nep-fmk New Economics Papers
on Financial Markets
Issue of 2008‒07‒20
twelve papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. The stock market and the Fed By Fabrizio Mattesini; Leonardo Becchetti
  2. Do IMF and World Bank programs induce government crises? An empirical analysis By Axel Dreher; Martin Gassebner
  4. Stochastic Behavioral Asset Pricing Models and the Stylized Facts By Lux, Thomas
  5. Moral Behavior in Stock Markets: Islamic finance and socially responsible investment By Pitluck, Aaron Z.
  6. The Economics of Financial Derivative Instruments By NWAOBI, GODWIN C
  7. Pricing Financial Derivatives on Weather Sensitive Assets By Jerzy Filar; Boda Kang; Malgorzata Korolkiewicz
  8. Quadratic Hedging of Basis Risk By Hardy Hulley; T. A. McWalter
  9. Market conditions, default risk and credit spreads By Tang, Dragon Yongjun; Yan, Hong
  10. The pricing of correlated default risk: evidence from the credit derivatives market By Tarashev, Nikola A.; Zhu, Haibin
  11. Interaction of market and credit risk: an analysis of inter-risk correlation and risk aggregation By Böcker, Klaus; Hillebrand, Martin
  12. A value at risk analysis of credit default swaps By Raunig, Burkhard; Scheicher, Martin

  1. By: Fabrizio Mattesini (Faculty of Economics, University of Rome "Tor Vergata"); Leonardo Becchetti (Faculty of Economics, University of Rome "Tor Vergata")
    Abstract: The paper investigates the reaction of the Federal Reserve to developments in the stock market. The issue is analyzed by first constructing an Index of Stock Price Misalignement in which the fundamental value of the stocks is computed on the basis of the discounted cash flow approach and by then including this index, among the regressors, into a forward looking Taylor rule. In accordance with the descriptive evidence, based mainly on the analysis of the FOMC meetings and public statements, our findings show that the Fed tends to lower the Fed funds rate when stock prices fall below their fundamental value, while there is no evidence of monetary stringency during episodes of exuberance in the stock market.
    Date: 2008–07–14
  2. By: Axel Dreher (ETH Zurich, KOF Swiss Economic Institute, Switzerland and CESifo, Germany); Martin Gassebner (ETH Zurich, KOF Swiss Economic Institute, Switzerland)
    Abstract: We examine whether and under which circumstances World Bank projects and IMF programs affect the likelihood of major government crises. Using a sample of more than 90 developing countries over the period 1970-2002, we find that crises are on average more likely as a consequence of Bank and Fund involvement. While the effects of the IMF to some extent depend on the model specification, those of the World Bank are shown to be robust to the choice of control variables and method of estimation. We also find that governments face an increasing risk to enter a crisis when they remain under an arrangement once the economy performs better. The (economic) conditions present when a new arrangement is initiated, however, do not affect the impact of Fund and Bank on the probability of a crisis. Finally, while crisis probability rises when a government turns to the IFIs itself, programs inherited by preceding governments do not affect the probability of a crisis.
    Keywords: Political Crisis, International Financial Institutions
    JEL: D72 F34 P48
    Date: 2008–06
  3. By: Marwan Elkhoury
    Abstract: Credit rating agencies (CRAs) play a key role in financial markets by helping to reduce the informative asymmetry between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries. CRAs´ role has expanded with financial globalization and has received an additional boost from Basel II which incorporates the ratings of CRAs into the rules for setting weights for credit risk. Ratings tend to be sticky, lagging markets, and overreact when they do change. This overreaction may have aggravated financial crises in the recent past, contributing to financial instability and cross-country contagion. The recent bankruptcies of Enron, WorldCom, and Parmalat have prompted legislative scrutiny of the agencies. Criticism has been especially directed towards the high degree of concentration of the industry. Promotion of competition may require policy action at national and international level to encourage the establishment of new agencies and to channel business generated by new regulatory requirements in their direction.
    Date: 2007
  4. By: Lux, Thomas
    Abstract: High-frequency fincial data are characterized by a set of ubiquitous statistical properties that prevail with surprising uniformity. While these 'stylized facts' have been well-known for decades, attempts at their behavioral explanation have remained scarce. However, recently a new branch of simple stochastic models of interacting traders have been proposed that share many of the salient features of empirical data. These models draw some of their inspiration from the broader current of behavioral fince. However, their design is closer in spirit to models of multi-particle interaction in physics than to traditional asset-pricing models. This reflects a basic insight in the natural sciences that similar regularities like those observed in financial markets (denoted as 'scaling laws' in physics) can often be explained via the microscopic interactions of the constituent parts of a complex system. Since these emergent properties should be independent of the microscopic details of the system, this viewpoint advocates negligence of the details of the determination of individuals' market behavior and instead focuses on the study of a few plausible rules of behavior and the emergence of macroscopic statistical regularities in a market with a large ensemble of traders. This chapter will review the philosophy of this new approach, its various implementations, and its contribution to an explanation of the stylized facts in finance.
    Date: 2008
  5. By: Pitluck, Aaron Z.
    Abstract: This paper addresses the puzzle of why the inclusion of non-financial social justice or religious criteria by professional fund managers has been so popular in Malaysia and yet has had to date relatively little influence in the United States stock market. Drawing from over 125 ethnographic interviews with financial workers in Malaysia, this paper argues that moral investment behavior in stock markets is shaped primarily by ‘market structure’ rather than by ‘mandates.’ In both countries mandates are a weak form of social control of fund manager’s behavior. This is because mandates are not principal-agent contracts but are primarily marketing exercises and cultural tools. Social investing in the United States is weak because it relies solely on mandates to communicate clients’ ethical desires to their fund managers. Islamic and Ethical finance in Malaysia is strong because Islamic social movements have reformed the Malaysian stock market’s structure. Specifically, a uniform interpretation of Islamic investing was institutionalized with the creation of a nearly-unique quasi-governmental body. As a consequence, Islamic principles systematically influence the behavior of corporations listed in Malaysia, at present narrowly, but with the potential for wider influence in future. The paper closes with implications for social investment in the United States.
    Keywords: Investor Behavior; Ethics; Malaysia; United States; Islamic Finance; Socially Responsible Investment
    JEL: G11 O53 Z10 G20 A13 A14 P52
    Date: 2008–03–15
    Abstract: The phenomenal growth of derivative markets across the globe indicates their impact on the global financial scene. As the securities markets continue to evolve, market participants, investors and regulators are looking at different way in which the risk management and hedging needs of investors may be effectively met through the derivative instruments. However, it is equally recognised that derivative markets present market participants and regulators with different and complex regulatory(control) issues, which must be adequately addressed if derivative markets are to gain and maitain investor confidence. And yet, more and more companies are using(or being forced to use) futures and derivatives to stay competitive in a fast-changing world characterised by both unprecedented opportunities and unprecedented risks. Thus, the thrust of this paper is to provide a detailed study of the manner in which the market works and how the knowledge can be used to make profits and avoid losses in a competitive economy setting.
    Keywords: derivatives;futures;options; commodities; OTC;assets; stocks; indexes; swaps; instruments;foreignexchange; forex; hedging; spot;markets;arbitrage; risk; exchanges; brokers; storage; economies; financial; prices
    JEL: G11 E44 G24 G13 M0 D53 G15 F31
    Date: 2008–07–05
  7. By: Jerzy Filar (School of Mathematics and Statistics, University of South Australia); Boda Kang (School of Finance and Economics, University of Technology, Sydney); Malgorzata Korolkiewicz (School of Mathematics and Statistics, University of South Australia)
    Abstract: We study pricing of derivatives when the underlying asset is sensitive to weather variables such as temperature, rainfall and others. We shall use temperature as a generic example of an important weather variable. In reality, such a variable would only account for a portion of the variability in the price of an asset. However, for the purpose of launching this line of investigations we shall assume that the asset price is a deterministic function of temperature and consider two functional forms: quadratic and exponential. We use the simplest mean-reverting process to model the temperature, the AR(1) time series model and its continuous-time counterpart the Ornstein-Uhlenbeck process. In continuous time, we use the replicating portfolio approach to obtain partial differential equations for a European call option price under both functional forms of the relationship between the weather-sensitive asset price and temperature. For the continuous-time model we also derive a binomial approximation, a finite difference method and a Monte Carlo simulation to numerically solve our option price PDE. In the discrete time model, we derive the distribution of the underlying asset and a formula for the value of a European call option under the physical probability measure.
    Keywords: weather-sensitive asset; financial derivatives; diffusion; binomial approximation; numerical methods; time series; actuarial value
    Date: 2008–06–01
  8. By: Hardy Hulley (School of Finance and Economics, University of Technology, Sydney); T. A. McWalter (Programme in Advanced Mathematics of Finance, School of Computational and Applied Mathematics, University of the Witwatersrand,)
    Abstract: This paper examines a simple basis risk model based on correlated geometric Brownian motions. We apply quadratic criteria to minimize basis risk and hedge in an optimal manner. Initially, we derive the Follmer-Schweizer decomposition of a European claim. This allows pricing and hedging under the minimal martingale measure, corresponding to the local risk-minimizing strategy. Furthermore, since the mean-variance tradeoff process is deterministic in our setup, the minimal martingale- and variance-optimal martingale measures coincide. Consequently, the mean-variance optimal strategy is easily constructed. Simple closed-form pricing and hedging formulae for put and call options are derived. Due to market incompleteness, these formulae depend on the drift parameters of the processes. By making a further equilibrium assumption, we derive an approximate hedging formula, which does not require knowledge of these parameters. The hedging strategies are tested using Monte Carlo experiments, and are compared with recent results achieved using a utility maximization approach.
    Keywords: Option hedging; incomplete markets; basis risk; local risk minimization; mean-variance hedging
    Date: 2008–06–01
  9. By: Tang, Dragon Yongjun; Yan, Hong
    Abstract: This study empirically examine the impact of market conditions on credit spreads as motivated by recently developed structural credit risk models. Using credit default swap (CDS) spreads, we find that, in the time series, average credit spreads are decreasing in GDP growth rate, but increasing in GDP growth volatility. We document that credit spreads are lower when investor sentiment is high and when the systematic jump risk is low. In the cross section, we confirm that firm-level cash flow volatility raises credit spreads. More importantly, we demonstrate that the impact of market conditions on credit spreads is substantially affected by firm heterogeneity. During economic expansions, ceteris paribus, firms with high cash flow betas have lower credit spreads than those with low cash flow betas. This relation disappears during economic recessions, consistent with theoretical predictions. In diesem Arbeitspapier untersuchen wir empirisch, wie die gesamtwirtschaftlichen Bedingungen die Renditeabstände von Unternehmensanleihen, die mit einem Ausfallrisiko behaftet sind, beeinflussen. Dabei verwenden wir Spreads von Kreditausfallswaps (Credit Default Swap, CDS) als Näherungswert für Kreditspreads und stellen fest, dass die durchschnittlichen Kreditspreads im Zeitverlauf bei wirtschaftlicher Expansion niedriger und bei wirtschaftlicher Rezession höher sind. Wenn das Wirtschaftswachstum volatiler ist, führt dies ebenfalls zu höheren Kreditspreads. Wir stellen fest, dass Kreditspreads bei positiver Anlegerstimmung und geringem Risiko eines marktweiten Sprungs niedriger ausfallen. Firmenübergreifend stellen wir fest, dass ein auf Unternehmensebene volatiler Cashflow zu einer Erhöhung der Kreditspreads führt. Was noch entscheidender ist, wir zeigen, dass in Zeiten wirtschaftlicher Expansion – bei ansonsten gleichen Bedingungen – Unternehmen, deren Cashflow stark mit dem gesamtwirtschaftlichen Wachstum korreliert, geringere Kreditspreads aufweisen als solche mit einer schwachen Cashflow-Korrelation. Im Einklang mit den theoretischen Voraussagen verschwindet dieser Zusammenhang in Zeiten wirtschaftlicher Rezession.
    Keywords: Credit Risk, Credit Default Swaps, Credit Spreads, Market Conditions
    JEL: E43 E44 G12 G13
    Date: 2008
  10. By: Tarashev, Nikola A.; Zhu, Haibin
    Abstract: In order to analyze the pricing of portfolio credit risk – as revealed by tranche spreads of a popular credit default swap (CDS) index – we extract risk-neutral probabilities of default (PDs) and physical asset return correlations from single-name CDS spreads. The time profile and overall level of index spreads validate our PD measures. At the same time, the physical asset return correlations are too low to account for the spreads of index tranches and, thus, point to a large correlation risk premium. This premium, which covaries negatively with current realized correlations and positively with future realized correlations, sheds light on market perceptions of and attitude towards correlation risk. Das Portfoliokreditrisiko setzt sich aus drei Hauptkomponenten zusammen: der Ausfallwahrscheinlichkeit (probability of default, PD), der Verlustquote (loss given default, LGD) und der Wahrscheinlichkeitsverteilung für gemeinsame Ausfälle. Mit der rasanten Entwicklung innovativer Produkte im Bereich der strukturierten Finanzierung ist die Bedeutung der dritten Komponente zusehends gestiegen. Allerdings herrscht keine Einigkeit darüber, wie die Marktteilnehmer diese schätzen. Im vorliegenden Arbeitspapier schlagen wir zunächst einen auf CDSMarktdaten beruhenden Ansatz zur Ableitung der Wahrscheinlichkeitsverteilung für gemeinsame Ausfälle vor. Mit diesem Ansatz werden risikoneutrale PDs und physische Asset-Return-Korrelationen aus der Höhe der Preise und dem Gleichlauf (Co-movement) von Single-name-CDS-Spreads abgeleitet. Anschließend benutzen wir diese Schätzungen in einer konkreten Anwendung unseres Ansatzes zur Berechnung von Prognosen für Tranchenspreads eines bekannten CDS-Index (Dow Jones CDX North America Investment Grade Index) und vergleichen diese mit empirischen Spreads am CDS-Indexmarkt.
    Keywords: Portfolio credit risk, Correlation risk premium, CDS index, Tranche spread, Copula
    JEL: C15 G12 G13
    Date: 2008
  11. By: Böcker, Klaus; Hillebrand, Martin
    Abstract: In this paper we investigate the interaction between a credit portfolio and another risk type, which can be thought of as market risk. Combining Merton-like factor models for credit risk with linear factor models for market risk, we analytically calculate their interrisk correlation and show how inter-risk correlation bounds can be derived. Moreover, we elaborate how our model naturally leads to a Gaussian copula approach for describing dependence between both risk types. In particular, we suggest estimators for the correlation parameter of the Gaussian copula that can be used for general credit portfolios. Finally, we use our findings to calculate aggregated risk capital of a sample portfolio both by numerical and analytical techniques. Die Berechnung einer bankweit aggregierten Risikokennzahl (normalerweise ausgedrückt durch das ökonomische Kapital) ist ein äußerst wichtiger Bestandteil eines modernen Risikocontrollings and als solches von besonderer Bedeutung für bankinterne als auch regulatorische Zwecke. Eine wichtige Frage dabei betrifft die Behandlung von risikoreduzierenden Diversifikationseffekten, die als Folge der Geschäftsstrategie einer Bank (z.B. durch Produktdiversifikation oder geografische Diversifikation) auftreten können. Solche Diversifikationseffekte stellen einen Wettbewerbsvorteil dar, den Banken deshalb bei der Bestimmung ihrer Kapitaladäquanz mit einbeziehen wollen. Auch die Bankenaufsicht erkennt in ihren Ausführungen über die bankinternen Kapitalbeurteilungsverfahren nach den Grundsätzen der zweiten Säule von Basel II die Existenz von Diversifikationseffekten an. Bei der praktischen Berechnung des Diversifikationseffektes unterscheidet man oft zwischen Intrarisiko- und Interrisikodiversifikation. Letztere behandelt die Diversifikation innerhalb einer Risikoart (z.B. Markt- oder Kreditrisiko), wohingegen Interrisiko-Diversifikation die Diversifikation zwischen verschiedenen Risikoarten beschreibt und meist durch eine Interrisiko-Korrelationsmatrix erfasst wird.
    Keywords: Risk aggregation, Inter-risk correlation, economic capital, ICAAP, diversification
    JEL: C13 G21 G28 G31
    Date: 2008
  12. By: Raunig, Burkhard; Scheicher, Martin
    Abstract: We study the risk of holding credit default swaps (CDS) in the trading book. In particular, we compare the Value at Risk (VaR) of a CDS position to the VaR for investing in the respective firm’s equity. Our sample consists of CDS – stock price pairs for 86 actively traded firms over the period from March 2003 to October 2006. We find that the VaR for a stock is usually far larger than the VaR for a position in the same firm’s CDS. However, the distance between CDS VaR and equity VaR is markedly smaller for firms with high credit risk. The distance also declines for longer holding periods. We also observe a positive correlation between CDS and equity VaR. Kreditderivate wie Credit Default Swaps (CDS) haben in den letzten Jahren den Handel mit Kreditrisiko signifikant vereinfacht. Ein standardisiertes Kontrakt-Design, niedrige Transaktionskosten und eine große and heterogene Gruppe von Marktteilnehmern haben dazu beigetragen, dass CDS die Benchmark - Funktion für die Preisbestimmung im Markt für Unternehmens-Verschuldung erreichen. Heute ist der CDS das am meisten gehandelte Kreditderivat. Wir analysieren das Risiko von CDS, die im Handelsbuch gehalten werden. Wir vergleichen den Value at Risk (VaR) der CDS Position mit dem VaR für eine Position in der Aktie der gleichen Firma. Unsere Stichprobe umfasst CDS – Aktien Paare für 86 aktiv gehandelte Firmen im Zeitraum von März 2003 bis Oktober 2006. Wir finden, dass der VaR der Aktie meistens den VaR der CDS - Position deutlich übersteigt. Die Distanz zwischen dem CDS - VaR und dem Aktien - VaR ist jedoch bei Firmen mit hohem Kreditrisiko deutlich geringer. Die Distanz sinkt auch bei längeren Haltedauern. Wir beobachten weiter eine positive Korrelation zwischen dem CDS - VaR und dem Aktien - VaR.
    Keywords: Credit default swap, Value at Risk, Capital structure arbitrage
    JEL: E43 G12 G13
    Date: 2008

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