New Economics Papers
on Financial Markets
Issue of 2008‒10‒07
twelve papers chosen by

  1. Stages of the Ongoing Global Financial Crisis: Is There a Wandering Asset Bubble? By Lucjan T. Orlowski
  2. The sub prime crisis : implications for emerging markets By Gwinner, William B.; Sanders, Anthony
  3. Stress Testing at the IMF By Stéphanie Stolz; Marina Moretti; Mark Swinburne
  4. Closed forms for European options in a local volatility model By Eric Benhamou; Emmanuel Gobet; Mohammed Miri
  5. Combining Canadian Interest-Rate Forecasts By David Jamieson Bolder; Yuliya Romanyuk
  6. Structural breaks in the interest rate pass-through and the euro. A cross-country study in the euro area and the UK By Giuseppe Marotta
  7. Global Volatility and Forex Returns in East Asia By Sanja Kalra
  8. Volatility Transmission between Renminbi and Asia-Pacific on-shore and off-shore U.S. dollar futures By Roberta Colavecchio; Michael Funke
  9. Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility? By Jessica Wachter
  10. Who drove the boom in euro-denominated bond issues? By Galina Hale; Mark M. Spiegel
  11. Default and the maturity structure in sovereign bonds By Cristina Arellano; Ananth Ramanarayanan
  12. "Hedge Fund Replication" By Akihiko Takahashi; Kyo Yamamoto

  1. By: Lucjan T. Orlowski
    Abstract: This study argues that the severity of the current global financial crisis is strongly influenced by changeable allocations of the global savings. This process is named a “wandering asset bubble”. Since its original outbreak induced by the demise of the subprime mortgage market and the mortgage-backed securities in the U.S., this crisis has reverberated across other credit areas, structured financial products and global financial institutions. Four distinctive stages of the crisis are identified: the meltdown of the subprime mortgage market, spillovers into broader credit market, the liquidity crisis epitomized by the fallout of Bear Sterns with some contagion effects on other financial institutions, and the commodity price bubble. Monetary policy responses aimed at stabilizing financial markets are proposed.
    Date: 2008–09
  2. By: Gwinner, William B.; Sanders, Anthony
    Abstract: This paper discusses some of the key characteristics of the U.S. subprime mortgage boom and bust, contrasts them with characteristics of emerging mortgage markets, and makes recommendations for emerging market policy makers. The crisis has raised questions in the minds of many as to the wisdom of extending mortgage lending to low and moderate income households. It is important to note, however, that prior to the growth of subprime lending in the 1990s, U.S. mortgage markets already reached low and moderate-income households without taking large risks or suffering large losses. In contrast, in most emerging markets, mortgage finance is a luxury good, restricted to upper income households. As policy makers in emerging market seek to move lenders down market, they should adopt policies that include a variety of financing methods and should allow for rental or purchase as a function of the financial capacity of the household. Securitization remains a useful tool when developed in the context of well-aligned incentives and oversight. It is possible to extend mortgage lending down market without repeating the mistakes of the subprime boom and bust.
    Keywords: Debt Markets,,Access to Finance,Bankruptcy and Resolution of Financial Distress,Emerging Markets
    Date: 2008–09–01
  3. By: Stéphanie Stolz; Marina Moretti; Mark Swinburne
    Abstract: For almost a decade, the IMF has been using stress tests to identify vulnerabilities across institutions that could undermine the stability of a country's financial system. This working paper focuses on the IMF's experience with stress testing in the Financial Sector Assessment Program (FSAP). It provides background on the nature of an FSAP and the role of macro stress testing within it. It also describes how the methodology of stress testing in FSAPs has been evolving and what are fairly common approaches now being used. Finally, it discusses the main strengths and challenges for future development of macro stress testing in FSAPs and provides an overview of stress testing practice in European FSAPs.
    Keywords: Financial Sector Assessment Program , Financial systems , Financial stability , Credit risk , Liquidity , Technical assistance , Working Paper ,
    Date: 2008–09–05
  4. By: Eric Benhamou (LJK - Laboratoire Jean Kuntzmann - CNRS : UMR5224 - Université Joseph Fourier - Grenoble I - Université Pierre Mendès-France - Grenoble II - Institut Polytechnique de Grenoble); Emmanuel Gobet (LJK - Laboratoire Jean Kuntzmann - CNRS : UMR5224 - Université Joseph Fourier - Grenoble I - Université Pierre Mendès-France - Grenoble II - Institut Polytechnique de Grenoble); Mohammed Miri (LJK - Laboratoire Jean Kuntzmann - CNRS : UMR5224 - Université Joseph Fourier - Grenoble I - Université Pierre Mendès-France - Grenoble II - Institut Polytechnique de Grenoble)
    Abstract: Because of its very general formulation, the local volatility model does not have an analytical solution for European options. In this article, we present a new methodology to derive closed form solutions for the price of any European options. The formula results from an asymptotic expansion, terms of which are Black-Scholes price and related Greeks. The accuracy of the formula depends on the payoff smoothness and it converges with very few terms.
    Date: 2008–09–30
  5. By: David Jamieson Bolder; Yuliya Romanyuk
    Abstract: Model risk is a constant danger for financial economists using interest-rate forecasts for the purposes of monetary policy analysis, portfolio allocations, or risk-management decisions. Use of multiple models does not necessarily solve the problem as it greatly increases the work required and still leaves the question "which model forecast should one use?" Simply put, structural shifts or regime changes (not to mention possible model misspecifications) make it difficult for any single model to capture all trends in the data and to dominate all alternative approaches. To address this issue, we examine various techniques for combining or averaging alternative models in the context of forecasting the Canadian term structure of interest rates using both yield and macroeconomic data. Following Bolder and Liu (2007), we study alternative implementations of four empirical term structure models: this includes the Diebold and Li (2003) approach and three associated generalizations. The analysis is performed using more than 400 months of data ranging from January 1973 to July 2007. We examine a number of model-averaging schemes in both frequentist and Bayesian settings, both following the literature in this field (such as de Pooter, Ravazzolo and van Dijk (2007)) in addition to introducing some new combination approaches. The forecasts from individual models and combination schemes are evaluated in a number of ways; preliminary results show that model averaging generally assists in mitigating model risk, and that simple combination schemes tend to outperform their more complex counterparts. Such findings carry significant implications for central-banking analysis: a unified approach towards accounting for model uncertainty can lead to improved forecasts and, consequently, better decisions.
    Keywords: Interest rates; Econometric and statistical methods
    JEL: C11 E43 E47
    Date: 2008
  6. By: Giuseppe Marotta
    Abstract: We search for breaks in the short term business lending rate pass-through in euro countries, possibly associated with the introduction of the euro. One break is detected in six national retail rates among EMU countries; two breaks are found in other six cases, and in the UK as well. The last break occurs much earlier for France while several quarters later for other countries, suggesting a loose link if ever with the event. Pass-throughs decrease (except for France), becoming even more incomplete (except for Netherlands); though the adjustment to equilibrium is faster, cross-country heterogeneity remains fairly large. With the new harmonized interest rates database, available since 2003, pass-throughs are much closer to one, especially for larger loans.
    Keywords: Interest rates; Monetary policy; Economic and Monetary Union (EMU); Cointegration analysis; Structural breaks
    JEL: E43 E52 E58 F36
    Date: 2006–12
  7. By: Sanja Kalra
    Abstract: During 2001-07, increases in mature market volatility were associated with declines in forex returns for East Asian countries, consistent with an overall "flight to safety" effect. Estimates from GARCH models suggest that a 5 percentage point increase in mature market equity volatility generated an exchange rate depreciation of up to ½ percent. This sensitivity rose during the latter period in the sample, suggesting greater integration of Asian financial markets with global markets. Unconditional standard deviations estimated from these models also provide operational measures of "long-term" and "excess" volatility in forex markets. Long-run forex volatility declined as Asian economies settled down with generally stronger fundamentals in the post-crisis period to more flexible regimes along with a generally lower level of mature market volatility.
    Keywords: Foreign exchange , East Asia , Exchange rates , Financial stability , Economic integration , Economic models , Financial crisis , Working Paper ,
    Date: 2008–09–05
  8. By: Roberta Colavecchio; Michael Funke
    Abstract: This paper uses multivariate GARCH techniques to study volatility spillovers between the Chinese non-deliverable forward market and seven of its Asia-Pacific counterparts over the period January 1998 to March 2005. To account for the time-variability of conditional correlation, a dynamic correlation structure is included in the volatility model specification. The empirical results demonstrate that the renminbi non-deliverable forward (NDF) has been a driver of various Asian currency markets but that such co-movements exhibit a substantial degree of heterogeneity. As to the determinants of the magnitude of these co-movements, we test the relevance of potential factors and find that it is the degree of real and financial integration, in particular, that exerts the largest influence on volatility transmission.
    Keywords: China, renminbi, Asia, forward exchange rates, non-deliverable forward market, multivariate GARCH models
    JEL: C22 F31 F36
    Date: 2008–03
  9. By: Jessica Wachter
    Abstract: This paper introduces a model in which the probability of a rare disaster varies over time. I show that the model can account for the high equity premium and high volatility in the aggregate stock market. At the same time, the model generates a low mean and volatility for the government bill rate, as well as economically significant excess stock return predictability. The model is set in continuous time, assumes recursive preferences and is solved in closed-form. It is shown that recursive preferences, as well as time-variation in the disaster probability, are key to the model's success.
    JEL: G12
    Date: 2008–10
  10. By: Galina Hale; Mark M. Spiegel
    Abstract: We make use of micro-level data for over 45,000 private bonds issued by over 5000 firms from 22 countries in 1990-2006 to analyze the impact that the launch of the EMU had on the currency denomination of the bond issues. To our knowledge, ours is the first systematic analysis of issue at the micro level. The use of the micro data allows us to distinguish between the response to the advent of the euro by new and seasoned bond issuers, and to condition on other issue characteristics. We find that the impact on new issuers is larger than on seasoned issuers and that most of the increase in the euro-denominated bond issuance was along the "extensive" margin. Insofar as new entrants to the bond market will define the overall currency composition in the long run, these results imply that aggregate studies might be underestimating the euro effect. We also find that to a large extent the increase in euro issuance was "at the expense" of U.S. dollar issuance, suggesting that the euro competes with the U.S. dollar as a currency of choice for international financial transactions.
    Keywords: Bond market ; Euro
    Date: 2008
  11. By: Cristina Arellano; Ananth Ramanarayanan
    Abstract: This paper studies the maturity composition and the term structure of interest rate spreads of government debt in emerging markets. We document that in Argentina, Brazil, Mexico, and Russia, when interest rate spreads rise, debt maturity shortens and the spread on short-term bonds is higher than on long-term bonds. To account for this pattern, we build a dynamic model of international borrowing with endogenous default and multiple maturities of debt. Short-term debt can deliver higher immediate consumption than long-term debt; large longterm loans are not available because the borrower cannot commit to save in the near future towards repayment in the far future. However, issuing long-term debt can insure against the need to roll-over short-term debt at high interest rate spreads. The trade-off between these two benefits is quantitatively important for understanding the maturity composition in emerging markets. When calibrated to data from Brazil, the model matches the dynamics in the maturity of debt issuances and its comovement with the level of spreads across maturities.
    Keywords: Bonds ; Debt ; Default (Finance) ; Emerging markets ; International finance
    Date: 2008
  12. By: Akihiko Takahashi (Faculty of Economics, University of Tokyo); Kyo Yamamoto (Graduate School of Economics, University of Tokyo)
    Abstract: This chapter provides a comprehensive explanation of hedge fund replication. This chapter first reviews the characteristics of hedge fund returns. Then, the emergence of hedge fund replication products is discussed. Hedge fund replication methods are classified into three categories: Rule-based, Factor-based, and Distribution replicating approaches. These approaches attempt to capture different aspects of hedge fund returns. This chapter explains the three methods.
    Date: 2008–09

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