nep-fmk New Economics Papers
on Financial Markets
Issue of 2008‒09‒29
twelve papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. The Panic of 2007 By Gary B. Gorton
  2. The sub-prime crisis, the credit squeeze and Northern Rock: The lessons to be learnt By Maximilian J. B. Hall
  3. Expected Stock Returns and Variance Risk Premia By Tim Bollerslev; Tzuo Hao; George Tauchen
  4. EGARCH and Stochastic Volatility: Modeling Jumps and Heavy-tails for Stock Returns By Jouchi Nakajima
  5. Testing for Co-integration in Vector Autoregressions with Non-Stationary Volatility By Giuseppe Cavaliere; Anders Rahbek; A.M.Robert Taylor
  6. Estimating hedge fund leverage By Patrick M McGuire; Camilo Kostas Tsatsaronis
  7. Dynamic Analysis of the Insurance Linked Securities Index By Mathieu Gatumel; Dominique Guegan
  8. Measuring financial asset return and volatility spillovers, with application to global equity markets By Francis X. Diebold; Kamil Yilmaz
  9. Using The Artificial Neural Network (ANN) to Assess Bank Credit Risk: A Case Study of Indonesia By Maximilian J. B. Hall; Dadang Muljawan; Suprayogi; Lolita Moorena
  10. Volatility Dynamics in Foreign Exchange Rates: Further Evidence from the Malaysian Ringgit and Singapore Dollar By Kin-Yip Ho; Albert K Tsui
  11. Nonlinearities in real exchange rate determination: do African exchange rates follow a radom walk? By Juan Carlos Cuestas; Estefania Mourelle
  12. The Asian crisis: what did local stock markets expect? By Jacob Gyntelberg; Alicia Garcia Herrero; Camilo Andrea Tesei

  1. By: Gary B. Gorton
    Abstract: How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.
    JEL: E1 E32 G2
    Date: 2008–09
  2. By: Maximilian J. B. Hall (Dept of Economics, Loughborough University)
    Abstract: On 14 September 2007, after failing to find a 'White Knight' to take over its business, Northern Rock bank turned to the Bank of England ('the Bank') for a liquidity lifeline. This was duly provided but failed to quell the financial panic, which manifested itself in the first fully-blown nationwide deposit run on a UK bank for 140 years. Subsequent provision of a blanket deposit guarantee duly led to the (eventual) disappearance of the depositor queues from outside the bank's branches but only served to heighten the sense of panic in policymaking circles. Following the Government's failed attempt to find an appropriate private sector buyer, the bank was then nationalised in February 2008. Inevitably, post mortems ensued, the most transparent of which was that conducted by the all-party House of Commons' Treasury Select Committee. And a variety of reform proposals are currently being deliberated at fora around the globe with a view to patching up the global financial system to prevent a recurrence of the events which precipitated the bank's illiquidity. This article briefly explains the background to these extraordinary events before setting out, in some detail, the tensions and flaws in UK arrangements which allowed the Northern Rock spectacle to occur. None of the interested parties – the Bank, the Financial Services Authority (FSA) and the Treasury – emerges with their reputation intact, and the policy areas requiring immediate attention, at both the domestic and international level, are highlighted. Some reform recommendations are also provided for good measure, particularly in the area of formal deposit protection.
    Keywords: UK banks, banking regulation and supervision, central banking, deposit protection.
    JEL: E53 E58 G21 G28
    Date: 2008–08
  3. By: Tim Bollerslev; Tzuo Hao; George Tauchen (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: Motivated by the implications from a stylized self-contained general equilibrium model incorporating the effects of time-varying economic uncertainty, we show that the difference between implied and realized variation, or the variance risk premium, is able to explain a non-trivial fraction of the time series variation in post 1990 aggregate stock market returns, with high (low) premia predicting high (low) future returns. Our empirical results depend crucially on the use of “model-free,” as opposed to Black- Scholes, options implied volatilities, along with accurate realized variation measures constructed from high-frequency intraday, as opposed to daily, data. The magnitude of the predictability is particularly strong at the intermediate quarterly return horizon, where it dominates that afforded by other popular predictor variables, like the P/E ratio, the default spread, and the consumption-wealth ratio (CAY).
    Keywords: Equilibrium asset pricing, stochastic volatility, risk neutral expectation, return predictability, option implied volatility, realized volatility, variance risk premium
    JEL: C22 C51 C52 G12 G13 G14
    Date: 2008–09–03
  4. By: Jouchi Nakajima (Institute for Monetary and Economic Studies, Bank of Japan (E-mail:
    Abstract: This paper proposes the EGARCH model with jumps and heavy- tailed errors, and studies the empirical performance of different models including the stochastic volatility models with leverage, jumps and heavy-tailed errors for daily stock returns. In the framework of a Bayesian inference, the Markov chain Monte Carlo estimation methods for these models are illustrated with a simulation study. The model comparison based on the marginal likelihood estimation is provided with data on the U.S. stock index.
    Keywords: Bayesian analysis, EGARCH, Heavy-tailed error, Jumps, Marginal likelihood, Markov chain Monte Carlo, Stochastic volatility
    JEL: C11 C15 G12
    Date: 2008–09
  5. By: Giuseppe Cavaliere; Anders Rahbek; A.M.Robert Taylor (School of Economics and Management, University of Aarhus, Denmark)
    Abstract: Many key macro-economic and financial variables are characterised by permanent changes in unconditional volatility. In this paper we analyse vector autoregressions with non-stationary (unconditional) volatility of a very general form, which includes single and multiple volatility breaks as special cases. We show that the conventional rank statistics computed as in Johansen (1988,1991) are potentially unreliable. In particular, their large sample distributions depend on the integrated covariation of the underlying multivariate volatility process which impacts on both the size and power of the associated co-integration tests, as we demonstrate numerically. A solution to the identified inference problem is provided by considering wild bootstrap-based implementations of the rank tests. These do not require the practitioner to specify a parametric model for volatility, nor to assume that the pattern of volatility is common to, or independent across, the vector of series under analysis. The bootstrap is shown to perform very well in practice.
    Keywords: Co-integration, non-stationary volatility, trace and maximum eigenvalue tests, wild bootstrap
    JEL: C30 C32
    Date: 2008–09–08
  6. By: Patrick M McGuire; Camilo Kostas Tsatsaronis
    Abstract: Hedge funds are major players in the international financial system and nimble investment strategies including the use of leverage allow them to build up large positions. Yet the monitoring of systemic risks posed by the build-up of leverage is hampered by incomplete information on hedge funds' balance sheet positions. This paper describes how an extension of "regression-based style analysis" and publicly available data on fund returns yield an indicator of the average amount of funding leverage used by hedge funds. The approach can take into account non-linear exposures through the use of synthetic option returns as possible risk factors. The resulting estimates of leverage are generally plausible for several hedge fund families, in particular those whose returns are well captured by the risk factors used in the estimation. In the absence of more detailed information on hedge fund investments, these estimates can serve as a tool for macro-prudential surveillance of financial system stability.
    Keywords: hedge funds, systemic risk, leverage, style analysis
    Date: 2008–09
  7. By: Mathieu Gatumel (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, Ecole d'économie de Paris - Paris School of Economics - Université Panthéon-Sorbonne - Paris I)
    Abstract: This paper aims to provide a dynamic analysis of the insurance linked securities index. We are discussing the behaviour of the index for three years and pointing out the consequences of some major events like Katrina or the last and current financial crisis. Some stylized facts of the index, like the non-Gaussianity, the asymmetry or the clusters of volatility, are highlighted. We are using some GARCH-type models and the generalized hyperbolic distributions in order to capture these elements. The GARCH in Mean model with a Normal Inverse Gaussian distribution seems to be very efficient to fit the log-returns of the insurance linked securities index.
    Keywords: Insurance Linked Securities, Garch-type models, Normal Inverse Gaussian Distribution
    Date: 2008–09
  8. By: Francis X. Diebold; Kamil Yilmaz
    Abstract: The authors provide a simple and intuitive measure of interdependence of asset returns and/or volatilities. In particular, they formulate and examine precise and separate measures of return spillovers and volatility spillovers. The authors framework facilitates study of both noncrisis and crisis episodes, including trends and bursts in spillovers, and both turn out to be empirically important. In particular, in an analysis of 19 global equity markets from the early 1990s to the present, they find striking evidence of divergent behavior in the dynamics of return spillovers vs. volatility spillovers: Return spillovers display a gently increasing trend but no bursts, whereas volatility spillovers display no trend but clear bursts.
    Keywords: Assets (Accounting)
    Date: 2008
  9. By: Maximilian J. B. Hall (Dept of Economics, Loughborough University); Dadang Muljawan (Central Bank of Indonesia); Suprayogi (Industrial Engineering Program, Bandung Institute of Technology, Indonesia); Lolita Moorena (Central Bank of Indonesia Internship program, Bandung Institute of Technology, Indonesia)
    Abstract: Ever since the Asian Financial Crisis, concerns have risen over whether policy-makers have sufficient tools to maintain financial stability. The ability to predict financial disturbances enables the authorities to take precautionary action to minimize their impact. In this context, the authorities may use any financial indicators which may accurately predict shifts in the quality of bank exposures. This paper uses key macro-economic variables (i.e. GDP growth, the inflation rate, stock prices, the exchange rates, and money in circulation) to predict the default rate of the Indonesian Islamic banks’ exposures. The default rates are forecasted using the Artificial Neural Network (ANN) methodology, which incorporates the Bayesian Regularization technique. From the sensitivity analysis, it is shown that stock prices could be used as a leading indicator of future problem.
    Keywords: default risk, artificial neural network, Bayesian regularization, transition matrix.
    JEL: E25 G32 C63 E27 C11
    Date: 2008–07
  10. By: Kin-Yip Ho (Department of Economics, Cornell University, Ithaca, USA); Albert K Tsui (Department of Economics, National University of Singapore)
    Abstract: Singapore dollar are analyzed in this paper. Our approach can simultaneously capture the empirical regularities of persistent and asymmetric effects in volatility and timevarying correlations of financial time series. Consistent with the results of Tse and Tsui (1997), there is only some weak support for asymmetric volatility in the case of the Malaysian ringgit when the two currencies are measured against the US dollar. However, there is strong evidence that depreciation shocks have a greater impact on future volatility levels compared with appreciation shocks of the same magnitude when both currencies measured against the yen. Moreover, evidence of time-varying correlation is highly significant when both currencies are measured against the yen. Regardless of the choice of the numeraire currency and the volatility models, shocks to exchange rate volatility are found to be significantly persistent.
    Keywords: Constant correlations; Exchange rate volatility; Fractional integration; Long memory; Bivariate asymmetric GARCH; Varying correlations
    JEL: C12 G15
    Date: 2008–08–22
  11. By: Juan Carlos Cuestas; Estefania Mourelle
    Abstract: In this paper we aim at modelling the long run behaviour of the Real Effective Exchange Rates (REER) for a pool of African countries. Not much attention has been paid to this group of countries, in particular, to the existence of nonlinearities in the long run path of such a variable. Controlling for two sources of nonlinearites, i.e. asymmetric adjustment to equilibrium and nonlinear deterministic trends allows us to gain some insight about the behaviour of the African REER. We find that these sources of nonlinearites help us to explain the apparent unit root behaviour found applying linear unit root tests for most of the countries.
    Keywords: PPP, Real Exchange Rates, Unit roots, Nonlinearities.
    JEL: C32 F15
    Date: 2008–07
  12. By: Jacob Gyntelberg; Alicia Garcia Herrero; Camilo Andrea Tesei
    Abstract: In this paper we investigate whether cross-sectional information from local equity markets contained information on devaluation expectations during the Asian crisis. We concentrate on the information content of equity prices as these markets were in general the largest and most liquid at the time and, thus, presumably the best carriers of information. Using an event-study approach for the period leading up to each of the devaluations which occurred during the Asian crisis (namely those of Indonesia, Korea, Malaysia, the Philippines and Thailand), we compare returns in the equity prices of exporting and non-exporting firms. This is based on the assumption that the expectation of a devaluation should help the stock of exporting firms outperform those of non-exporting firms. Overall we do find some evidence supporting this hypothesis, although at different degrees depending on the country. Our second finding is that local equity market prices, as reflected in the different patterns seen for exporters and non-exporters, did to at least to some extent price in the possibility that the Thai devaluation would be followed by other countries in the region.
    Keywords: Asian crisis, currency crisis, information content of local equity prices
    Date: 2008–09

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