nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒03‒24
eight papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Asset Prices in the Presence of a Tax Authority By Marc Rapp; Bernhard Schwetzler
  2. Forecasts of US Short-term Interest Rates: A Flexible Forecast Combination Approach By Guidolin, Massimo; Timmermann, Allan G
  3. The Forward Premium Puzzle: new evidence from futures contracts By Kerstin Bernoth; Juergen von Hagen; Casper de Vries
  4. Gradualism, Transparency and Improved Operational Framework: A Look at the Overnight Volatility Transmission By Silvio Colarossi; Andrea Zaghini
  5. A Primer on Sovereign Debt Buybacks and Swaps By Carlos I. Medeiros; Parmeshwar Ramlogan; Magdalena Polan
  6. Introduction to Applied Stress Testing By Martin Cihák
  7. Capital Structure and International Debt Shifting By Luc Laeven; Gaetan Nicodeme; Harry Huizinga

  1. By: Marc Rapp (Leipzig Graduate School of Management (HHL)); Bernhard Schwetzler (Leipzig Graduate School of Management (HHL))
    Abstract: This paper examines the equilibrium effect of a shift in the capital income tax rate upon state prices, risk-neutral probabilities, and corresponding security prices in a single-period binomial model economy with an exogenous risk-free rate. The policy design under consideration consists of a simple linear tax code that applies the economic rent as a tax base. It is shown that if tax proceeds are transferred to outsiders, a shift in the tax rate affects state prices, risk-neutral probabilities as well as equilibrium security prices. Thereby, the effect for the equilibrium price of a security is sensitive with respect to the correlation between its own payoff and the payoff of the market portfolio. If in contrast tax proceeds are redistributed within the cohort of market participants, risk-neutral probabilities, and security prices are unaffected by a change in the tax rate, although state prices are sensitive with respect to the tax rate.
    Keywords: Equilibrium security prices, capital income tax, risk-neutral probability measure,
    JEL: D50 G12 G31
  2. By: Guidolin, Massimo; Timmermann, Allan G
    Abstract: This paper develops a flexible approach to combine forecasts of future spot rates with forecasts from time-series models or macroeconomic variables. We find empirical evidence that accounting for both regimes in interest rate dynamics and combining forecasts from different models helps improve the out-of-sample forecasting performance for US short-term rates. Imposing restrictions from the expectations hypothesis on the forecasting model are found to help at long forecasting horizons.
    Keywords: forecast combinations; term structure of interest rates
    JEL: C53 G12
    Date: 2007–03
  3. By: Kerstin Bernoth; Juergen von Hagen; Casper de Vries
    Date: 2007–01
  4. By: Silvio Colarossi (Banca d'Italia); Andrea Zaghini (Banca d'Italia and CFS)
    Abstract: This paper proposes a possible way of assessing the effect of interest rate dynamics on changes in the decision-making approach, communication strategy and operational framework of a Central bank. Through a GARCH specification we show that the USA and Euro area displayed a limited but significant spillover of volatility from money market to longer-term rates. We then checked the stability of this phenomenon in the most recent period of improved policymaking and found empirical evidence that the transmission of overnight volatility along the yield curve vanished soon after specific policy changes of the FED and ECB.
    Keywords: Monetary Policy, Yield Curve, GARCH
    JEL: E4 E5 G1
    Date: 2007–03–09
  5. By: Carlos I. Medeiros; Parmeshwar Ramlogan; Magdalena Polan
    Abstract: This paper sets forth some basic principles that could help debt managers in emerging market and other countries to plan and implement sovereign debt buyback and swap operations. It discusses the macroeconomic context in which buybacks and swaps are undertaken, the objectives of buybacks and swaps, the analytical framework for deciding whether to undertake a particular buyback or swap operation and for selecting among alternative operations, and some key issues in the determination of the strategy for executing buybacks and swaps. The focus is on developing the analytical framework for evaluating sovereign debt buyback and swap operations, since very little work has been done in this area. In this regard, the paper presents a step-wise decision-making procedure, in which discounted cash flow analysis and the use of strategic benchmarks for the debt play central roles.
    Keywords: Sovereign debt , liability management , debt buybacks , debt swaps , net advantage , strategic benchmarks ,
    Date: 2007–03–15
  6. By: Martin Cihák
    Abstract: Stress testing is a useful and increasingly popular, yet sometimes misunderstood, method of analyzing the resilience of financial systems to adverse events. This paper aims to help demystify stress tests, and illustrate their strengths and weaknesses. Using an Excel-based exercise with institution-by-institution data, readers are walked through stress testing for credit risk, interest rate and exchange rate risks, liquidity risk and contagion risk, and are guided in the design of stress testing scenarios. The paper also describes the links between stress testing and other analytical tools, such as financial soundness indicators and supervisory early warning systems. Furthermore, it includes surveys of stress testing practices in central banks and the IMF.
    Keywords: Stress testing , financial soundness indicators , early warning systems ,
    Date: 2007–03–15
  7. By: Luc Laeven; Gaetan Nicodeme; Harry Huizinga
    Abstract: This paper presents a model of a multinational firm's optimal debt policy that incorporates international taxation factors. The model yields the prediction that a multinational firm's indebtedness in a country depends on a weighted average of national tax rates and differences between national and foreign tax rates. These differences matter because multinationals have an incentive to shift debt to high-tax countries. The predictions of the model are tested using a novel firm-level dataset for European multinationals and their subsidiaries, combined with newly collected data on the international tax treatment of dividend and interest streams. Our empirical results show that corporate debt policy indeed not only reflects domestic corporate tax rates but also differences in international tax systems. These findings contribute to our understanding of how corporate debt policy is set in an international context.
    Keywords: Corporate taxation , financial structure , debt shifting , Debt , Tax rates , Tax policy , Capital , Economic models ,
    Date: 2007–02–26
  8. By: Andrea Gheno
    Abstract: In recent years both practitioners and academics have realised that traditional discounted cash flow models erroneously consider the option value embedded in firms. Hence equity and debt valuation methodologies based on option theory have recently become quite popular. Such methodologies take inspiration from the Merton (1974) model which was originally introduced to measure the impact of default risk on corporate bonds yields. Thirty years later the Merton model for its simplicity and rigour remains unrivalled and is the basis of some of the most sophisticated credit risk models. In this paper it will be shown how practitioners often improperly adapt the Merton model for aims beyond its original scope.

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