nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒09‒16
four papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Hedge Funds and Financial Stability: The State of the Debate By Michael R. King; Philipp Maier
  2. The Volatility Effect: Lower Risk without Lower Return By Blitz, D.C.; Vliet, P. van
  3. A Note on Public Debt, Tax-Exempt Bonds, and Ponzi Games By Berthold U. Wigger
  4. Estimating and Comparing the Implied Cost of Equity for Canadian and U.S. Firms By Jonathan Witmer; Lorie Zorn

  1. By: Michael R. King; Philipp Maier
    Abstract: The authors review the state of the debate on hedge funds and the potential threat that hedge funds pose to financial stability. The collapse of a hedge fund or a group of hedge funds might pose a systemic risk directly by damaging systematically important financial institutions, or indirectly by increasing market volatility and generating a liquidity shock in key markets. Both the hedge fund sector and the prime brokerage industry supporting them are highly concentrated, with a small number of dominant players that have a complex business relationship. Therefore, while the potential for a systemic risk from the hedge fund sector is considered small, the potential for <em>damage</em> from such shocks may have increased due to the increased spread, complexity, and tighter linkages of the global financial system. Going forward, the relationship between large complex financial institutions and hedge funds must be monitored closely. In terms of policy, direct regulation that increases transparency - whether of counterparty exposures or trading positions - does not appear feasible, may create a moral-hazard problem, and may reduce overall market efficiency. Indirect regulation via prime brokers, market discipline, and improved riskmanagement practices are the most promising approaches for addressing potential risks from the hedge fund sector.
    Keywords: Financial stability; Financial institutions; Financial system regulation and policies
    JEL: G15 G18 G2
    Date: 2007
  2. By: Blitz, D.C.; Vliet, P. van (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)
    Abstract: We present empirical evidence that stocks with low volatility earn high risk-adjusted returns. The annual alpha spread of global low versus high volatility decile portfolios amounts to 12% over the 1986-2006 period. We also observe this volatility effect within the US, European and Japanese markets in isolation. Furthermore, we find that the volatility effect cannot be explained by other well-known effects such as value and size. Our results indicate that equity investors overpay for risky stocks. Possible explanations for this phenomenon include (i) leverage restrictions, (ii) inefficient two-step investment processes, and (iii) behavioral biases of private investors. In order to exploit the volatility effect in practice we argue that investors should include low risk stocks as a separate asset class in the strategic asset allocation phase of their investment process.
    Keywords: alpha;strategic asset allocation;volatility;volatility effect;low risk stocks;CAPM;Fama-French factors;international;
    Date: 2007–07–04
  3. By: Berthold U. Wigger
    Abstract: By issuing tax-exempt bonds, the government can incur debt and never pay back any principal or interest, even if the economy without public debt evolves on a dynamically efficient growth path. The welfare effects of such a Ponzi type borrowing scheme are mixed. The current young will unambiguously benefit.Depending on preferences and the aggregate technology, also a finite number of subsequent generations may benefit. The welfare of all generations thereafter, however, will be lower than in the economy without public debt.
    Date: 2007–07–17
  4. By: Jonathan Witmer; Lorie Zorn
    Abstract: This paper estimates the implied cost of equity for Canadian and U.S. firms using a methodology based on the dividend discount model and utilizing firms' current stock price and analysts' forecasted earnings. We find that firm size and firm stock liquidity are negatively related to cost of equity, while greater firm financial leverage and greater dispersion in analysts' earnings forecasts are associated with a higher cost of equity. Moreover, longer-term sovereign bond yields also seem to play a role in a firm's cost of equity. After controlling for several factors, both at a firm-level and at an aggregate level, we find that the cost of equity for Canadian firms is 30-50 bps higher than that of U.S. firms during 1988-2006. Because our estimates may not fully account for factors such as currency risk, inflation uncertainty, degree of market integration, personal taxes, and differences in regulatory environments, we might shed further light on these results by incorporating proxies for these factors and perhaps extending our comparison to more countries.
    Keywords: Financial markets; International topics
    JEL: G30 G38
    Date: 2007

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