nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒03‒03
seventeen papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. The Role of Debt and Equity Finance over the Business Cycle By Covas, Francisco; Den Haan, Wouter
  2. Stress Testing Housing Loan Portfolios: A Regulatory Case Study By Neil Esho; Anthony Coleman; Ilanko Sellathurai; Niruba Thavabalan
  3. Market Discipline and Subordinated Debt of Australian Banks By Neil Esho; Paul Kofman; Michael G Kollo; Ian G. Sharpe
  4. On the Coherence of VAR Risk Measure for Levy Stable Distributions By Wilson Sy
  5. Implementation of the Basel II Capital Framework 1. Standardised approach to credit risk By Australian Prudential Regulation Authority
  6. Implementation of the Basel II Capital Framework 2. Standardised approach to operational risk By Australian Prudential Regulation Authority
  7. Implementation of the Basel II Capital Framework 3. Internal ratings-based approach to credit risk By Australian Prudential Regulation Authority
  8. Best Instruments for Market Discipline in Banking By Greg Caldwell
  9. Asset Pricing with Limited Risk Sharing and Heterogeneous Agents By Gomes, Francisco J; Michaelides, Alexander
  10. The Returns to Currency Speculation in Emerging Markets By Burnside, A Craig; Eichenbaum, Martin; Rebelo, Sérgio
  11. GARCH-based identification of triangular systems with an application to the CAPM: still living with the roll critique By Todd Prono
  12. Performance, competition and the dynamics of rules: the case of a financial market By Valérie Revest
  13. The Term Structure of Real Rates and Expected Inflation By Andrew Ang; Geert Bekaert; Min Wei
  14. The Crash of 1882, Counterparty Risk, and the Bailout of the Paris Bourse By Eugene N. White
  15. Stocks as Lotteries: The Implications of Probability Weighting for Security Prices By Nicholas Barberis; Ming Huang
  16. Endogenous State Prices, Liquidity, Default, and the Yield Curve By Raphael A. Espinoza; Charles A. E. Goodhart; Dimitrios P. Tsomocos
  17. Slippery slopes of stress : ordered failure events in German banking By Kick, Thomas; Koetter, Michael

  1. By: Covas, Francisco; Den Haan, Wouter
    Abstract: This paper documents that debt and equity issuance are procyclical for most size-sorted firm categories of listed U.S. firms. The procyclicality of equity issuance decreases monotonically with firm size. At the aggregate level, however, the results are not conclusive. The reason is that issuance is countercyclical for very large firms which, although few in number, have a large effect on the aggregate because of their enormous size. We show that the shadow price of external funds is procyclical if firms use the standard one-period contract. This model property generates procyclical equity and - as in the data - the procyclicality decreases with firm size. Another factor that causes equity to be procyclical in the model is a countercyclical cost of equity issuance. The calibrated model (i) generates a countercyclical default rate, (ii) generates a stronger cyclical response for small firms, and (iii) magnifies shocks, whereas the model without equity as an external financing source does the exact opposite.
    Keywords: agency problems; firm heterogeneity; magnification
    JEL: E32 E44
    Date: 2007–02
  2. By: Neil Esho; Anthony Coleman; Ilanko Sellathurai; Niruba Thavabalan (Australian Prudential Regulation Authority)
    Abstract: Against the backdrop of sharply rising house prices and Central Bank warnings that housing credit growth was not sustainable, the Australian Prudential Regulation Authority (APRA) conducted a ‘stress test’ to gauge the resilience of 120 Australian banks, building societies and credit unions to a substantial correction in the housing market. The stress test scenario mapped a 30 per cent fall in house prices to a substantial increase in default and loss rates. The results showed that all 120 institutions would remain solvent under the imposed conditions, however 11 institutions’ capital ratios fell below their regulatory minima. This paper details the stress testing methodology and traces through the various stages of the project, from background research, to stress test design, implementation, supervisory follow-up, public dissemination of the results and resulting policy changes.<p>
    Date: 2005–09–09
  3. By: Neil Esho; Paul Kofman; Michael G Kollo; Ian G. Sharpe (Australian Prudential Regulation Authority)
    Abstract: We examine evidence of market discipline in domestic and international subordinated debt of Australian banks. We estimate fixed effects panel error correction models to examine long-run relationships and short-run dynamics between bond risk spreads and accounting measures of bank risk. We find a significant long-run equilibrium relationship between the risk spread and both the impaired loans ratio and risk-adjusted capital ratio of Australian banks, consistent with the presence of market discipline. There is also evidence of significant short-run causality with changes in the one quarter lagged risk spread predicting changes in the current impaired loans ratio and somewhat weaker evidence of reverse causality. The results generally support the Basel Committee’s regulatory approach of seeking a greater role for market discipline in prudential regulation and supervision.<p>
    Date: 2005–10–01
  4. By: Wilson Sy (Australian Prudential Regulation Authority)
    Abstract: The Value-at-Risk (VaR) risk measure has been widely used in finance and insurance for capital and risk management. However, in recent years it has fallen somewhat out of favour due to a seminal paper by Artzner et al. (1999) who showed that VaR does not in general have all the four coherence properties which are desirable for a risk measure. In particular, the violation of the sub-additive property discourages diversification and is counter-intuitive to risk finance. In this paper, it is proved (Theorem 3.1) that VaR for independent Levy-stable random variates is a coherent risk measure being translational invariant, monotonic, positively homogeneous and sub-additive. That is, Levy-stable distributions are VaR coherent. As Levy-stable distributions are a rich class of probability distributions, the VaR risk measure may still have widespread applications. A brief comparative discussion is also given for L-stable variates for the expected shortfall risk measure.<p>
    Date: 2006–05–01
  5. By: Australian Prudential Regulation Authority (Australian Prudential Regulation Authority)
    Date: 2005–07–19
  6. By: Australian Prudential Regulation Authority (Australian Prudential Regulation Authority)
    Date: 2005–07–28
  7. By: Australian Prudential Regulation Authority (Australian Prudential Regulation Authority)
    Date: 2005–07–28
  8. By: Greg Caldwell
    Abstract: The author develops a dynamic model of banking competition to determine which capital instrument is most effective in disciplining banks' risk choice. Comparisons are conducted between equity, subordinated debentures (SD), and uninsured deposits (UD) as funding sources. The model, adapted from Repullo (2004), analyzes the effectiveness of regulatory capital when banks incorporate charter value and competition for depositors into their risk-taking decision. The paper's main finding is that although all three instruments can induce market discipline on banks, equity weakly dominates SD and UD (with SD weakly dominating UD).
    Keywords: Financial institutions
    JEL: G21 G28
    Date: 2007
  9. By: Gomes, Francisco J; Michaelides, Alexander
    Abstract: We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously.
    Keywords: equity premium; incomplete risk sharing; life-cycle models; limited stock market participation; preference heterogeneity
    JEL: G11 G12
    Date: 2007–02
  10. By: Burnside, A Craig; Eichenbaum, Martin; Rebelo, Sérgio
    Abstract: The carry trade strategy involves selling forward currencies that are at a forward premium and buying forward currencies that are at a forward discount. We compare the payoffs to the carry trade applied to two different portfolios. The first portfolio consists exclusively of developed country currencies. The second portfolio includes the currencies of both developed countries and emerging markets. Our main empirical findings are as follows. First, including emerging market currencies in our portfolio substantially increases the Sharpe ratio associated with the carry trade. Second, bid-ask spreads are two to four times larger in emerging markets than in developed countries. Third and most dramatically, the payoffs to the carry trade for both portfolios are uncorrelated with returns to the U.S. stock market.
    Keywords: carry trade; exchange rate; uncovered interest parity
    JEL: F3 F41
    Date: 2007–02
  11. By: Todd Prono
    Abstract: This paper presents a new method for identifying triangular systems of time-series data. Identification is the product of a bivariate GARCH process. Relative to the literature on GARCH-based identification, this method distinguishes itself both by allowing for a timevarying covariance and by not requiring a complete estimation of the GARCH parameters. Estimation follows OLS and standard univariate GARCH and ARMA techniques, or GMM. A Monte Carlo study of the GMM estimator is provided. The identification method is then applied in testing a conditional version of the CAPM.
    Keywords: Capital assets pricing model ; Time-series analysis
    Date: 2006
  12. By: Valérie Revest (CEPN - Centre d'économie de l'Université de Paris Nord - [CNRS : UMR7115] - [Université Paris-Nord - Paris XIII])
    Abstract: This article explores the issue of the failure of the French New Market, a French Financial market, in the light of the dynamics of organisational rules between 1996 and 2005. The French New Market (FNM) was created in 1996 in order to finance European growing firms. After its creation, this market successively expanded, declined and finally disappeared in 2005. The dynamics testifies a lack of consistency and relevance in the rules during this period, given the identity and of the FNM. More generally, we show that rules changes shed light on how such a market functions, and also attest as to whether it flourishes or encounters difficulties.
    Keywords: Financial Market, French New Market, Rules, Dynamics, Functioning
    Date: 2007–02–09
  13. By: Andrew Ang; Geert Bekaert; Min Wei
    Abstract: Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time-varying prices of risk, and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve in the U.S. is fairly flat around 1.3%. In one real rate regime, the real term structure is steeply downward sloping. An inflation risk premium that increases with maturity fully accounts for the generally upward sloping nominal term structure.
    JEL: C50 E31 E32 E43 G12
    Date: 2007–02
  14. By: Eugene N. White
    Abstract: The rapid growth of derivative markets has raised concerns about counterparty risk. It has been argued that their mutual guarantee funds provide an adequate safety net. While this mutualization of risk protects clients and brokers from idiosyncratic shocks, it is generally assumed that it also offers protection against systemic shocks, largely based on the observation that no twentieth century exchange has been forced to shut down. However, an important exception occurred in 1882 when the crash of the French stock market nearly forced the closure of the Paris Bourse. This exchange's structure was very similar to today's futures markets, with a dominant forward market leading the Bourse to adopt a common fund to guarantee transactions. Using new archival data, this paper shows how the crash overwhelmed the Bourse's common fund. Only an emergency loan from the Bank of France, intermediated by the largest banks, prevented a closure of the Bourse.
    JEL: E58 G18 N23
    Date: 2007–02
  15. By: Nicholas Barberis; Ming Huang
    Abstract: We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be "overpriced," and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.
    JEL: D1 D8 G11 G12
    Date: 2007–02
  16. By: Raphael A. Espinoza; Charles A. E. Goodhart; Dimitrios P. Tsomocos
    Abstract: We show, in an exchange economy with default, liquidity constraints and no aggregate uncertainty, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Two agents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cashin-advance financing costs. We show that, with Von Neumann-Morgenstern logarithmic utility functions, the price of AD securities, are inversely related to liquidity. The upshot of our argument is that agents’ expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade or money nor default. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable. The risk-premium in the term structure is therefore a pure default risk premium.
    Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rate
    JEL: E43 G12
    Date: 2007
  17. By: Kick, Thomas; Koetter, Michael
    Abstract: Outright bank failures without prior indication of financial instability are very rare. Supervisory authorities monitor banks constantly. Thus, they usually obtain early warning signals that precede ultimate failure and, in fact, banks can be regarded as troubled to varying degrees before outright closure. But to our knowledge virtually all studies that predict bank failures neglect the ordinal nature of bank distress. Exploiting the distress database of the Deutsche Bundesbank we distinguish four different distress events that banks experience. Only the worst entails a bank to exit the market. Weaker orders of distress are, first, compulsory notifications of the authorities about potential problems, second, corrective actions such as warnings and hearings and, third, actions by banking pillar's insurance schemes. Since the four categories of hazard functions are not proportional, we specify a generalized ordered logit model to estimate the respective probabilities of distress simultaneously. Our model estimates each set of probabilities with high accuracy and conrms, first, the necessity to account for different kinds of distress events and, second, the violation of the proportional odds assumption implicit in most limited dependent analyses of bank failure.
    Keywords: Bank, failure, distress, generalized ordered logit
    JEL: C35 G21 G33 K23 L50
    Date: 2007

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