nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒02‒24
seven papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Consistency of Dividend Signalling and Future Maturity Level:Evidence from UK Data By Carlos Martins
  2. Slow Moving Capital By Mitchell, Mark; Pedersen, Lasse Heje; Pulvino, Todd
  3. Random Walk Expectations and the Forward Discount Puzzle By Bacchetta, Philippe; van Wincoop, Eric
  4. SWAPS: Beyond Hedging, Speculation, and Arbitrage Are There Also Risks of Their Own? By Govori, Fadil
  5. Credit Derivatives: Conception, Types, and Risks Associated By Govori, Fadil
  6. Options Market: Contracts, Underlying Securities, Strategies, Trading Mechanics, and Advantages and Risks By Govori, Fadil
  7. Option-implied preferences adjustments, density forecasts, and the equity risk premium By Francisco Alonso; Roberto Blanco; Gonzalo Rubio

  1. By: Carlos Martins (Universidade de Aveiro)
    Abstract: This paper analyses the relation between dividends and the mature level of a firm, by using market-to-book ratio as a proxy for Tobin’s Q, and Tobin’s Q as a indicator of either existence of new positive NPV projects or maturity level reached. The existent theory argues that the dividend payment decision either conveys information regarding future earnings (Signalling Theory) or is based on an Agency Theory Problem, concerning both Managers-Shareholders and Shareholders-Debtholders relationships. Here, another dividend signalling power is partially found, as dividend changes in period t seem to indicate a tendency in high Q firms to became more mature in t+1. This relation was not found for low Q firms, indicating that already mature firms do not change their status after a dividend change.
    Keywords: Dividend Signalling, Mature Firms; Signalling Theory; Payout Policy.
    JEL: G35 C63
    Date: 2007–02
  2. By: Mitchell, Mark; Pedersen, Lasse Heje; Pulvino, Todd
    Abstract: We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.
    Keywords: capital constraint; convertible bond; frictions; hedge funds; limits of arbitrage; liquidity; merger arbitrage; risk management; valuation
    JEL: G1 G12 G14
    Date: 2007–02
  3. By: Bacchetta, Philippe; van Wincoop, Eric
    Abstract: Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk while at the same time exchange rate changes are predictable by interest rate differentials. In this paper we investigate whether these two features of the data may in fact be related. In particular, we ask whether the predictability of exchange rates by interest differentials naturally results when participants in the FX market adopt random walk expectations. We find that random walk expectations can explain the forward premium puzzle, but only if FX portfolio positions are revised infrequently. In contrast, with frequent portfolio adjustment and random walk expectations, we find that high interest rate currencies depreciate much more than what UIP would predict.
    Keywords: excess return; incomplete information; predictability
    JEL: E4 F3 G1
    Date: 2007–02
  4. By: Govori, Fadil
    Abstract: Swaps are over-the-counter (OTC) derivatives. They are negotiated outside exchanges. A swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. Mainly, market participants create swaps to hedge volatility in the financial markets. A simple way to understand a swap is to view a swap as a series of forward contracts. Swaps are relatively new instruments in derivative markets. The swaps market has grown rapidly over the past two decades. By some estimates, the current level is about $190 trillion. The most popular swap is the interest rate swap, in which a fixed interest rate exchanges for floating interest rate. A currency swap is more complicated than the interest rate swap because there is actually an exchange of cash involved. A credit derivative is a privately negotiated contract with payoffs linked to a credit-related event, such as a default or credit rating downgrade. A credit default swap is an agreement between two counterparties that allows one party to be long a third-party credit risk, and the other to be short the same credit risk. Credit spread option is a contract that focuses on the yield differential between credit-sensitive instruments and the reference security. A total return swap is a contract that allows an investor to receive the total economic return of an asset (security) without actually owning the asset. An equity swap is a contract where a set of future cash flows are exchanged between two counterparties, based on the performance of a share of stock or stock market index. Participants in derivative markets use interest rate derivatives to "hedge" their cash flow. The products they use are pay-fixed swaps, receive-fixed swaps, basis swaps, interest rate cap and swaptions, and forward starting swaps. The other use of swaps is speculation. Like investing in stock options, credit default swaps give a speculator a way to make a large profit from changes in a company's credit quality. Also interest rate swaps are very popular due to the arbitrage opportunities they provide. Trading of swaps and other derivatives is not without its own special risks and costs. Although derivatives can be used to help manage risks of other instruments, they also have risks of their own.
    Keywords: Swaps; Derivatives; Interest Rate Swaps; Currency Swaps; Credit Derivatives
    JEL: G24 G13 G32 G15 G12
    Date: 2007–02
  5. By: Govori, Fadil
    Abstract: Credit derivatives offer a flexible way to protect against credit risk and provide opportunities to enhance yield by purchasing credit synthetically. They are privately negotiated contracts with payoffs linked to a credit-related event, such as a default or credit rating downgrade. Credit risk is the possibility that a counterparty involved in debt contract will fail to service or repay a debt. Credit risk affects both debtors and creditors. The two most common aspects of credit risk are the market risk of the contracts and the default or downgrade risk. There are two steps in calculating credit risk: estimating the credit exposure and calculating the probability of default. Once we have calculated these two statistics, we can quantify the credit risk. Banks and dealers have worked with lawyers to develop techniques that help mitigate the credit exposure inherent in derivatives transactions. These techniques are: Netting, collateral, third-party guarantee, leverage. Based on the type of risk being transferred, credit derivatives may be broadly classified into the following: Credit default swaps; credit spread options; total return swaps; credit linked notes and equity default swaps A credit default swap is an agreement between two counterparties that allows one party to be long a third-party credit risk, and the other to be short the same credit risk. A credit default swap option represents the right but not the obligation to buy or sell protection on an underlying reference credit at a specified strike spread at a specified date in the future. A total return swap is a contract that allows an investor to receive the total economic return of an asset (security) without actually owning the asset. A credit-linked note is a security in which the coupon or the price of the note links to the performance of a reference asset (security). It offers borrowers a hedge against credit risk and investors a higher yield for buying a credit exposure. A credit derivative contract may be reference to a single reference entity, or a portfolio of reference entities - accordingly it is called single name credit derivative, or portfolio credit derivative. A special variant of a portfolio trade is a basket default swap. Trading of credit derivatives is not without its own special risks and costs. Although credit derivatives can be used to help manage risks of other instruments, they also have risks of their own. The risks associated with credit derivatives are neither new nor unique. They are the same kinds of risks associated with traditional debt, equity, or currency instruments.
    Keywords: Credit Derivative; Credit Swaps; Securitization; Asset-Backed Securities; Credit Risk
    JEL: G13 G21 G15
    Date: 2007–02
  6. By: Govori, Fadil
    Abstract: Options are derivatives, because their value derives from other securities which in the case of stock options for example, are particular stocks. Options give the option holder the right, but not the obligation, to buy or sell particular asset for a particular price, called the strike price, within a specified time. The elements of a standardized option contract specifies whether it is a put or call, its style as to when the option can be exercised, the underlying security, the number of shares of the underlying security for each contract, which is almost always 100 shares for equity options, the strike price, and the expiration date. Sometimes, an option seller is considered to be an option writer—and in many contexts, these 2 words are used as synonyms—but this is not necessarily so, or even likely. To prevent undesired scenarios, adjustments are made to the option contracts (sometimes called adjusted options), when the relationship to the underlying security is significantly altered. Besides common stock, there are also options for stock indexes, foreign exchange, interest rate futures, agricultural commodities, and precious metals. Because options prices are dependent upon the prices of their underlying securities, options can be used in various combinations for various possible market moves. Any investor contemplating these strategies should keep in mind the risks, which are more complex than with simple options, the tax consequences, the margin requirements, and the commissions that must be paid to affect these strategies. Options were originally traded over the counter (OTC), and still are. Organized exchanges offer standardized contracts that are cheaper and easier to sell. When a large dividend is paid by the underlying stock, its price drops on the ex-dividend date, resulting in a lower value for the calls. The stock price may remain lower after the payment, because the dividend payment lowers the assets of the company and therefore its worth. Options are used extensively for hedging because they allow an investor to protect a position for a small cost, and speculators like them because their profit potential is much greater than the underlying securities. Leverage is the fundamental advantage of options. A small investment can benefit from the price movements of securities that would either cost much more to own outright, or would require a much greater risk.
    Keywords: Options; Options Market; Option Contract; Call Option; Put Option; Derivatives
    JEL: G13 G11 G24 G18 G12 G15
    Date: 2007–02
  7. By: Francisco Alonso (Banco de España); Roberto Blanco (Banco de España); Gonzalo Rubio (Euskal Herriko Unibertsitatea; Universitat Pompeu Fabra)
    Abstract: The main objective of this paper is to analyse the value of information contained in prices of options on the IBEX 35 index at the Spanish Stock Exchange Market. The forward looking information is extracted using implied risk-neutral density functions estimated by a mixture of two lognormals and several alternative risk adjustments: the power, exponential and habit inspired based stochastic discount factors. Moreover, by allowing additional flexibility in the shape of the stochastic discount factor, two other ad hoc time varying risk aversion adjustments are also employed. Our results show that, between October 1996 and March 2000, we can reject the hypothesis that the risk neutral densities provide accurate predictions of the distributions of future realisations of the IBEX 35 index at four and eight week horizons. When forecasting through risk adjusted densities the performance of this period is statistically improved and we no longer reject that hypothesis. Somehow surprisingly, all risk adjusted densities generate similar forecasting statistics. Finally, from October 1996 to December 2004, the ex ante risk premium perceived by investors and that are embedded in option prices is between 12 and 18 percent higher than the premium required to compensate the same investors for the realised volatility in stock market returns.
    Keywords: risk-adjustments, option-implied densities, forecasting performance, equity-risk premium
    JEL: G10 G12
    Date: 2006–11

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