New Economics Papers
on Financial Markets
Issue of 2007‒09‒24
ten papers chosen by

  1. Cracking the Conundrum By David K. Backus; Jonathan H. Wright
  2. Sparse and Stable Markowitz Portfolios By Brodie, Joshua; Daubechies, Ingrid; De Mol, Christine; Giannone, Domenico
  3. The effect of realised volatility on stock returns risk estimates By Aurea Grane; Helena Veiga
  4. Ex-ante risk premia in the US stock market: analysing experts' behaviour at the individual level By Alain Abou; Georges Prat
  5. Asset pricing and predictability of stock returns in the french market By Ellouz, Siwar; Bellalah, Mondher
  6. Nonlinear stock prices adjustment in the G7 countries By Georges Prat; Fredj Jawadi
  7. Bonds and Brands : intermediaries and reputation in sovereign debt markets 1820-1830 By Marc Flandreau; Juan H. Flores
  8. Identification of Affine Term Structure Models With Observed Factors: Economic Shocks on Brazilian Yield Curves By Marco S. Matsumura; Ajax R. B. Moreira
  9. Volatility in the Gold Futures Market By Jonathan A. Batten; Brian M. Lucey
  10. Financial Exchange Rates and International Currency Exposures By Philip R. Lane; Jay C. Shambaugh

  1. By: David K. Backus; Jonathan H. Wright
    Abstract: From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25%, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic and financial market volatility, more predictable monetary policy, and the state of the business cycle.
    JEL: E43 E52 G12
    Date: 2007–09
  2. By: Brodie, Joshua; Daubechies, Ingrid; De Mol, Christine; Giannone, Domenico
    Abstract: The Markowitz mean-variance optimizing framework has served as the basis for modern portfolio theory for more than 50 years. However, efforts to translate this theoretical foundation into a viable portfolio construction algorithm have been plagued by technical difficulties stemming from the instability of the original optimization problem with respect to the available data. In this paper we address these issues of estimation error by regularizing the Markowitz objective function through the addition of a penalty proportional to the sum of the absolute values of the portfolio weights (l1 penalty). This penalty stabilizes the optimization problem, encourages sparse portfolios, and facilitates treatment of transaction costs in a transparent way. We implement this methodology using the Fama and French 48 industry portfolios as our securities. Using only a modest amount of training data, we construct portfolios whose out-of-sample performance, as measured by Sharpe ratio, is consistently and significantly better than that of the naïve portfolio comprising equal investments in each available asset. In addition to their excellent performance, these portfolios have only a small number of active positions, a highly desirable attribute for real life applications. We conclude by discussing a collection of portfolio construction problems which can be naturally translated into optimizations involving l1 penalties and which can thus be tackled by algorithms similar to those discussed here.
    Keywords: Penalized Regression; Portfolio Choice; Sparse Portfolio
    JEL: C00 G11
    Date: 2007–09
  3. By: Aurea Grane; Helena Veiga
    Abstract: In this paper, we estimate minimum capital risk requirements for short, long positions and three investment horizons, using the traditional GARCH model and two other GARCH-type models that incorporate the possibility of asymmetric responses of volatility to price changes; and, most importantly, we analyse the models performance when realised volatility is included as an explanatory variable into the models' variance equations. The results suggest that the inclusion of realised volatility improves the models forecastability and their capacity to calculate accurate measures of minimum capital risk requirements.
    Date: 2007–09
  4. By: Alain Abou (EconomiX - [CNRS : UMR7166] - [Université de Paris X - Nanterre]); Georges Prat (EconomiX - [CNRS : UMR7166] - [Université de Paris X - Nanterre])
    Abstract: Semi-annual surveys carried out by J. Livingston on a panel of experts has enabled us to compute the expected returns on a portfolio made up of US industrial stocks. Having calculated the difference between these expected returns and the risk free rate given by zero coupon bonds, we generated about 3000 individual ex-ante risk premia over the 41-year period between 1952 and 1993. Three main conclusions may be drawn from our study. First, these ex-ante premia have mean values that seem closer to the predictions derived from the consumption-based asset pricing theory than the ones obtained for the ex-post premia. Second, the experts' professional affiliation appears to be a significant criterion in discriminating premia. Third, in accordance with the Arbitrage Pricing Theory, ex-ante premia depend on common factors bound up with macroeconomic variables and agents’ individual forecasts for inflation and industrial production growth.
    Keywords: Stock market, equity risk premium, expected returns
    Date: 2007–09–18
  5. By: Ellouz, Siwar; Bellalah, Mondher
    Abstract: This paper studies the predictability of returns in the French stock market. It provides an analysis of predictable components of monthly common stock returns. We study a single-beta conditional model and we show that stock market risk premium is variable over the time and is important for capturing predictable variations of stock returns. We find also that the expected excess returns on small and medium capitalization stocks are more sensitive to changes in the predetermined variables such as dividend yields, default spread and term spread, than expected excess returns on large capitalization stocks.
    Keywords: predictability; predetermined variables; conditional asset pricing; stock returns.
    JEL: G14 G11 G12
    Date: 2007–03–07
  6. By: Georges Prat (EconomiX - [CNRS : UMR7166] - [Université de Paris X - Nanterre]); Fredj Jawadi
    Abstract: This paper aims to modeling stock prices adjustment dynamics toward their fundamentals. We used the class of Switching Transition Error Correction Models (STECM) and we showed that stock prices deviations toward fundamentals could be characterized by nonlinear adjustment process with mean reversion. First, according to Anderson (1997), De Grauwe and Grimaldi (2005) and Boswijk et al.(2006), we justify these nonlinearities by the presence of heterogeneous transaction costs, behavioural heterogeneity and the interaction between shareholders expectations. After, we present STECM specification. We apply this model to describe the G7 indexes adjustment dynamics toward their fundamentals. We showed that the G7 stock indexes adjustment is smooth and nonlinearly mean-reverting and that the convergence speeds vary according to the disequilibrium extent. Finally, using two indicators proposed by Peel and Taylor (2000), we determine phases of under- and overvaluation of stock prices and measure intensity of stock prices adjustment strengths.
    Keywords: Stock Prices, Heterogeneous Transaction Costs, Nonlinear Adjustment
    Date: 2007–09–18
  7. By: Marc Flandreau; Juan H. Flores
    Abstract: How does sovereign debt emerge and become sustainable? This paper provides a new answer to this unsolved puzzle. Focusing on the early 19th century, we argue that intermediaries’ market power served to overcome information asymmetries and sustained the development of sovereign debt. Relying on insights from corporate finance, we argue that capitalists turned to intermediaries’ reputations to guide their investment strategies. The outcome was a two-tier global bond market, which was sustained by hierarchical relations among intermediaries. This novel theoretical perspective is backed by new archival evidence and empirical data that have never been gathered so far.
    Date: 2007–07
  8. By: Marco S. Matsumura; Ajax R. B. Moreira
    Abstract: We propose different exactly identified specifications of affine models with observed macri factors. The models are compared estimating Brazilian domestic and sovereign yield curves.
    Date: 2007–04
  9. By: Jonathan A. Batten; Brian M. Lucey
    Abstract: We investigate the volatility structure of gold, trading as a futures contract on the Chicago Board of Trade (CBOT) using intraday (high frequency) data from January 1999 to December 2005. Apart from investigating the now familiar GARCH properties we also utilize a rarely used measure of volatility–the Garman Klass estimator – to provide new insights in intraday and interday volatility. This nonparametric measure incorporates the open, close, high and low price within a particular time interval. Both sets of results suggest significant variation across the trading day and week consistent with microstructure theories, although volatility is only slightly positively correlated with volume when measured by tick-count.
    Keywords: Garman Klass estimator; volatility; gold; intraday patterns; futures
    Date: 2007–06–25
  10. By: Philip R. Lane; Jay C. Shambaugh
    Abstract: Our goal in this project is to gain a better empirical understanding of the international financial implications of currency movements. To this end, we construct a database of international currency exposures for a large panel of countries over 1990-2004. We show that trade-weighted exchange rate indices are insufficient to understand the financial impact of currency movements. Further, we demonstrate that many developing countries hold short foreign-currency positions, leaving them open to negative valuation effects when the domestic currency depreciates. However, we also show that many of these countries have substantially reduced their foreign currency exposure over the last decade. Last, we show that our currency measure has high explanatory power for the valuation term in net foreign asset dynamics: exchange rate valuation shocks are sizable, not quickly reversed and may entail substantial wealth shocks.
    Keywords: Financial integration, capital flows, external assets and liabilities
    Date: 2007–09–12

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.