nep-fmk New Economics Papers
on Financial Markets
Issue of 2008‒03‒15
eleven papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Valuation of Convexity Related Derivatives By Jiří Witzany
  2. Noise vs. News In Equity Returns By Robert S. Chirinko; Hisham Foad
  3. Estimating Regime Dependent Switches in Emerging Equity Markets By Turk, Mehmet; Ozun, Alper
  4. The real estate risk premium : A developed/emerging country panel data analysis By John-John, D’ARGENSIO; Frederic, LAURIN
  5. A multi-horizon scale for volatility By Alexander Subbotin
  6. Changing regime volatility: A fractionally integrated SETAR model By Gilles Dufrenot; Dominique Guegan; Anne Peguin-Feissolle
  7. Forecasting VaR and Expected shortfall using dynamical Systems : a risk Management Strategy, By Dominique Guegan; Cyril Caillault
  8. Market Returns and Weak-Form Efficiency: the case of the Ghana Stock Exchange By Frimpong, Joseph Magnus; Oteng-Abayie, Eric Fosu
  9. Demystifying Subprime Crisis By Saraogi, Ravi
  10. Stochastic Volatility Models in Estimation of Exchange Rates By Turk, Mehmet; Ozun, Alper
  11. China's Exchange Rate Policy: A Survey of the Literature By Robert Lafrance

  1. By: Jiří Witzany (University of Economics, Prague, Czech Republic)
    Abstract: We will investigate valuation of derivatives with payoff defined as a nonlinear though close to linear function of tradable underlying assets. Derivatives involving Libor or swap rates in arrears, i.e. rates paid in a wrong time, are a typical example. It is generally tempting to replace the future unknown interest rates with the forward rates. We will show rigorously that indeed this is not possible in the case of Libor or swap rates in arrears. We will introduce formally the notion of plain vanilla derivatives as those that can be replicated by a finite set of elementary operations and show that derivatives involving the rates in arrears are not plain vanilla. We will also study the issue of valuation of such derivatives. Beside the popular convexity adjustment formula, we will develop an improved two or more variable adjustment formula applicable in particular on swap rates in arrears. Finally, we will get a precise fully analytical formula based on the usual assumption of log-normality of the relevant tradable underlying assets applicable to a wide class of convexity related derivatives. We will illustrate the techniques and different results on a case study of a real life controversial exotic swap.
    Keywords: interest rate derivatives, Libor in arrears, constant maturity swap, valuation models, convexity adjustment
    JEL: C13 E43 E47 G13
    Date: 2008–03
  2. By: Robert S. Chirinko (University of Illinois at Chicago and CESifo); Hisham Foad (Department of Economics, San Diego State University)
    Abstract: What role does noise play in equity markets? Answering this question usually leads immediately to specifying a model of fundamentals and hence the pervasive joint hypothesis quagmire. We avoid this dilemma by measuring noise volatility directly by focusing on the behavior of country closed-end funds (CCEF’s) during foreign (i.e., non-U.S.) holidays – for example, the last days of Ramadan in Islamic countries. These holiday periods are times when the flow of fundamental information relevant to foreign equity markets is substantially reduced and hence trading of CCEF’s in U.S. markets can be responding only weakly, if at all, to fundamental information. We find that, controlling for the effects of industry and global shocks and of the overall U.S. market, there remains a substantial amount of noise in the equity returns of U.S. CCEF’s. In the absence of noise, the noise ratio statistic would be near zero. However, our results indicate statistically significant departures from zero, with values averaged over all U.S. CCEF’s ranging from 76-84%xx depending on assumptions about the leakage of information during holiday periods and kurtosis. Noise is negatively related to institutional ownership of U.S. CCEF's and is much less important for U.K. CCEF's. The lower levels of noise for matched U.K. and U.S. CCEF’s provide some initial evidence that the U.K. securities transaction tax is effective in reducing stock market noise.
    Date: 2007–08
  3. By: Turk, Mehmet; Ozun, Alper
    Abstract: High and sudden volatility in the financial markets might cause unexpected losses. Increasing volatility in the prices of financial securities follows regime shifts in the markets. In general, there exist two regimes in the financial markets, namely, “stable” and “volatile” regimes. Therefore, estimating regime shifts in financial time series is crucial for the efficient risk management. From that perspective, the regime switching probabilities in emerging stock markets are examined with one of the regime switching models called Two State MSH(2)-AR, Autoregressive Markov Switching Heteroscedasticity Model. In the empirical analysis, we use daily time series data between 09/01/2004 and 13/09/2007 from i) emerging markets including Turkey, Russia, Ukraine, Brazil and Lebanon; ii) an advanced market, namely Dow Jones Industrial Average, iii) a world stock index, MSCI (Morgan Stanley Composite Index). Using data from different markets gives us to chance of evaluating the model’s performance with different time series. In addition, finding different regimes in the indexes within the same time period means that the investor have chance to diversify their portfolios.
    Keywords: Emerging markets; Regime switches; Markov chains; Volatility ; stock exchanges
    JEL: E32 G15 F21 F36
    Date: 2008
  4. By: John-John, D’ARGENSIO (UNIVERSITE CATHOLIQUE DE LOUVAIN, Center for Operations Research and Econometrics (CORE)); Frederic, LAURIN (UNIVERSITE CATHOLIQUE DE LOUVAIN, Center for Operations Research and Econometrics (CORE))
    Abstract: The objective of this paper is to identify the determinants of office capitalization rates for a panel of 52 countries (developed and emerging countries) between 2000 and 2006. Our assumption, based on Capital Asset Pricing Model, is that the capitalization rate should be at least proportional to the country’s risk perception, as measured by the risk premium on the 10-year government bond yield. Because of the endogeneity of the latter variable, our empirical methodology requires that we estimate first a model explaining the 10-year bond yield. It will be the occasion to discuss the determinants of the risk premium on the bond market. Using a SURE random effect Hausman-Taylor estimator (Hausman & Taylor, 1981), w also take into account the possible correlation between the country risk characteristics on the bond markets and those that determine the real estate market. Our results show that government bond yield is the main determinant of the capitalization rate. We estimate that 1 percentage point increase in the government bond yield will raisse the capitalization rate by about 0.19 percentage point. Real estate variables play also a role, but to a lesser extent. Turning to determinants of the 10-year bond yield, macroeconomic fundamentals are significant determinants of the country risk premium, especially the capacity to honor short-term financial engagements. In addition, the country’s risk history has also very important effect on the investors’ current risk perception.
    JEL: R33 G12 C33 G15
    Date: 2008–02–15
  5. By: Alexander Subbotin (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, Higher School of Economics - State University)
    Abstract: We decompose volatility of a stock market index both in time and scale using wavelet filters and design a probabilistic indicator for valatilities, analogous to the Richter scale in geophysics. The peak-over-threshold method is used to fit the generalized Pareto probability distribution for the extreme values in the realized variances of wavelet coefficients. The indicator is computed for the daily Dow Jones Industrial Averages index data from 1986 to 2007 and for the intraday CAC 40 data from 1995 to 2006. The results are used for comparison and structural multi-resolution analysis of extreme events on the stock market and for the detection of financial crises.
    Keywords: Stock market, volatility, wavelets, multi-resolution analysis, financial crisis.
    Date: 2008–03
  6. By: Gilles Dufrenot (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales - CNRS : UMR6579); Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Anne Peguin-Feissolle (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales - CNRS : UMR6579)
    Abstract: This paper presents a 2-regime SETAR model with different long-memory processes in both regimes. We briefly present the memory properties of this model and propose an estimation method. Such a process is applied to the absolute and squared returns of five stock indices. A comparison with simple FARIMA models is made using some forecastibility criteria. Our empirical results suggest that our model offers an interesting alternative competing framework to describe the persistent dynamics in modeling the returns.
    Keywords: SETAR - Long-memory - Stock indices - Forecasting
    Date: 2008–03–06
  7. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Cyril Caillault (FORTIS Investments - Fortis investments)
    Abstract: Using non-parametric (copulas) and parametric models, we show that the bivariate distribution of an Asian portfolio is not stable along all the period under study. We suggest several dynamic models to compute two market risk measures, the Value at Risk and the Expected Shortfall: the RiskMetric methodology, the Multivariate GARCH models, the Multivariate Markov-Switching models, the empirical histogram and the dynamic copulas. We discuss the choice of the best method with respect to the policy management of bank supervisors. The copula approach seems to be a good compromise between all these models. It permits taking financial crises into account and obtaining a low capital requirement during the most important crises.
    Keywords: Value at Risk - Expected Shortfall - Copula - RiskMetrics - Risk management -<br />GARCH models - Switching models.
    Date: 2008–03–06
  8. By: Frimpong, Joseph Magnus; Oteng-Abayie, Eric Fosu
    Abstract: This paper examines the weak-form efficient market hypothesis (EMH) in the case of the Ghana Stock Exchange (GSE) an emerging market. Daily returns from the Databank Stock Index (DSI) over a 5-year period 1999-2004 were used for the exercise. Random walk (RW) and GARCH(1,1) models are used as the basis for our analysis. The GSE DSI returns series exhibit volatility clustering, an indication of inefficiency on the GSE. The weak-form efficient market (random walk) hypothesis was rejected for the GSE, meaning that the market is inefficient. The inefficient market has important implications for investors, both domestic and international. Knowledge of profitable arbitrage opportunities due to market predictability serves to attract investors to diversify from more efficient markets to invest on the GSE bourse to increase their returns.
    Keywords: Ghana Stock Exchange; FINSAP; efficient market hypothesis; nonlinearity test
    JEL: G14 C12 C22
    Date: 2007–08–08
  9. By: Saraogi, Ravi
    Abstract: The article explains in lucid terms what the US Subprime Crisis is all about.
    Keywords: subprime; crisis; US
    JEL: A10
    Date: 2007–09–20
  10. By: Turk, Mehmet; Ozun, Alper
    Abstract: Volatility in financial markets should be correctly estimated for an efficient risk management. In emerging markets, due to relatively low trade volume, economic and political instability, and regulatory changes, higher volatility persists in financial asset prices as compared to those in advanced markets. In highly volatile markets, unexpected shifts in financial asset prices can be predicted by using flexible models enabling data filtering. In this research article, we use logarithmic normal stochastic volatility with Kalman filter and two regime switching stochastic volatility with Hamilton filter to estimate volatilities of exchange rates. In a comparative way, we examine the success of the two models in volatility estimation using time series from the Turkish markets. By employing daily USD/TRY exchange rates from 01/01/2004 to 25/07/2007, we empirically examine if the models are successful in predicting exchange rates in short-term and long-term. The article has originality in being first research article, as much as the authors know, which examines stochastic volatility models in a comparative perspective using data from Turkish exchange rate markets.
    Keywords: Regime Switching models; stochastic volatility; Hamilton filters; Kalman filters; exchange rate; Turkish lira
    JEL: G14 C14 F31
    Date: 2008
  11. By: Robert Lafrance
    Abstract: China's integration into the world economy has benefited its people by reducing poverty and raising living standards, and it has benefited the industrialized world by producing manufactured goods at lower cost. It has also raised geopolitical concerns as China's power grows, economic concerns as the manufacturing base in many industrialized countries erodes, and polemics as proposals of protectionist measures to counter China's export growth are put forward. The author reviews the literature on how China's exchange rate regime could evolve and contribute, through greater flexibility, to tempering domestic inflationary pressures and to facilitating an orderly resolution of global imbalances. His main conclusions are that China would benefit from moving towards a more flexible exchange rate regime and allowing the People’s Bank of China greater independence to pursue an inflation-control objective. In a transition phase, a managed float would be useful to limit volatility as firms adapt to the new system and the banking system is put on a sounder footing, a monetary policy framework is put in place, and capital controls are progressively eased. Shock therapy (a quick and pronounced revaluation) would be ill advised.
    Keywords: Exchange rate regimes
    JEL: F33 F36
    Date: 2008

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