New Economics Papers
on Financial Markets
Issue of 2008‒04‒12
thirteen papers chosen by

  1. The Virtues and Vices of Equilibrium and the Future of Financial Economics By J. Doyne Farmer; John Geanakoplos
  2. Cournot Competition, Financial Option markets and Efficiency By Bert Willems
  3. Creditor Protection, Contagion, and Stock Market Price Volatility By Hale, Galina B; Razin, Assaf; Tong, Hui
  4. The Economic Value of Predicting Stock Index Returns and Volatility. By Wessel Marquering; Marno Verbeek
  5. Implied Volatility at Expiration By Alexey Medvedev
  6. Credit Booms and Lending Standards: Evidence From The Subprime Mortgage Market By Dell'Ariccia, Giovanni; Igan, Deniz; Laeven, Luc
  7. Bond Supply and Excess Bond Returns By Greenwood, Robin; Vayanos, Dimitri
  8. Creditor Rights and Corporate Risk-taking By Acharya, Viral V; Amihud, Yakov; Litov, Lubomir P.
  9. Financial Integration of Stock Markets among New EU Member States and the Euro Area By Ian Babetskii; Lubos Komarek; Zlatuse Komarkova
  10. Macro Factors and the Term Structure of Interest Rates By Hans Dewachter; Marco Lyrio
  11. An Empirical Analysis of Affine Term Structure Models Using the Generalized Method of Moments By Peter De Goeij; Marno Verbeek
  12. How to Match Trades and Quotes for Nyse Stocks? By Olivier Vergote
  13. Pricing of Currency Options in Credible Exchange Rate Target Zones: an Extension and an Alternative Valuation Approach. By Dirk Veestraeten

  1. By: J. Doyne Farmer; John Geanakoplos
    Date: 2008–04–04
  2. By: Bert Willems
    Abstract: Allaz and Vila (1993) show that the existence of futures markets increases the efficiency of markets in a Cournot setting. This paper looks at the efficiency effect of financial options in a similar framework. It shows that also the existence of financial options makes markets more efficient; though to a smaller extent than futures. This is particularly relevant for markets with market power and costly storage, like the electricity market.
    Date: 2008–03
  3. By: Hale, Galina B; Razin, Assaf; Tong, Hui
    Abstract: We study a mechanism through which strong creditor protection affect positively the level, and negatively the volatility, of the aggregate stock market price. In a Tobin-q model with liquidity and productivity shocks, two channels are at work: (1) Creditor protection raises the stock value in a credit-constraint regime; (2) Creditor protection lowers the probability of the credit crunch. We confront the key predictions of the model to a panel of 40 countries over the period from 1984 to 2004. We find support to the hypothesis that creditor protection have a positive effect on the level, and a negative effect of the volatility, of stock prices, via the negative effect of the creditor protection on the probability of credit crunch.
    Keywords: credit crunch; Probit estimation; Tobin q
    JEL: E1 G2
    Date: 2008–01
  4. By: Wessel Marquering; Marno Verbeek
    Abstract: In this paper, we analyze the economic value of predicting index returns as well as volatility. On the basis of fairly simple linear models, estimated recursively, we produce genuine out-of-sample forecasts for the return on the S\&P 500 index and its volatility. Using monthly data from 1954 to 1998, we test the statistical significance of return and volatility predictability and examine the economic value of a number of alternative trading strategies. We find strong evidence for market timing in both returns and volatility. Joint tests indicate no dependence between return and volatility timing, while it appears easier to forecast returns when volatility is high. For a mean-variance investor, this predictability is economically profitable, even if short sales are not allowed and transaction costs are quite large.
    Date: 2008–03
  5. By: Alexey Medvedev (PhD student, Swiss Finance Institute and University of Geneva)
    Abstract: The main result of the paper is a formula for zero time-to-maturity limit of implied volatilities of European options under a broad class of stochastic volatility models. Based on this formula, we propose a closed-form approximation of the implied volatility smile. Numerical examples suggest that our approximation is accurate in the absence of mean-reversion in stochastic volatility.
    Keywords: Option pricing, stochastic volatility, implied volatility, short-maturity asymptotics.
    JEL: G12
    Date: 2004–11
  6. By: Dell'Ariccia, Giovanni; Igan, Deniz; Laeven, Luc
    Abstract: This paper studies the relationship between the recent boom and current delinquencies in the subprime mortgage market. Specifically, we analyze the extent to which this relationship can be explained by a decrease in lending standards that is unrelated to improvements in underlying economic fundamentals. We find evidence of a decrease in lending standards associated with substantial increases in the number of loan applications. We also find that the underlying market structure of the mortgage industry mattered, with larger declines in lending standards being associated with increases in the number of competing lenders. Finally, increased ability to securitize mortgages appears to have affected lender behaviour, with lending standards experiencing greater declines in areas with higher mortgage securitization rates. The results are consistent with theoretical predictions from recent financial accelerator models based on asymmetric information, and shed some light on the underlying causes and characteristics of the current crisis in the subprime mortgage market.
    Keywords: credit boom; financial accelerators; lending standards; moral hazard; mortgages; subprime loans
    JEL: E51 G21
    Date: 2008–02
  7. By: Greenwood, Robin; Vayanos, Dimitri
    Abstract: We examine empirically how the maturity structure of government debt affects bond yields and excess returns. Our analysis is based on a theoretical model of preferred habitat in which clienteles with strong preferences for specific maturities trade with arbitrageurs. Consistent with the model, we find that (i) the supply of long- relative to short-term bonds is positively related to the term spread, (ii) supply predicts positively long-term bonds' excess returns even after controlling for the term spread and the Cochrane-Piazzesi factor, (iii) the effects of supply are stronger for longer maturities, and (iv) following periods when arbitrageurs have lost money, both supply and the term spread are stronger predictors of excess returns.
    Keywords: bond prices; limited arbitrage; preferred habitat; return predictability
    JEL: G1 H6
    Date: 2008–02
  8. By: Acharya, Viral V; Amihud, Yakov; Litov, Lubomir P.
    Abstract: We propose that stronger creditor rights in bankruptcy reduce corporate risk-taking. Employing country-level data, we find that strong creditor rights are associated with a greater propensity of firms to engage in diversifying mergers, and this propensity changes in response to changes in the country creditor rights. Also, in countries with stronger creditor rights companies’ operating risk is lower, and acquirers with low-recovery assets prefer targets with high-recovery assets. These relationships are strongest in countries where management is dismissed in reorganization, suggesting an agency-cost effect. Our results suggest that there might be a "dark" side to strong creditor rights in that they can induce costly risk avoidance in corporate policies. Thus, stronger creditor rights may not necessarily be optimal.
    Keywords: Bankruptcy; Default; Diversification; Managerial turnover; Recovery
    JEL: G31 G32 G33 G34
    Date: 2008–02
  9. By: Ian Babetskii; Lubos Komarek; Zlatuse Komarkova
    Abstract: The paper considers the empirical dimension of financial integration among stock markets in four new European Union member states (the Czech Republic, Hungary, Poland and Slovakia) in comparison with the euro area. The main objective is to test for the existence and determine the degree of the four states’ financial integration relative to the euro currency union. The analysis is performed at the country level (using national stock exchange indices) and at the sectoral level (considering banking, chemical, electricity and telecommunication indices). Our empirical evaluation consists of (1) an analysis of alignment (by means of standard and rolling correlation analysis) to outline the overall pattern of integration; (2) the application of the concept of beta convergence (through the use of time series, panel and state-space techniques) to identify the speed of integration; and (3) the application of so-called sigma convergence to measure the degree of integration. We find evidence of stock market integration on both the national and sectoral levels between the Czech Republic, Hungary, Poland and the euro area.
    Keywords: Beta convergence, new EU member states, sigma convergence, stock markets.
    JEL: C23 G15 G12
    Date: 2007–12
  10. By: Hans Dewachter; Marco Lyrio
    Abstract: This paper presents an essentially affine model of the term structure of interest rates making use of macroeconomic factors and their long-run expectations. The model extends the approach pioneered by Kozicki and Tinsley (2001) by modeling consistently long-run inflation expectations simultaneously with the term structure. This model thus avoids the standard pre-filtering of long-run expectations, as proposed by Kozicki and Tinsley (2001). Application to the U.S. economy shows the importance of long-run inflation expectations in the modeling of long-term bonds. The paper also provides a macroeconomic interpretation for the factors found in a latent factor model of the term structure. More specifically, we find that the standard “level” factor is highly correlated to long-run inflation expectations, the “slope”' factor captures temporary business cycle conditions, while the “curvature” factor represents a clear independent monetary policy factor
    Date: 2008–03
  11. By: Peter De Goeij; Marno Verbeek
    Abstract: In this paper we formulate two tractable two-factor affine term structure models, imposing weak assumptions on the distributions of the measurement errors involved in the different yields. Exploiting the implied moment conditions, the models are estimated by the generalized method of moments using weekly term structure data for Germany, Japan, the UK and the USA. Despite our relatively weak assumptions, for each of these countries the overidentifying restrictions tests indicate that the estimated two-facotr models should be rejected. Apparently, the fact that many affine term structure models are rejected empirically, is unlikely to be due to the assumptions about the joint distribution of the measurement errors, but more likely to the lack of flexibility to explain certain aspects of the term structure.
    Date: 2008–03
  12. By: Olivier Vergote
    Abstract: This paper proposes a new procedure to determine the time of the prevailing quote relative to the time of the trade for NYSE stock data obtained from the TAQ database. The procedure tests whether the quote revision frequency around a trade is contaminated by quote revisions triggered by a trade, and then determines the smallest timing adjustment needed to eliminate this contamination. An application to various stocks and sample periods shows that the time difference between trade and quote reporting lags varies across stocks and time. The procedure takes this variation into account and hence offers a stock- and time-specific update to the Lee and Ready (1991) 5-second rule.
    Date: 2008–03
  13. By: Dirk Veestraeten
    Abstract: The paper examines pricing of options on target zone exchange rates. The pricing model of Dumas, Jennergren and Näslund (1993) is extended to asymmetric burden sharing in the defence of the target zone. This extension is relevant for various realistic set-ups, such as unilateral target zones. The paper also introduces an alternative pricing model that, in the tradition of Black and Scholes (1973), starts from geometric Brownian motion in which, however, the target zone limits are explicitly taken account of. This approach has a strong appeal from the practical point of view as it is less demanding in terms of required pricing inputs. This, however, goes at the cost of ignoring target zone nonlinearities. Simulations show that the simpler alternative model in most relevant cases moderately underprices by 1% to 3%.
    Date: 2008–03

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