New Economics Papers
on Financial Markets
Issue of 2008‒02‒09
ten papers chosen by

  1. Do Hedge Funds Profit From Mutual-Fund Distress? By Joseph Chen; Samuel Hanson; Harrison Hong; Jeremy C. Stein
  2. Dynamic Risk Exposure in Hedge Funds By Monica Billio; Mila Getmansky; Loriana Pelizzon
  3. Assessing the compensation for volatility risk implicit in interest rate derivatives By Fabio Fornari
  4. Support Vector Regression Based GARCH Model with Application to Forecasting Volatility of Financial Returns By Shiyi Chen; Kiho Jeong; Wolfgang Härdle
  5. Bayesian Variable Selection of Risk Factors in the APT Model By Robert Kohn; Rachida Ouysse
  6. The Emergence of Information Sharing in Credit Markets By Martin Brown; Christian Zehnder
  7. The governance of the World Bank : analysis and implications of the decisional power of the G10 By Arthur Foch
  8. The Fed and the ECB: Why such an apparent difference in reactivity? By Grégory Levieuge; Alexis Penot
  9. Liquidity, Institutional Quality and the Composition of International Equity Outflows By Itay Goldstein; Assaf Razin; Hui Tong
  10. Understanding Asian equity flows, market returns and exchange rates By Chayawadee Chai-Anant; Corinna Ho

  1. By: Joseph Chen; Samuel Hanson; Harrison Hong; Jeremy C. Stein
    Abstract: This paper explores the question of whether hedge funds engage in front-running strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds -- those suffering large outflows of assets under management -- are forced to sell stocks they own. We document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge funds are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individual stock level, short interest rises in advance of sales by distressed mutual funds.
    JEL: G12 G20 G31 H0
    Date: 2008–02
  2. By: Monica Billio (Department of Economics, University Of Venice Cà Foscari); Mila Getmansky (Isenberg School of Management, University of Massachusetts); Loriana Pelizzon (Department of Economics, University Of Venice Cà Foscari)
    Abstract: We measure dynamic risk exposure of hedge funds to various risk factors during different market volatility conditions using the regime-switching beta model. We find that in the high-volatility regime (when the market is rolling-down) most of the strategies are negatively and significantly exposed to the Large-Small and Credit Spread risk factors. This suggests that liquidity risk and credit risk are potentially common factors for different hedge fund strategies in the down-state of the market, when volatility is high and returns are very low. We further explore the possibility that all hedge fund strategies exhibit idiosyncratic risk in a high volatility regime and find that the joint probability jumps from approximately 0% to almost 100% only during the Long-Term Capital Management (LTCM) crisis. Out-of-sample forecasting tests confirm the economic importance of accounting for the presence of market volatility regimes in determining hedge funds risk exposure.
    Keywords: Hedge Funds; Risk Management; Regime-Switching Models, Liquidity
    JEL: G12 G29 C51
    Date: 2007
  3. By: Fabio Fornari (European Central Bank, DG Economics, Foreign Exchange and Balance of Payments Section, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Volatilities implied from interest rate swaptions are used to assess the size and the sign of the compensation for volatility risk, for dollar, euro and pound rates at a daily frequency, between October 1998 and August 2006. The measurement of the volatility risk premium rests on a simple model according to which variance forecasts are generated under the objective probability measure. Results show that especially between September 2001 and mid-2003 dollar implieds were embodying a large - negative - compensation for volatility risk, a component which was smaller in absolute terms - but not relative to the level of the respective implied volatilities - for the other two currencies. While the negative compensation for volatility risk is in line with previous studies focusing on other asset classes, we also document that it exhibits a term structure, more evident for dollar and euro rates than for pound rates. The volatility risk premium is strongly changing through time but much less than implied volatilities. Estimates of risk aversion based on the physical skewness and kurtosis of interest rate changes suggest that (minus) the volatility risk premium can almost directly be read as risk aversion, as its proportionality with such risk aversion measure is about 0.8. Also, compensation for volatility risk is positively related to expected volatility, although the relation is not completely linear. Daily compensation for volatility risk is influenced, as expected, by the level of the short term rate and its volatility as well as by a small but robust number of macroeconomic surprises. The latter induce more sizeable changes on compensation for volatility risk of dollar rates than of euro or pound rates. JEL Classification: G120, G130, G140.
    Keywords: Volatility risk premium, risk aversion, economic surprises.
    Date: 2008–01
  4. By: Shiyi Chen; Kiho Jeong; Wolfgang Härdle
    Abstract: In recent years, support vector regression (SVR), a novel neural network (NN) technique, has been successfully used for financial forecasting. This paper deals with the application of SVR in volatility forecasting. Based on a recurrent SVR, a GARCH method is proposed and is compared with a moving average (MA), a recurrent NN and a parametric GACH in terms of their ability to forecast financial markets volatility. The real data in this study uses British Pound-US Dollar (GBP) daily exchange rates from July 2, 2003 to June 30, 2005 and New York Stock Exchange (NYSE) daily composite index from July 3, 2003 to June 30, 2005. The experiment shows that, under both varying and fixed forecasting schemes, the SVR-based GARCH outperforms the MA, the recurrent NN and the parametric GARCH based on the criteria of mean absolute error (MAE) and directional accuracy (DA). No structured way being available to choose the free parameters of SVR, the sensitivity of performance is also examined to the free parameters.
    Keywords: recurrent support vector regression, GARCH model, volatility forecasting
    JEL: C45 C53 G32
    Date: 2008–01
  5. By: Robert Kohn (School of Economics, The University of New South Wales); Rachida Ouysse (School of Economics, The University of New South Wales)
    Abstract: In this paper we use a probabilistic approach to risk factor selection in the arbitrage pricing theory model. The methodology uses a bayesian framework to simultaneously select the pervasive risk factors and estimate the model. This will enable correct inference and testing of the implications of the APT model. Furthermore, we are able to make inference on any function of the parameters, in particular the pricing errors. We can also carry out tests of efficiency of the APT using the posterior odds ratio and bayesian confidence intervals. We investigate the macroeconomic risk factors of Chen, Roll, and Ross (1986) and the firm characteristic factors of Fama and French (1992,1993). Using monthly portfolio returns grouped by size and book to market, we find that the economic variables have zero risk premia although some appear to have non zero posterior probability. The "Market" factor is not priced. An APT model with factors mimicking size (SMB), book to market equity (HML), value-weighted portfolio and Standard and Poor, is supported by a conditionally independent prior and offers a significant decrease in the pricing error over a two-factor APT with SMB and HML. The posterior probability and cumulative distributions functions of the average risk premia and the pricing errors are compared to the normal distribution. The results show that under certain conditions the distortions are very small.
    Keywords: Variable selection; Posterior density; Bayes factors; MCMC; APT models
    JEL: C1 C22 C52
    Date: 2007–10
  6. By: Martin Brown; Christian Zehnder
    Abstract: We examine how asymmetric information and competition in the credit market affect voluntary information sharing between lenders. We study an experimental credit market in which information sharing can help lenders to distinguish good borrowers from bad ones, because borrowers may exogenously switch locations. Lenders, however, are also engaged in spatial competition, and lose market power by sharing information with close competitors. Our results suggest that more asymmetric information in the credit market increases information sharing behavior significantly. Stronger competition between lenders reduces information sharing, but its impact seems to be only of second order importance.
    Keywords: Credit Market, Information Sharing, Spatial Competition, Adverse Selection
    JEL: C92 G21 D82
    Date: 2007–04
  7. By: Arthur Foch (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I)
    Abstract: This article discusses the World Bank's formal rules of governance. It states that theoretically, each of the World Bank's member states is represented within the decision making process but in practice it is otherwise. Indeed, we demonstrate that in reality the democratic imbalance in favor of the Most Developed Countries (MDCs), caused by the voting system of the WB, is much stronger than it appears. In the first place, our analysis of the formal decision making process demonstrates that the voting system is such that a coalition of particularly coordinated countries - the eleven countries of the G10 - can, on its own, constitute a majority permitting them to vote decisively on all issues. This implies that the remaining 174 members have no influence on voting results. Thus, this minority coalition alone is in position to approve loans and their attached conditions. In the second place, four features of the World Bank's governance which protect and re-enforce the power of this coalition are found. On the one hand, this analysis provides some explanations to the failure of various initiatives made to increase the voice of the Less Developed Countries (LDCs). On the other hand, it identifies several means susceptible of increasing the power of these countries in the institution. The main interest of this study shows that the democratic imbalance caused by the voting system is more important than it seems. Indeed, not only do the World Bank's formal rules of governance give the G10 the voting weight at all three levels of decision making but several governing features also permit the G10 to protect and re-enforce the power that they already have. Due to their right of veto, the MDCs can notably block any reform proposals.
    Keywords: World Bank, governance, decision-making power, decision-making authorities, conditionality.
    Date: 2007–11
  8. By: Grégory Levieuge (LEO - Laboratoire d'économie d'Orleans - CNRS : UMR6221 - Université d'Orléans); Alexis Penot (GATE - Groupe d'analyse et de théorie économique - CNRS : UMR5824 - Université Lumière - Lyon II - Ecole Normale Supérieure Lettres et Sciences Humaines)
    Abstract: Compared with the U.S., the amplitude of the European monetary policy rate cycle is strikingly narrow. Is it an evidence of a less reactive ECB? This observation can certainly reflect the preferences and then the strategy of the ECB. But its greater inertia must also be assessed in the light of the singularity of the European structure and of the shocks hitting it. From this perspective, several contributions assert that the nature, size and persistence of shocks mainly explain the different interest rate setting. Therefore, they rely on the idea that both areas share the same monetary policy rule and, more surprising, the same structure. This paper aims at examining this conclusions with an alternative modelling. The results confirm that the euro area and U.S. monetary policy rules are not fundamentally different. But we reject the differences of nature and amplitude of shocks. What is often interpreted as such is in fact the consequence of how distinctly both economies absorb shocks. So differences in the amplitude of the interest rate cycles in both areas are basically explained by structural dissimilarities.
    Keywords: interest rate; macroeconomic shocks; monetary policy rules ; policy activism; structural divergence
    Date: 2008
  9. By: Itay Goldstein; Assaf Razin; Hui Tong
    Abstract: We examine the choice between Foreign Direct Investment and Foreign Portfolio Investment at the level of the source country. Based on a theoretical model, we predict that (1) source countries with higher probability of aggregate liquidity crises export relatively more FPI than FDI, and (2) this effect strengthens as the source country’s capital market transparency worsens. To test these hypotheses, we apply a dynamic panel model and examine the variation of FPI relative to FDI for 140 source countries from 1985 to 2004. Our key variable is the probability of an aggregate liquidity crisis, estimated from a Probit model, as proxied by episodes of economy-wide sales of external assets. Consistent with our theory, we find that the probability of a liquidity crisis has a strong effect on the composition of foreign equity investment. Furthermore, greater capital market opacity in the source country strengthens the effect of the crisis probability.
    JEL: F2 F23 F3 G11
    Date: 2008–01
  10. By: Chayawadee Chai-Anant; Corinna Ho
    Abstract: This paper examines from various angles foreign investors' daily transactions in six emerging Asian equity markets and their relationship with local market returns and exchange rate changes over the period 1999-2006. Confirming much of the literature, we find that equity market returns matter for net equity purchases, and vice versa. In addition, we find that while currency returns tend to show little influence over foreign investors' demand for Asian equities, net equity purchases do have some explanatory power over near-term exchange rate changes. Moreover, we find that foreign investors do quite often move in or out of multiple Asian markets simultaneously - but more so on the way in than on the way out. Nonetheless, during specific events of heightened market volatility, we observe some interesting deviations from the full-sample average relationships.
    Keywords: Asian equity markets, foreign investor, market returns, currency returns, exchange rate
    Date: 2008–02

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