nep-fmk New Economics Papers
on Financial Markets
Issue of 2008‒02‒23
six papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Testing the Finance-Growth Link: is There a Difference Between Developed and Developing Countries? By Gilles Dufrenot; Valerie Mignon; Anne Peguin-Feissolle
  2. Stress testing of the Czech banking sector By Petr Jakubík; Jaroslav Heømánek
  3. The "growing pains" of TIPS issuance By Jennifer E. Roush
  4. On the Qualitative Effect of Volatility and Duration on Prices of Asian Options By Peter Carr; Christian-Oliver Ewald; Yajun Xiao
  5. The Impact of the FOMC's Monetary Policy Actions on the growth of Credit Risk: the Monetary Policy - Liquidity Paradox By Kwamie Dunbar
  6. Credit Risk Assessment Considering Variations in Exposure: Application to Commitment Lines By Shigeaki Fujiwara

  1. By: Gilles Dufrenot; Valerie Mignon; Anne Peguin-Feissolle
    Abstract: We revisit the evidence of the existence of a long-run link between financial intermediation and economic growth, by testing of cointegration between the growth rate of real GDP, control variables and three series reflecting financial intermediation. We consider a model with a factor structure that allows us to determine whether the finance-growth link is due to cross countries dependence and/or whether it characterises countries with strong heterogeneities. We employ techniques recently proposed in the panel data literature, such as PANIC analysis and cointegration in common factor models. Our results show differences between the developed and developing countries. We run a comparative regression analysis on the 1980-2006 period and find that financial intermediation is a positive determinant of growth in developed countries, while it acts negatively on the economic growth of developing countries.
    Keywords: Financial intermediation; growth; common factor; panel data; PANIC analysis
    JEL: C5 G2 O5
    Date: 2007–12
  2. By: Petr Jakubík (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic; Czech National Bank); Jaroslav Heømánek (Czech National Bank)
    Abstract: This article presents the results of stress tests of the Czech banking sector conducted using models of credit risk and credit growth broken down by sector. The use of these models enables the stress tests to be linked to the CNB’s official quarterly macroeconomic forecast. In addition, the article updates the stress scenarios, including simple sensitivity analyses of credit risk for individual sectors. Based on the analysis, an answer is sought to the question of whether the observed credit growth to corporate sector and households poses any threat to the stability of the banking sector. The analyses conclude that the banking sector as a whole seems to be resilient to the macroeconomic shocks under consideration.
    Keywords: stress testing, financial stability, credit risk, credit growth
    JEL: G21 G28 G33
    Date: 2008–02
  3. By: Jennifer E. Roush
    Abstract: This paper provides updated calculations of the relative cost to the U.S. Treasury of previously issued TIPS by comparing the payment stream on each security to that of hypothetical nominal counterpart. While the costs of the program (so measured) are large, totaling $5 to $8 billion to date, I show that they owe largely to market illiquidity in the early years of the program. Indeed, absent these market growing pains, the program would have yielded a substantial net savings to the government as investors were apparently willing to pay a substantial premium to insure against inflation risk.
    Date: 2008
  4. By: Peter Carr; Christian-Oliver Ewald; Yajun Xiao
    Abstract: We show that under the Black Scholes assumption the price of an arithmetic average Asian call option with fixed strike increases with the level of volatility . This statement is not trivial to prove and for other models in general wrong. In fact we demonstrate that in a simple binomial model no such relationship holds. Under the Black-Scholes assumption however, we give a proof based on the maximum principle for parabolic partial differential equations. Furthermore we show that an increase in the length of duration over which the average is sampled also increases the price of an arithmetic average Asian call option, if the discounting effect is taken out. To show this, we use the result on volatility and the fact that a reparametrization in time corresponds to a change in volatility in the Black-Scholes model. Both results are extremely important for the risk management and risk assessment of portfolios that include Asian options.
    Keywords: Asian Options, Volatility, Vega, Duration, Qualitative Riskmanagement.
    JEL: G11 G31 G39
    Date: 2008–02
  5. By: Kwamie Dunbar (University of Connecticut)
    Abstract: Credit risk is influenced by interest rates and market liquidity. This paper examines the direct and indirect impacts of unexpected monetary policy shifts on the growth of corporate credit risk, with the aim of quantifying the size and direction of the response. The results surprisingly indicate that monetary policy and liquidity impulses move counter to each other in their effects on credit risk ("The monetary policy-liquidity paradox"). The analysis indicates that while contractionary monetary policy creates tight money which subsequently leads to a slowing in the growth of credit risk and a reduction of liquidity in credit markets, reduced liquidity indirectly affects credit risk by accelerating its growth. The net effect of these transitory opposing forces generates the final impact on credit risk. An unexpected policy shifts is captured via a combination of the forward Fed fund rate curve and the Fed's FOMC policy announcements. Following the approach of Bernanke and Kuttner (2005), Hausman and Wongswan (2006) who examined asset prices under FOMC announcements, the study found that the estimated credit risk responses to FOMC announcements vary across credit qualities. Hence the analyses indicates that a typical unanticipated 25 basis point cut in the target fed funds rate generally resulted in an acceleration in the growth of credit risk by 0.50 percent for AAA rated corporate grade debt, and by 3.5 percent for BB rated corporate debt. Moreover, the study found a direct effect of the FOMC's policy instrument on market liquidity which had a significant effect on the growth in credit risk. The results indicate that a 1 percentage point increase in liquidity for AAA and CCC rated bonds resulted in a 0.7% and 52.45% decrease in the rate of growth in credit risk respectively.
    Keywords: Credit Risk, Default Risk, Credit Default Swap, Monetary Policy, Credit Markets, Financial Markets, Vector Autoregressive Model, Federal funds rate.
    Date: 2008–02
  6. By: Shigeaki Fujiwara (Deputy Director and Institute for Monetary and Economic Studies, Bank of Japan (E-mail: shigeaki.fuiiwarafalboj.or.ip'))
    Abstract: With the worldwide financial market confUsion caused by the subprime mortgage problem and the increase in credit line contracts with relaxed covenants, there are cases where financial institutions are facing demands to provide additional credit to securitized vehicles with heightened liquidity and credit risks. These are typical examples demonstrating the importance of risk management considering variations in exposure. There are also calls for incorporation of future variations in exposure into the model for the Basel II advanced internal ratings-based approach. This paper adopts commitment lines as a credit provision with variable exposure and constructs a credit risk model whereby stochastic new borrowing demand is linked to changes in a firm's asset value. Through simulations, the paper then considers the interdependence among exposure at default, probability of default, loss given default, expected loss, and unexpected loss. The paper also prepares a simple model for the covenants, and verifies the influence of the rigidness of covenants on expected loss and other risk factors.
    Keywords: : Commitment lines, Probability of default, Loss given default, Exposure at default, Expected loss, Unexpected loss
    JEL: G21 G32 G33
    Date: 2008–02

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