakers worry that they may detrimentally affect the effort spent by financial intermediaries in screening and mo-nitoring credit exposures. This paper examines the equity market’s response to loan announcements. In common with the literature it reports a significantly positive average excess return – the well known ‘bank certification’ effect. However, if the lending bank is known to actively manage its credit risk ex-posure through large-scale securitization programmes, the magnitude of the effect falls by two thirds. The equity market does not appear to place any value on news of loans extended by banks that are known to transfer credit risk off their books.
    Keywords: bank loans; credit derivatives; bank certification
    JEL: G12 G21
    Date: 2006–12–12
  6. By: Arvind Krishnamurthy; Annette Vissing-Jorgensen
    Abstract: We show that the US Debt/GDP ratio is negatively correlated with the spread between corporate bond yields and Treasury bond yields. The result holds even when controlling for the default risk on corporate bonds. We argue that the corporate bond spread reflects a convenience yield that investors attribute to Treasury debt. Changes in the supply of Treasury debt trace out the demand for convenience by investors. We show that the aggregate demand curve for the convenience provided by Treasury debt is downward sloping and provide estimates of the elasticity of demand. We analyze disaggregated data from the Flow of Funds Accounts of the Federal Reserve and show that individual groups of Treasury holders also have downward sloping demand curves. Even groups with the most elastic demand curves have demand curves that are far from flat. The results have bearing for important questions in finance and macroeconomics. We discuss implications for the behavior of corporate bond spreads, interest rate swap spreads, the riskless interest rate, and the value of aggregate liquidity. We also discuss the implications of our results for the financing of the US deficit, Ricardian equivalence, and the effects of foreign central bank demand on Treasury yields.
    JEL: E43 G12
    Date: 2007–01
  7. By: Nicolae B. Garleanu; Lasse H. Pedersen
    Abstract: This paper provides a model of the interaction between risk-management practices and market liquidity. On one hand, tighter risk management reduces the maximum position an institution can take, thus the amount of liquidity it can offer to the market. On the other hand, risk managers can take into account that lower liquidity amplifies the effective risk of a position by lengthening the time it takes to sell it. The main result of the paper is that a feedback effect can arise: tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity.
    JEL: G10
    Date: 2007–02
  8. By: Iquiapaza, Robert; Lamounier, Wagner; Amaral, Hudson
    Abstract: In this research it is evaluated the effect of the asymmetric information, the agency costs and the property structure in the determination of the dividend payments. The Tobit regression model was used for censured data, giving consistence to the estimates with the payout index truncated at zero. They were considered the statements of 178 open companies quoted at Bovespa, in the period of 2000-2004. It was verified that the probability of dividend payments increases with the growth possibilities, the size, the cash flow, the decrease of the company’s debt and the adhesion of the company to the governance levels. Companies with ADRs at NYSE, or with smaller asymmetric information, pay smaller dividends, what is in line with the signaling hypothesis. It was verified a negative relationship of the dividend payments with the growth opportunities and positive with the cash flow, as foreseen by the pecking order hypothesis. Lastly, after controlling by asymmetric information, the property concentration for the controller (insider) presented a negative relationship with the dividends policy.
    Keywords: Dividends; asymmetric information; agency costs; property structure.
    JEL: G3
    Date: 2006–09–30
  9. By: Qayyum, Abdul; Kemal, A. R.
    Abstract: Our paper examines the volatility spillover between the stock market and the foreign exchange market in Pakistan. For long run relationship we use Engle Granger two step procedure and the volatility spillover is modelled through bivariate EGARCH method. The estimated results from cointegration analysis show that there is no long run relationship between the two markets. The results from the volatility modelling show that the behaviour of both the stock exchange and the foreign exchange markets are interlinked. The returns of one market are affected by the volatility of other market. Particularly the returns of the stock market are sensitive to the returns as well as the volatility of foreign exchange market. On the other hand returns in the foreign exchange market are mean reverting and they are affected by the volatility of stock market returns. There is strong relationship between the volatility of foreign exchange market and the volatility of returns in stock market.
    Keywords: Stock Market; Forex Market; EGARCH; Volatility Spillover; Stock market return; Foreign Exchange return; Pakistan
    JEL: G1
    Date: 2006

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