New Economics Papers
on Financial Markets
Issue of 2009‒07‒28
six papers chosen by

  1. Overdependence on Credit Ratings Was a Primary Cause of the Crisis By Frank Partnoy
  2. A question of liquidity: the great banking run of 2008? By Judit Montoriol-Garriga; Evan Sekeris
  3. CDOs and Systematic Risk: Why bond ratings are inadequate By Jan Pieter Krahnen; Christian Wilde
  4. Options Introduction and Volatility in the EU ETS By Julien Chevallier; Yannick Le Pen; Benoît Sévi
  5. Trading Frequency and Volatility Clustering By Yi Xue; Ramazan Gencay
  6. A Factor Analysis of Bond Risk Premia By Sydney C. Ludvigson; Serena Ng

  1. By: Frank Partnoy (University of San Diego School of Law)
    Abstract: The first part of the paper describes how over time credit rating agencies ceased to play the role of information intermediaries. Rating agencies did not provide information about the risk associated with the securitized instruments, but they simply enabled structurers to create and maintain tranches of these instruments with unjustifiably high credit ratings. The second part of the paper suggests how future policy may minimize overdependence on credit ratings, by removing regulatory licences and by implementing shock-therapy mechanisms to wean investors simple rating mnemonics.
    Keywords: Rating Agencies, Subprime Mortgages, Securitization
    JEL: G24
    Date: 2009–05
  2. By: Judit Montoriol-Garriga; Evan Sekeris
    Abstract: The current financial crisis has given rise to a new type of bank run, one that affects both the banks' assets and liabilities. In this paper we combine information from the commercial paper market with loan level data from the Survey of Terms of Business Loans to show that during the 2007-2008 financial crises banks suffered a run on credit lines. First, as in previous crises, we find an increase in the usage of credit lines as commercial spreads widen, especially among the lowest quality firms. Second, as the crises deepened, firms drew down their credit lines out of fear that the weakened health of their financial institution might affect the availability of the funds going forward. In particular, we show that these precautionary draw-downs are strongly correlated with the perceived default risk of their bank. Finally, we conclude that these runs on credit lines have weakened banks further, curtailing their ability to effectively fulfill their role as financial intermediaries.
    Keywords: Bank assets ; Bank liabilities ; Financial crises ; Commercial credit
    Date: 2009
  3. By: Jan Pieter Krahnen; Christian Wilde
    Abstract: This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments.
    Keywords: credit risk, risk transfer, systematic risk
    JEL: G21 G28
    Date: 2009–06
  4. By: Julien Chevallier (EconomiX - CNRS : UMR7166 - Université de Paris X - Nanterre); Yannick Le Pen (LEMNA - Laboratoire d'économie et de management de Nantes Atlantique - Université de Nantes : EA4272); Benoît Sévi (GRANEM LEMNA - Université d'Angers - Université de Nantes)
    Abstract: To improve risk management in the European Union Emissions Trading Scheme (EU ETS), the European Climate Exchange (ECX) has introduced option instruments in October 2006 after regulatory authorization. The central question we address is: can we identify a potential destabilizing effect of the introduction of options on the underlying market (EU ETS futures)? Indeed, the literature on commodities futures suggest that the introduction of derivatives may either decrease (due to more market depth) or increase (due to more speculation) volatility. As the identification of these effects ultimately remains an empirical question, we use daily data from April 2005 to April 2008 to document volatility behavior in the EU ETS. By instrumenting various GARCH models, endogenous break tests, and rolling window estimations, our results overall suggest that the introduction of the option market had no effect on the volatility in the EU ETS. These finding are robust to other likely influences linked to energy and commodity markets.
    Keywords: EU ETS, Option prices, Volatility, GARCH, Rolling Estimation, Endogenous Structural Break Detection
    Date: 2009–07–20
  5. By: Yi Xue (Department of Economics, Simon Fraser University); Ramazan Gencay (Department of Economics, Simon Fraser University)
    Abstract: Volatility clustering, with autocorrelations of the hyperbolic decay rate, is unquestionably one of the most important stylized facts of financial time series. This paper presents a market microstructure model, that is able to generate volatility clustering with hyperbolic autocorrelations through traders with multiple trading frequencies using Bayesian information updating in an incomplete market. The model illustrates that signal extraction, which is induced by multiple trading frequency, can increase the persistence of the volatility of returns. Furthermore, we show that the local temporal memory of the underlying time series of returns and their volatility varies greatly varies with the number of traders in the market
    Keywords: Trading frequency, Volatility clustering, Signal extraction, Hyperbolic decay
    JEL: G10 G11 D43 D82
    Date: 2009–01
  6. By: Sydney C. Ludvigson; Serena Ng
    Abstract: This paper uses the factor augmented regression framework to analyze the relation between bond excess returns and the macro economy. Using a panel of 131 monthly macroeconomic time series for the sample 1964:1-2007:12, we estimate 8 static factors by the method of asymptotic principal components. We also use Gibb sampling to estimate dynamic factors from the 131 series reorganized into 8 blocks. Regardless of how the factors are estimated, macroeconomic factors are found to have statistically significant predictive power for excess bond returns. We show how a bias correction to the parameter estimates of factor augmented regressions can be obtained. This bias is numerically trivial in our application. The predictive power of real activity for excess bond returns is robust even after accounting for finite sample inference problems. Forecasts of excess bond returns (or bond risk premia) are countercyclical. This implies that investors are compensated for risks associated with recessions.
    JEL: G12
    Date: 2009–07

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