New Economics Papers
on Financial Markets
Issue of 2008‒07‒30
eight papers chosen by

  1. The Other Side of the Trading Story: Evidence from NYSE By Wong, Woon K; Copeland, Laurence; Lu, Ralph
  2. Evolutionary Finance By Igor V. Evstigneev; Thorsten Hens; Klaus Reiner Schenk-Hoppé
  3. Financial system: shock absorber or amplifier? By Franklin Allen; Elena Carletti
  4. Multiple Potential Payers and Sovereign Bond Prices By Kim Oosterlinck; Loredana Ureche-Rangau
  5. Asset Allocation Using Flexible Dynamic Correlation Models with Regime Switching By Edoardo Otranto
  6. Credit risk models: why they failed in the credit crisis By Wilson Sy
  7. Jump Telegraph-Diffusion Option Pricing By Nikita Ratanov
  8. Co-integration and Causality Among Jakarta Stock Exchange, Singapore Stock Exchange, and Kuala Lumpur Stock Exchange By Febrian, Erie; Herwany, Aldrin

  1. By: Wong, Woon K (Cardiff Business School); Copeland, Laurence (Cardiff Business School); Lu, Ralph
    Abstract: We analyse the well-known TORQ dataset of trades on the NYSE over a 3-month period, breaking down transactions depending on whether the active or passive side was institutional or private. This allows us to compare the returns on the different trade categories. We find that, however we analyse the results, institutions are best informed, and earn highest returns when trading with individuals as counter party. We also confirm the conclusions found elsewhere in the literature that informed traders often place limit orders, especially towards the end of the day (as predicted on the basis of laboratory experiments in Bloomfield, O.Hara, and Saar (2005)). Finally, we find that trading between institutions accounts for the bulk of trading volume, but carries little information and seems to be largely liquidity-driven.
    Keywords: liquidity trade; informed trades
    JEL: G14 G12
    Date: 2008–07
  2. By: Igor V. Evstigneev (Economic Studies, University of Manchester); Thorsten Hens (Swiss Banking Institute, University of Zurich); Klaus Reiner Schenk-Hoppé (Leeds University Business School and School of Mathematics, University of Leeds)
    Abstract: Evolutionary finance studies the dynamic interaction of investment strategies in financial markets. This market interaction generates a stochastic wealth dynamics on a heterogenous population of traders through the fluctuation of asset prices and their random payoffs. Asset prices are endogenously determined through short-term market clearing. Investors' portfolio choices are characterized by investment strategies which provide a descriptive model of decision behavior. The mathematical framework of these models is given by random dynamical systems. This chapter surveys the recent progress made by the authors in the theory and applications of evolutionary finance models. An introduction to and the motivation of the modeling approach is followed by a theoretical part which presents results on the market selection (and co-existence) of investment strategies, discusses the relation to the Kelly rule and implications for asset pricing theory, and introduces a continuous-time mathematical finance version. Applications are concerned with simulation studies of the market dynamics, empirical estimation of asset prices and their dynamics, and the evolution of investment strategies using genetic programming.
    Keywords: Evolutionary Finance, Wealth Dynamics, Market Interaction
    JEL: G11 C61 C62
    Date: 2008–05
  3. By: Franklin Allen; Elena Carletti
    Abstract: This paper identifies two types of market failures. The first concerns a coordination problem associated with panics. The problem in analysing this type of market failure from a policy perspective is that there is no widely accepted method for selecting equilibria. The second market failure concerns the incompleteness of financial markets. The essential problem here is that the incentives to provide liquidity lead to an inefficient allocation of resources. The paper outlines three manifestations of market failure associated with liquidity provision: financial fragility, contagion and asset price bubbles. The framework developed allows some insight into the question of when the financial system acts a shock absorber and when it acts as an amplifier. Having identified when there is a market failure, the paper looks at whether there are policies that can correct the undesirable effects of such failures.
    Keywords: bank regulation, financial crisis, financial intermediation, market failure
    Date: 2008–07
  4. By: Kim Oosterlinck (Universite Libre de Bruxelles); Loredana Ureche-Rangau (Universite de Picardie)
    Abstract: Sovereign bonds are usually priced under the assumption that only the sovereign issuer may be responsible of their repayment. In some cases however, bondholders may legitimately expect to be repaid by more than one agent. For example, when a country breaks-up, successor states may agree to recognize their responsibility for part of the debt. Other extreme events, such as repudiations, may lead (and have led) bondholders to consider several bailout candidates at the same point in time. This paper first discusses the theoretical financial implications stemming from an infrequent and challenging situation, namely the existence of multiple potential payers. Then, through a historical precedent, the 1918 Russian repudiation, the paper confirms that the existence of multiple potential payers has a diversification effect which lowers the volatility of the bond price and increases its value. These results are strengthened by a comparison with a closely related standard case of default.
    Keywords: Sovereign bonds; Repudiation; Default; Portfolio diversification; Multiple payers; Russia; Romania; Financial history.
    JEL: F34 G15 G33 N20 N24
    Date: 2008–06
  5. By: Edoardo Otranto
    Abstract: The asset allocation decision is often considered as a trade-off between maximizing the expected return of a portfolio and minimizing the portfolio risk. The riskiness is evaluated in terms of variance of the portfolio return, so that it is fundamental to consider correctly the variance of its components and their correlations. The evidence of the heteroskedastic behavior of the returns and the time-varying relationships among the portfolio components have recently shifted attention to the multivariate GARCH models with time varying correlation. In this work we insert a particular Markov Switching dynamics in some Dynamic Correlation models to consider the abrupt changes in correlations affecting the assets in different ways. This class of models is very general and provides several specifications, constraining some coefficients. The models are applied to solve a sectorial asset allocation problem and are compared with alternative models.
    Keywords: Markov Chain, Multivariate GARCH, portfolio performance, switching parameters, volatility.
    Date: 2008
  6. By: Wilson Sy (Australian Prudential Regulation Authority)
    Abstract: Abstract: Credit risk models are shown to play a key part in the global credit crisis. We discuss how the credit market has exposed the shortcomings of the credit risk models and we identify their main shortcomings. To overcome the shortcomings, a new causal framework is proposed to build deductive credit default models which have predictive capabilities.
    Date: 2008–07–10
  7. By: Nikita Ratanov (Universidad del Rosario)
    Abstract: The paper develops a class of Financial market models with jumps based on a Brownian motion, and inhomogeneous telegraph processes: random motions with alternating velocities. We assume that jumps occur when the velocities are switching. The distribution of such a process is described in detail. For this model we obtain the structure of the set of martingale measures. The model can be completed adding another asset based on the same sources of randomness. Explicit formulae for prices of standard European options in completed market are obtained.
    Keywords: option pricing model, telegraph process, diffusion, martingale measure,
    Date: 2008–04–03
  8. By: Febrian, Erie; Herwany, Aldrin
    Abstract: For both risk management and portfolio selection purposes, modeling the linkage across financial markets is crucial, especially among neighboring stock markets. In investigating the dependence or co-movement of three or more stock markets in different countries, researchers frequently use co-integration and causality analysis. Nevertheless, they conducted the causality in mean tests but not the causality in variance tests. This paper examines the co-integration and causal relations among three major stock exchanges in Southeast Asia, i.e Jakarta Stock Exchange, Singapore Stock Exchange, and Kuala Lumpur Stock Exchange. It employs the recently developed techniques for investigating unit roots, co-integration, time-varying volatility, and causality in variance. For estimating market risk of portfolio, this paper employs Value-at-Risk with delta-normal approach.
    Keywords: Risk Management, Causality, Co-integration, Stock Markets
    JEL: G1 D53
    Date: 2007–10–15

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