nep-fmk New Economics Papers
on Financial Markets
Issue of 2008‒08‒31
seven papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. The Costs and Benefits of Reinsurance By J. David Cummins; Georges Dionne; Robert Gagné; Abdelhakim Nouira
  2. Robust Equilibrium Yield Curves By Isaac Kleshchelski; Nicolas Vincent
  3. Is There Hedge Fund Contagion By Boyson, Nicole; Stahel, Christof; Stulz, Rene
  4. Hedge Fund Contagion and Liquidity By Boyson, Nicole M.; Stahel, Christof W.; Stulz, Rene
  5. How Much Do Banks Use Credit Derivatives to Hedge Loans? By Minton, Bernadette; Stulz, Rene; Williamson, Rohan
  6. The Effect of Bank Mergers on Loan Prices: Evidence from the U.S. By Erel, Isil
  7. Geographic Deregulation and Commercial Bank Performance in US State Banking Markets By YongDong Zou; Stephen M. Miller; Bernard Malamud

  1. By: J. David Cummins; Georges Dionne (HEC Montréal); Robert Gagné (IEA, HEC Montréal); Abdelhakim Nouira
    Abstract: Purchasing reinsurance reduces insurers’ insolvency risk by stabilizing loss experience, increasing capacity, limiting liability on specific risks, and/or protecting against catastrophes. Consequently, reinsurance purchase should reduce capital costs. However, transferring risk to reinsurers is expensive. The cost of reinsurance for an insurer can be much larger than the actuarial price of the risk transferred. In this article, we analyze empirically the costs and the benefits of reinsurance for a sample of U.S. property-liability insurers. The results show that reinsurance purchase increases significantly the insurers’ costs but reduces significantly the volatility of the loss ratio. With purchasing reinsurance, insurers accept to pay higher costs of insurance production to reduce their underwriting risk.
    Keywords: reinsurance, insolvency risk, risk management, financial intermediation, cost functions, panel data.
    Date: 2008–06
  2. By: Isaac Kleshchelski; Nicolas Vincent (IEA, HEC Montréal)
    Abstract: This paper studies the quantitative implications of the interaction between robust control and stochastic volatility for key asset pricing phenomena. We present an equilibrium term structure model with a representative agent and an output growth process that is conditionally heteroskedastic. The agent does not know the true model of the economy and chooses optimal policies that are robust to model misspecification. The choice of robust policies greatly amplifies the effect of conditional heteroskedasticity in consumption growth, improving the model’s ability to explain asset prices. In a robust control framework, stochastic volatility in consumption growth generates both a state-dependent market price of model uncertainty and a stochastic market price of risk. We estimate the model using data from the bond and equity markets, as well as consumption data. We show that the model is consistent with key empirical regularities that characterize the bond and equity markets. We also characterize empirically the set of models the robust representative agent entertains, and show that this set is ?small?. That is, it is statistically difficult to distinguish between models in this set.
    Keywords: Yield curves, Market price of Uncertainty, Robust control.
    JEL: D81 E43 G11 G12
    Date: 2007–11
  3. By: Boyson, Nicole (Northeastern U); Stahel, Christof (George Mason U); Stulz, Rene (Ohio State U)
    Abstract: Calling contagion the dependence in the probability of occurrence of extreme returns across different hedge fund styles and asset classes that cannot be explained by correlation, we find no systematic evidence of contagion between monthly returns on eight hedge fund styles and equity, bond, and currency markets. In contrast, the average probability that a style index has a return in the lower 10% tail increases from 1.67% to 39.92% as the number of other styles indices with a return in the lower 10% tail increases from 0 to 7. To explain this strong evidence of contagion across hedge fund styles, we investigate how the intensity of contagion depends on various proxies for funding liquidity and asset liquidity. We find that hedge fund contagion is magnified when prime brokerage firms have poor performance (which we would expect to affect hedge fund funding liquidity adversely) and when asset market liquidity is low. Commodity Trading Advisors (CTAs) are not subject to hedge fund contagion.
    Date: 2008–03
  4. By: Boyson, Nicole M. (Northeastern U); Stahel, Christof W. (George Mason U); Stulz, Rene (Ohio State U)
    Abstract: Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. We investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.
    Date: 2008–05
  5. By: Minton, Bernadette (Ohio State U); Stulz, Rene; Williamson, Rohan (Georgetown U)
    Abstract: This paper examines the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. Banks hedge less risky loans more than riskier ones. The banks are more likely to be net protection buyers if they have lower capital ratios, a lower net interest rate margin, engage in asset securitization, originate foreign loans, have more commercial and industrial loans in their portfolio, and have fewer agricultural loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the validity of the often-held view that the use of credit derivatives makes banks sounder.
    Date: 2008–01
  6. By: Erel, Isil (Ohio State U)
    Abstract: Bank mergers will increase or decrease loan spreads, depending on whether the increased market power outweighs gains in operating efficiency. Using a proprietary loan-level data set for U.S. commercial banks, I find that, on average, mergers reduce loan spreads, and that the reduction is greater for acquirers with larger declines in operating costs post merger. Market overlap between the acquirer and the target leads to more potential for cost savings, which push spreads down. However, if the overlap is significant, the enhanced market power dominates the cost savings and, therefore, spreads increase. The findings are robust to using variation in dates of intrastate banking deregulation as an exogenous instrument for the timing of the in-market mergers. Furthermore, contrary to what might be expected, bigger acquirers do not impose less favorable terms on small businesses. Indeed, the average reduction in spreads is significant for small loans, showing that small borrowers typically pay lower interest rates to banks that have expanded during the previous few years through mergers.
    JEL: G21
    Date: 2007–12
  7. By: YongDong Zou (Sany Group); Stephen M. Miller (University of Connecticut and University of Nevada, Las Vegas); Bernard Malamud (University of Nevada, Las Vegas)
    Abstract: This paper examines the effects of geographical deregulation on commercial bank performance across states. We reach some general conclusions. First, the process of deregulation on an intrastate and interstate basis generally improves bank profitability and performance. Second, the macroeconomic variables -- the unemployment rate and real personal income per capita -- and the average interest rate affect bank performance as much, or more, than the process of deregulation. Finally, while deregulation toward full interstate banking and branching may produce more efficient banks and a healthier banking system, we find mixed results on this issue.
    Keywords: commercial banks, geographic deregulation, bank performance
    JEL: E5 G2
    Date: 2008–08

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