New Economics Papers
on Financial Markets
Issue of 2009‒11‒14
six papers chosen by

  1. Banks’ risk race: a signaling explanation By Besancenot, Damien; Vranceanu, Radu
  2. The equity premium puzzle: High required equity premium, undervaluation and self fulfilling prophecy By Fernandez, Pablo; Aguirreamalloa, Javier; Liechtenstein, Heinrich
  3. Betas used by professors: A survey with 2,500 answers By Fernandez, Pablo
  4. Extreme Dependence in International Stock Markets By Cathy Ning
  5. Density forecasting of the Dow Jones share index By Öller, L-E; Stockhammar, P
  6. Large-scale portfolios using realized covariance matrix: evidence from the Japanese stock market By Masato Ubukata

  1. By: Besancenot, Damien (University Paris 13 and CEPN (Centre d'Economie de l'université Paris Nord)); Vranceanu, Radu (ESSEC Business School, Department of Economics)
    Abstract: Many observers argue that the abnormal accumulation of risk by banks has been one of the major causes of the 2007-2009 financial turmoil. But what could have pushed banks to engage in such a risk race? The answer brought by this paper builds on the classical signaling model by Spence. If banks’ returns can be observed while risk cannot, less efficient banks can hide their type by taking more risks and paying the same returns as the efficient banks. The latter can signal themselves by taking even higher risks and delivering bigger returns. The game presents several equilibria that are all characterized by excessive risk taking as compared to the perfect information case.
    Keywords: Banking Sector; Imperfect Information; Risk Strategy; Risk/return Tradeoff; Signaling
    JEL: D82 G21 G32
    Date: 2009–10
  2. By: Fernandez, Pablo (IESE Business School); Aguirreamalloa, Javier (IESE Business School); Liechtenstein, Heinrich (IESE Business School)
    Abstract: We argue that the equity premium puzzle may be explained by the fact that most market participants (equity investors, investment banks, analysts, companies¿) do not use standard theory (such as a standard representative consumer asset pricing model) for determining their Required Equity Premium, but rather, they use historical data and advices from textbooks and finance professors. Consequently, ex-ante equity premia have been high, market prices have been consistently undervalued, and the ex-post risk premia has been also high. Professors use in class and in their textbooks high equity premia (average around 6%, range from 3 to 10%), and investors use higher equity premia for valuing companies (average around 6%). The overall result is that equity prices have been, on average, undervalued in the last decades and, consequently, the measured ex-post equity premium is also high. As most investors use historical data and textbook prescriptions to estimate the required and the expected equity premium, the undervaluation and the high ex-post risk premium are self fulfilling prophecies.
    Keywords: equity premium puzzle; required equity premium; historical equity premium;
    JEL: G12 G31 M21
    Date: 2009–09–07
  3. By: Fernandez, Pablo (IESE Business School)
    Abstract: We report 2,510 answers from professors from 65 countries and 934 institutions. 1,791 respondents use betas, but 107 of them do not justify the betas they use. 97.3% of the professors that justify the betas use regressions, webs, databases, textbooks or papers (the paper specifies which ones), although many of them state that calculated betas "are poorly measured and have many problems". Only 0.9% of the professors justify the beta using exclusively personal judgement (named qualitative, common sense, intuitive, and logical magnitude betas by different professors). The paper includes interesting comments from 160 professors. We all admit that different investors may have different expected cash flows, but many of us affirm that the required return should be equal for everybody: That is a kind of schizophrenic approach to valuation. Most professors teach that the expected cash flows should be computed using common sense and good judgement about the company, its industry, the national economies¿ However, many professors teach a formula to calculate the discount rate (instead of using again common sense).
    Keywords: historical beta; calculated beta; common sense;
    JEL: G12 G31 M21
    Date: 2009–09–09
  4. By: Cathy Ning (Department of Economics, Ryerson University, Toronto, Canada)
    Abstract: This paper investigates the structure and degree of extreme dependence in international equity markets using carefully selected tools from the theory of copulas. We examine both the static and dynamic dependence via unconditional and conditional copulas. We find significant asymmetric tail dependence in equity markets, with the overall larger lower tail dependence than upper tail dependence. Moreover, in Europe and East Asia but not in North America, the extreme dependence is time-varying in both its structure and degree. Our results also indicate a higher intra-continental than inter-continental tail dependence. Our findings have important implications in global risk management strategies.
    Keywords: Copulas; Tail dependence; Time varying dependence; International financial markets; Risk diversification.
    JEL: C14 C51 G15 G32
    Date: 2009–11
  5. By: Öller, L-E; Stockhammar, P
    Abstract: The distribution of differences in logarithms of the Dow Jones share index is compared to the normal (N), normal mixture (NM) and a weighted sum of a normal and an Assymetric Laplace distribution (NAL). It is found that the NAL fits best. We came to this result by studying samples with high, medium and low volatility, thus circumventing strong heteroscedasticity in the entire series. The NAL distribution also fitted economic growth, thus revealing a new analogy between financial data and real growth.
    Keywords: Density forecasting; heteroscedasticity; mixed Normal- Asymmetric Laplace distribution; Method of Moments estimation; connection with economic growth.
    JEL: C20
    Date: 2009
  6. By: Masato Ubukata (Graduate School of Economics, Osaka University)
    Abstract: The objective of this paper is to examine effects of realized covariance matrix estimators based on intraday returns on large-scale minimum-variance equity portfolio optimization. We empirically assess out-of-sample performance of portfolios with different covariance matrix estimators: the realized covariance matrix estimators and Bayesian shrinkage estimators based on the past monthly and daily returns. The main results are: (1) the realized covariance matrix estimators using the past intraday returns yield a lower standard deviation of the large-scale portfolio returns than the Bayesian shrinkage estimators based on the monthly and daily historical returns; (2) gains to switching to strategies using the realized covariance matrix estimators are higher for an investor with higher relative risk aversion; and (3) the better portfolio performance of the realized covariance approach implied by ex-post returns in excess of the risk-free rate, the standard deviations of the excess returns, the return per unit of risk (Sharpe ratio) and the switching fees seems to be robust to the level of transaction costs.
    Keywords: Large-scale portfolio selection; Realized covariance matrix; Intraday data
    JEL: G11
    Date: 2009–09

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