New Economics Papers
on Financial Markets
Issue of 2008‒09‒05
nine papers chosen by

  1. Consumption growth and time-varying expected stock returns By Stig Vinther Møller
  2. Should there be intraday money markets? By Antoine Martin; James McAndrews
  3. Modelling and Forecasting Multivariate Realized Volatility By Roxana Chiriac; Valeri Voev
  4. Pricing the term structure with linear regressions By Tobias Adrian; Emanuel Moench
  5. Structured finance and the financial turmoil of 2007-2008: and introductory overview By Sarai Criado; Adrian van Rixtel
  6. American Option Pricing using GARCH models and the Normal Inverse Gaussian distribution By Lars Stentoft
  7. The high-frequency impact of news on long-term yields and forward rates: Is it real? By Meredith J. Beechey; Jonathan H. Wright
  8. Mean Reversion in US and International Short Rates By Charlotte Christiansen
  9. The Risk Premium on the Euro Area Market Portfolio: The Role of Real Estate By Thomas Nitschka

  1. By: Stig Vinther Møller (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: When the consumption growth rate is measured based upon fourth quarter data, it tracks predictable variation in future excess stock returns. Low fourth quarter consumption growth rates predict high future excess stock returns such that expected returns are high at business cycle troughs and low at business cycle peaks. The consumption growth rate loses predictive power when it is measured based upon other quarters. This is consistent with the insight of Jagannathan and Wang (2007) that investors tend to review their consumption and investment plans during the end of each calendar year, and at possibly random times in be- tween. The consumption growth rate measured based upon fourth quarter data is a much stronger predictive variable than benchmark predictive variables such as the dividend-price ratio, the term spread, and the default spread.
    Keywords: Return predictability, Consumption growth
    JEL: C12 E21 E44 G12
    Date: 2008–09–02
  2. By: Antoine Martin; James McAndrews
    Abstract: In this paper, we consider the case for an intraday market for reserves. We discuss the separate roles of intraday and overnight reserves and argue that an intraday market could be organized in the same way as the overnight market. We present arguments for and against a market for intraday reserves when the marginal cost of overnight reserves is positive. We also consider how reserves should be supplied when the cost of overnight reserves is zero. In that case, the distinction between overnight and intraday reserves becomes blurred, raising an important question: What is the role of the overnight market?
    Keywords: Bank reserves ; Money market ; Banks and banking, Central
    Date: 2008
  3. By: Roxana Chiriac; Valeri Voev (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: This paper proposes a methodology for modelling time series of realized covariance matrices in order to forecast multivariate risks. The approach allows for flexible dynamic dependence patterns and guarantees positive definiteness of the resulting forecasts without imposing parameter restrictions. We provide an empirical application of the model, in which we show by means of stochastic dominance tests that the returns from an optimal portfolio based on the model’s forecasts second-order dominate returns of portfolios optimized on the basis of traditional MGARCH models. This result implies that any risk-averse investor, regardless of the type of utility function, would be better-off using our model.
    Keywords: Forecasting, Fractional integration, Stochastic dominance, Portfolio optimization, Realized covariance
    JEL: C32 C53 G11
    Date: 2008–09–02
  4. By: Tobias Adrian; Emanuel Moench
    Abstract: We develop an affine term structure model from a conditionally linear pricing kernel, without making distributional assumptions about shocks. Assuming pricing factors to be observable, we estimate the model by way of three-stage ordinary least squares, which can be interpreted as dynamic Fama-MacBeth regressions. We derive cross-equation restrictions for bond yields, which we do not impose in the estimation, but instead test. We can easily estimate specifications with large numbers of pricing factors, including volatility factors. We uncover specifications that give rise to lower pricing errors than do commonly advocated specifications, both in- and out-of-sample. Efficiency can be obtained by way of the generalized method of moments (GMM) estimator.
    Keywords: Interest rates ; Econometric models ; Regression analysis ; Bonds ; Rate of return
    Date: 2008
  5. By: Sarai Criado (Banco de España); Adrian van Rixtel (Banco de España)
    Abstract: This paper provides an overview of the most important structured finance instruments in the context of the development of the financial turmoil that started in the third quarter of 2007 and continued into 2008. These financial market tensions were triggered by concerns about exposures of financial institutions to the most risky segment of the US mortgage markets -the so-called subprime mortgage market- and related financial instruments, which predominantly were related to structured finance. As structured finance has developed very fast in recent years and often involves highly complex financial instruments and techniques, which may not be understood completely beyond a small circle of financial market experts, the aim of this paper is to provide an introduction to these instruments that may serve to better understand the specific characteristics of the financial turmoil. In this context, the paper proposes a specific classification of structured finance and discusses both securitizations and credit derivatives with the aim of explaining their specific contributions to the development of the financial turmoil. To this extent, the paper differentiates between two main categories of structured finance instruments. The first one played an important role in the initiation and propagation of the turmoil and includes mortgage-backed securities (MBS), asset backed commercial paper (ABCP) and collateralized debt obligations (CDOs), both cash flow and synthetic. The second category of structured finance instruments involves those that have been more instrumental in monitoring the crisis, both for market participants and policymakers. The main instruments here are credit default swaps (CDS), of which examples are presented for both single name and index contracts. Finally, the paper provides an overview of the specific contagion channels involving various structured finance instruments. This will be conducted on the basis of examples for hypothetical financial institutions that are nevertheless representative for real world developments such as they occurred in the course of 2007 and 2008.
    Keywords: financial turmoil, financial markets, financial institutions, structured finance, securitization, credit derivatives
    JEL: G10 G15 G21 G24
    Date: 2008–08
  6. By: Lars Stentoft (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: In this paper we propose a feasible way to price American options in a model with time varying volatility and conditional skewness and leptokurtosis using GARCH processes and the Normal Inverse Gaussian distribution. We show how the risk neutral dynamics can be obtained in this model, we interpret the effect of the riskneutralization, and we derive approximation procedures which allow for a computationally efficient implementation of the model. When the model is estimated on financial returns data the results indicate that compared to the Gaussian case the extension is important. A study of the model properties shows that there are important option pricing differences compared to the Gaussian case as well as to the symmetric special case. A large scale empirical examination shows that our model outperforms the Gaussian case for pricing options on three large US stocks as well as a major index. In particular, improvements are found when considering the smile in implied standard deviations.
    Keywords: GARCH models, Normal Inverse Gaussian distribution, American Options, Least Squares Monte Carlo method
    JEL: C22 C53 G13
    Date: 2008–09–02
  7. By: Meredith J. Beechey; Jonathan H. Wright
    Abstract: This paper uses high-frequency intradaily data to estimate the effects of macroeconomic news announcements on yields and forward rates on nominal and index-linked bonds, and on inflation compensation. To our knowledge, it is the first study in the macro announcements literature to use intradaily real yield data, which allow us to parse the effects of news announcements on real rates and inflation compensation far more precisely than we can using daily data. Long-term nominal yields and forward rates are very sensitive to macroeconomic news announcements. We find that inflation compensation is sensitive to announcements about price indices and monetary policy. However, for news announcements about real economic activity, such as nonfarm payrolls, the vast majority of the sensitivity is concentrated in real rates. Accordingly, we conclude that most of the sizeable impact of news about real economic activity on the nominal term structure of interest rates represents changes in expected future real short-term interest rates and/or real risk premia rather than changes in expected future inflation and/or inflation risk premia. This suggests that explanations for the puzzling sensitivity of long-term nominal rates need to look beyond just inflation expectations and toward models that encompass uncertainty about the long-run real rate of interest.
    Date: 2008
  8. By: Charlotte Christiansen (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: In this paper we extend the CKLS one factor short rate model to include extreme value nonlinear mean reversion. Similarly to a recent stock market study, we include the smallest short rate during the previous year in the mean equation. We investigate the US and five other major markets (Canada, Germany, Japan, Switzerland, and the UK). There is extreme value mean reversion in the US short rate. For Japan there is both linear and nonlinear mean reversion. For the remaining short rates there is no evidence of mean reversion.
    Keywords: Short term interest rate, Mean reversion, Extreme value, Nonlinearity
    JEL: G12 G15 E43 C13
    Date: 2008–09–02
  9. By: Thomas Nitschka
    Abstract: Incomplete consumption risk sharing implies that the market risk premium is high in times of lack of risk sharing and vice versa. In the time period from 1980 to 2007, this implication of incomplete consumption risk sharing for the market price of risk is not mirrored in excess returns on stocks but in returns on real estate both in the Euro Area and in the U.S. This finding thus casts doubt on the common practice to approximate the market return by a stock index return in empirical tests of the Sharpe-Lintner capital asset pricing model. However, cross-sectional asset pricing tests suggest that there are fundamental differences between the Euro Area and the U.S. in this respect. The return on real estate does not add any explanatory power for domestic or foreign asset returns in excess of a stock index return in the U.S. The opposite reasoning applies to the Euro Area. Finally, this paper shows that the distinction between rather global and country-specific pricing factors does not seem to be important for the pricing of excess returns on foreign currencies.
    Keywords: CAPM, market risk premium, real estate return, return predictability, foreign currency returns
    JEL: G10 G15
    Date: 2008–08

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