New Economics Papers
on Financial Markets
Issue of 2010‒01‒10
ten papers chosen by

  1. Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis By D. Sornette; R. Woodard
  2. TIPS, Inflation Expectations and the Financial Crisis By Thorsten Lehnert; Aleksandar Andonov; Florian Bardong
  3. Empirical Risk Factors in Realized Stock Returns By Jiri Novak; Dalibor Petr
  4. Modelling the Volatility-Return Trade-off when Volatility may be Nonstationary By Christian M. Dahl; Emma M. Iglesias
  5. Time-Variation in Term Permia: International Survey-Based Evidence By Christian Wolff; Ron Jongen; Willem F.C. Verschoor
  6. International Financial competition and bank risk-taking in emerging economies By Arnaud Bourgain; Patrice Pieretti; Skerdilajda Zanaj
  7. Asian Sovereign Debt and Country Risk By Johansson, Anders C.
  8. The information content of market liquidity: An empirical analysis of liquidity at the Oslo Stock Exchange By Skjeltorp, Johannes; Ødegaard, Bernt Arne
  9. Directional and non-directional risk exposures in Hedge Fund returns By Marie Lambert; George Hübner; Marie Lambert
  10. Behavioral Heterogeneity in the Option Market By Thorsten Lehnert; Bart Frijns; Remco Zwinkels

  1. By: D. Sornette; R. Woodard
    Abstract: The financial crisis of 2008, which started with an initially well-defined epicenter focused on mortgage backed securities (MBS), has been cascading into a global economic recession, whose increasing severity and uncertain duration has led and is continuing to lead to massive losses and damage for billions of people. Heavy central bank interventions and government spending programs have been launched worldwide and especially in the USA and Europe, with the hope to unfreeze credit and boltster consumption. Here, we present evidence and articulate a general framework that allows one to diagnose the fundamental cause of the unfolding financial and economic crisis: the accumulation of several bubbles and their interplay and mutual reinforcement has led to an illusion of a ``perpetual money machine'' allowing financial institutions to extract wealth from an unsustainable artificial process. Taking stock of this diagnostic, we conclude that many of the interventions to address the so-called liquidity crisis and to encourage more consumption are ill-advised and even dangerous, given that precautionary reserves were not accumulated in the ``good times'' but that huge liabilities were. The most ``interesting'' present times constitute unique opportunities but also great challenges, for which we offer a few recommendations.
    Keywords: Financial crisis, bubbles, real estate bubble, derivatives, super-exponential
    JEL: O16
    Date: 2009–05–02
  2. By: Thorsten Lehnert (Luxembourg School of Finance, University of Luxembourg); Aleksandar Andonov (Limburg Institute of Financial Economics, Maastricht University); Florian Bardong (Fixed Income Research, Barclays Global Investors, London)
    Abstract: Previous research indicates that the US market for inflation-linked bonds is not efficient and that market inefficiencies can be exploited by informed traders who include survey estimations or inflation model forecasts in trades on break-even inflation. Results from this extended research over a time-period in which the TIPS market matured and increased in depth, while the volatility of real yields and inflation increased, confirm that TIPS market inefficiency was not temporary but persisted over the entire time period between 1997 and 2009. Using estimations generated by the Survey of Professional Forecasters or forecasts based on the Kothari and Shanken (2004) inflation model to construct a break-even trading strategy leads to excess returns over a static buy-and-hold strategy. These excess returns remain substantial even after accounting for trading costs. Furthermore, TIPS returns still include a substantial liquidity premium, which increased during the financial crisis.
    Keywords: TIPS, market, inflation expectations, survey of Professional Forecasters, financial crisis
    JEL: E31 E43 E44
    Date: 2009
  3. By: Jiri Novak (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic); Dalibor Petr (Palacky University, Olomouc)
    Abstract: Measuring risk in the stock market context is one of the key challenges of modern finance. Despite of the substantial significance of the topic to investors and market regulators, there is a controversy over what risk factors should be used to price the assets or to determine the cost of capital. We empirically investigate the ability of several commonly proposed risk factors to predict Swedish stock returns. We consider the sensitivity of an asset returns to the variation in market returns, the market value of equity, the ratio of market value of equity to book value of equity and the short-term historical stock returns. We conclude that none of these factors is clearly significant for explaining stock returns at the Stockholm Stock Exchange, which casts doubt on their use as universal risk factors in various corporate governance contexts. It seems that the previously documented relationship is contingent on the data sample used and on the time period.
    Keywords: stock returns, asset pricing, risk, multifactor models, CAPM, size, book-to-market, momentum, Sweden
    JEL: G12 C21
    Date: 2009–12
  4. By: Christian M. Dahl (University of Aarhus and CREATES); Emma M. Iglesias (Department of Economics, Michigan State University and University of Essex)
    Abstract: In this paper a new GARCH–M type model, denoted the GARCH-AR, is proposed. In particular, it is shown that it is possible to generate a volatility-return trade-off in a regression model simply by introducing dynamics in the standardized disturbance process. Importantly, the volatility in the GARCH-AR model enters the return function in terms of relative volatility, implying that the risk term can be stationary even if the volatility process is nonstationary. We provide a complete characterization of the stationarity properties of the GARCH-AR process by generalizing the results of Bougerol and Picard (1992b). Furthermore, allowing for nonstationary volatility, the asymptotic properties of the estimated parameters by quasi-maximum likelihood in the GARCH-AR process are established. Finally, we stress the importance of being able to choose correctly between AR-GARCH and GARCH-AR processes: First, it is shown, by a small simulation study, that the estimators for the parameters in an ARGARCH model will be seriously inconsistent if the data generating process actually is a GARCH-AR process. Second, we provide an LM test for neglected GARCH-AR effects and discuss its finite sample size properties. Third, we provide an empirical illustration showing the empirical relevance of the GARCH-AR model based on modelling a wide range of leading US stock return series.
    Keywords: Quasi-Maximum Likelihood, GARCH-M Model, Asymptotic Properties, Risk-return Relation.
    JEL: C12 C13 C22 G12
    Date: 2009–10–02
  5. By: Christian Wolff (Luxembourg School of Finance, University of Luxembourg); Ron Jongen (Erasmus School of Economics, Erasmus University Rotterdam); Willem F.C. Verschoor
    Abstract: Using a large, previously unexplored international dataset of market expectations that covers a broad range of deposits, this paper presents a wealth of empirical evidence on the behavior of the term structure of interest rates in an international perspective. We find that our survey forecasts are of quite good quality, outperforming a relevant naive benchmark in most cases. We also find considerable international evidence in favor of rejecting the ‘pure’ version of the expectations hypothesis. We also find some evidence that the behavior of market participants, when making predictions about the future level of interest rates, is not entirely in line with rational behavior. There is strong evidence of time-variation in term premia. Furthermore, while this variation in term premia can be captured adequately by low-order members of the ARMA class models, there is clear evidence that conditional heteroskedasticity in the movement of term premia plays an important role in explaining the time-variation for a number of countries.
    Keywords: Interest rate expectations, expectations hypothesis, rationality, survey data, term structure, time-varying term premia.
    JEL: E43 G15 E42
    Date: 2009
  6. By: Arnaud Bourgain; Patrice Pieretti; Skerdilajda Zanaj (CREA, University of Luxembourg)
    Abstract: In this paper, we analyze the risk taking behavior of banks in emerging economies, in a context of international bank competition. In the spirit of Vives (2002 and 2006) who has developed the notion of "external market discipline", our paper introduces a new channel through which depositors can exercise pressure to control risk taking. They can reallocate their savings away from their home country to a more protective system of a developed economy. In such a frame- work, we show that there is no univoque relationship between the information disclosure of risk management and excessive risk taking. This relationship depends on the degree of financial openness of the emergent country, which ultimately defines how e¤ective the market discipline is. Furthermore, we analyze the risk taking choice of banks in emergent economies in presence of deposit insurance. We find no monotone relationship between the likeliness of excessive risk taking of banks in the emerging country and the level of deposit insurance.
    JEL: G21 G28 F39 L60
    Date: 2009
  7. By: Johansson, Anders C. (China Economic Research Center)
    Abstract: This paper analyzes systematic risk of sovereign bonds in four East Asian countries: China, Malaysia, Philippines, and Thailand. A bivariate stochastic volatility model that allows for time-varying correlation is estimated with Markov Chain Monte Carlo simulation. The volatilities and correlation are then used to calculate the time-varying betas. The results show that country-specific systematic risk in Asian sovereign bonds varies over time. When adjusting for inherent exchange rate risk, the pattern of systematic risk is similar, even though the level is generally lower. The findings have important implications for international portfolio managers that invest in emerging sovereign bonds and those who need benchmark instruments to analyze risk in assets such as corporate bonds in the emerging Asian financial markets.
    Keywords: Asia; sovereign bonds; systematic risk; stochastic volatility; Markov Chain Monte Carlo
    JEL: C32 F31 G12 G15
    Date: 2009–12–01
  8. By: Skjeltorp, Johannes (Norges Bank); Ødegaard, Bernt Arne (University of Stavanger)
    Abstract: We investigate the information content of aggregate stock market liquidity and ask whether it may be a useful realtime indicator, both for financial stress, and real economic activity in Norway. We describe the development in a set of liquidity proxies at the Oslo Stock Exchange (OSE) for the period 1980-2008, with particular focus on crisis period 2007 through 2008, showing how market liquidity and trading activity changed for the whole market as well as for individual industry sectors. We also evaluate the predictive power of market liquidity for economic growth both in-sample and out-of-sample.
    Keywords: Liquidity; Business Cycles; Financial crisis; Economic Activity
    JEL: G10 G20
    Date: 2009–12–03
  9. By: Marie Lambert (Luxembourg School of Finance, University of Luxembourg); George Hübner (HEC Management School, University of Liège); Marie Lambert (HEC Montreal.)
    Abstract: This paper re-examines the ability of the factor model approach to evaluate the performance of hedge funds. The analysis incorporates traditional asset based factors as well as an array of new and previously studied option based factors and instrumental variables. As hedge fund returns are not normally distributed, higher order moments play a significant role in maximizing the investors’ expected utility. As a result, hedge fund performance evaluation should assign a premium to higher order asset co-moments of hedge fund returns with the aggregate market in order to consistently capture the sources of hedge fund returns. We provide evidence that there is still much information embedded in option prices, particularly in the implied higher moments, which has not previously been exploited. These new option based factors increase the explanatory power of the models across all the hedge fund strategies.
    Keywords: Hedge funds, style, higher-moment, option-based factors, conditional factors
    JEL: G12 C32
    Date: 2009
  10. By: Thorsten Lehnert (Luxembourg School of Finance, University of Luxembourg); Bart Frijns (Department of Finance, Auckland University of Technology, New Zealand); Remco Zwinkels (Erasmus School of Economics, Erasmus University Rotterdam.)
    Abstract: This paper develops and tests a heterogeneous agents model for the option market. Our agents have different beliefs about the future level of volatility of the underlying stock index and trade accordingly. We consider two types of agents: fundamentalists and chartists, who are able to switch between groups according to a multinomial logit switching rule. The model simplifies to a GARCH-type specification with time-varying parameters. Estimation results for DAX30 index options reveal that different types of traders are actively involved in trading volatility. Our model improves frequently used standard GARCH-type models in terms of pricing performance.
    Keywords: Heterogeneous Agents, Option Markets, Fundamentalists, Chartists, GARCH.
    JEL: G12 C15
    Date: 2009

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.