New Economics Papers
on Financial Markets
Issue of 2007‒10‒13
eight papers chosen by

  1. Quantifying Inefficiency in Incomplete Asset Markets By Mario Tirelli; Sergio Turner
  2. Equilibrium Pricing Bounds on Option Prices By Elyès Jouini; Marie Chazal
  3. Theory and Inference for a Markov-Switching GARCH Model By Taoufik Bouezmarni; Jeroen V.K. Rombouts
  4. A market microstructure explanation of IPOs underpricing By Patarick Leoni
  5. Global Yield Curve Dynamics and Interactions: A Dynamic Nelson-Siegel Approach By Francis X. Diebold; Canlin Li; Vivian Z. Yue
  6. Portfolio effects and efficiency of lending under Basel II By Jokivuolle , Esa; Vesala, Timo
  7. The Equity Premium: 100 Years of Empirical Evidence from the UK By Andrew Vivian

  1. By: Mario Tirelli; Sergio Turner
    Abstract: It is known that the incompleteness of asset markets causes inefficiency in almost every equilibrium. Yet unexplored is the "size" of this inefficiency. The size of a Pareto improvement is the total willingness to pay for it, out of current consumption. Inefficiency is the maximum size of any Pareto improving reallocation. Inefficiency of US consumption in middle age is computed to be 10-11% of total consumption in youth, for CRRA parameters 1.5-3.25, in calibrated economy. The inefficiency of a general economy is approximated. A natural approximation, based on marginal rates of substitution (MRS), is preposterously crude in the calibrated economy, owing to a law of diminishing willingness to pay. Alternative approximations end up being functions of a classical notion, weighted social welfare maximized subject to resource constraints. They are simple, sharper in general and accurate in the calibrated economy.
    Date: 2007
  2. By: Elyès Jouini (CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - [CNRS : UMR7534] - [Université Paris Dauphine - Paris IX]); Marie Chazal (CREST - Centre de Recherche en Économie et Statistique - [INSEE] - [ École Nationale de la Statistique et de l'Administration Économique])
    Abstract: We consider the problem of valuing European options in a complete market but with incomplete data. Typically, when the underlying asset dynamics is not specified, the martingale probability measure is unknown. Given a consensus on the actual distribution of the underlying price at maturity, we derive an upper bound on the call option price by putting two kind of restrictions on the pricing probability measure.<br /><br />First, we put a restriction on the second risk-neutral moment of the underlying asset terminal value. Second, from equilibrium pricing arguments one can put a monotonicity restriction on the Radon-Nikodym density of the pricing probability with respect to the true probability measure. This density is restricted to be a nonincreasing function of the underlying price at maturity. The bound appears then as the solution of a constrained optimization problem and we adopt a duality approach to solve it.<br /><br />We obtain a weak sufficient condition for strong duality and existence for the dual problem to hold, for options defined by general payoff functions. Explicit bounds are provided for the call option. Finally, we provide a numerical example.
    Keywords: Option bounds, equilibrium prices, conic duality, semi-infinite programming
    Date: 2007–10–04
  3. By: Taoufik Bouezmarni; Jeroen V.K. Rombouts
    Abstract: We develop a Markov-switching GARCH model (MS-GARCH) wherein the conditional mean and variance switch in time from one GARCH process to another. The switching is governed by a hidden Markov chain. We provide sufficient conditions for geometric ergodicity and existence of moments of the process. Because of path dependence, maximum likelihood estimation is not feasible. By enlarging the parameter space to include the state variables, Bayesian estimation using a Gibbs sampling algorithm is feasible. We illustrate the model on SP500 daily returns.
    Keywords: GARCH, Markov-switching, Bayesian inference
    JEL: C11 C22 C52
    Date: 2007
  4. By: Patarick Leoni (Economics Department, National University of Ireland, Maynooth)
    Abstract: In a typical IPO game with first-price auctions, we argue that risk-averse investors always underbid in equilibrium because of subjective interpretations of the firm' communication about its actual value and resulting risk aversion about the likelihood of facing investors with higher valuations. We show that the noisier the investors' inferences of the firm' value (in the sense of first-order stochastic dominance) the higher the underbidding level. Our finding is independent of winner's curse effects and possible irrationality, and allows for a testable theory.
    Keywords: IPO underpricing; first-price auction; risk aversion; firm' communication
    JEL: C7 D81 G12 G32
    Date: 2007
  5. By: Francis X. Diebold (Department of Economics, University of Pennsylvania); Canlin Li (Graduate School of Management, University of California, Riverside); Vivian Z. Yue (Department of Economics, New York University)
    Abstract: The popular Nelson-Siegel (1987) yield curve is routinely fit to cross sections of intra-country bond yields, and Diebold and Li (2006) have recently proposed a dynamized version. In this paper we extend Diebold-Li to a global context, modeling a potentially large set of country yield curves in a framework that allows for both global and country-specific factors. In an empirical analysis of term structures of government bond yields for the Germany, Japan, the U.K. and the U.S., we find that global yield factors do indeed exist and are economically important, generally explaining significant fractions of country yield curve dynamics, with interesting differences across countries.
    Keywords: Term Structure, Interest Rate, Dynamic Factor Model, Global Yield, World Yield, Bond Market
    JEL: G1 E4 C5
    Date: 2007–05–30
  6. By: Jokivuolle , Esa (Bank of Finland Research); Vesala, Timo (Tapiola Group)
    Abstract: Although beneficial allocational effects have been a central motivation for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less discussed. In this paper, we investigate the effect of Basel II on the efficiency of bank lending. We consider competitive credit markets where entrepreneurs may apply for loans for investments of different risk profiles. In this setting, excessive risk taking typically arises because low risk borrowers cross-subsidize high risk borrowers through the price system that is based on average success rates. We find that while flat-rate capital requirements (such as Basel I) amplify overinvestment in risky projects, risk-based capital requirements alleviate the cross-subsidization effect, improving allocational efficiency. This also suggests that Basel II does not necessarily lead to exacerbation of macroeconomic cycles because the reduction in the proportion of high-risk investments softens the cyclicality of bank lending over the business cycle.
    Keywords: Basel II; bank regulation; capital requirements; credit risk; procyclicality
    JEL: D41 D82 G14 G21 G28
    Date: 2007–10–03
  7. By: Andrew Vivian
    Abstract: We examine the UK equity premium over more than a century using dividend growth to estimate expectations of capital gains employing the approach of Fama and French (2002). Over recent decades estimated equity premia implied by dividend growth have been much lower than that produced by average stock returns for the UK market as a whole; a finding corroborated by all economic sub-sectors. Our empirical analysis suggests this is primarily due to a declining discount rate, during the latter part of the 20th Century, which would rationally stimulate unanticipated equity price rises during this period. Thus, we conclude that historical stock returns over recent decades have been above investors’ expectations.
    Keywords: Equity Premium; Expected Returns; Dividend Growth Predictability
    JEL: G10 G12
    Date: 2007–09
  8. By: Albanese, Claudio
    Abstract: Although economically more meaningful than the alternatives, short rate models have been dismissed for financial engineering applications in favor of market models as the latter are more flexible and best suited to cluster computing implementations. In this paper, we argue that the paradigm shift toward GPU architectures currently taking place in the high performance computing world can potentially change the situation and tilt the balance back in favor of a new generation of short rate models. We find that operator methods provide a natural mathematical framework for the implementation of realistic short rate models that match features of the historical process such as stochastic monetary policy, calibrate well to liquid derivatives and provide new insights on complex structures. In this paper, we show that callable swaps, callable range accruals, target redemption notes (TARNs) and various flavors of snowballs and snowblades can be priced with methods numerically as precise, fast and stable as the ones based on analytic closed form solutions by means of BLAS level-3 methods on massively parallel GPU architectures.
    Keywords: Interest Rate Derivatives; stochastic monetary policy; callable swaps; snowballs; GPU programming; operator methods
    JEL: G13 G12
    Date: 2007–09–09

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