nep-fmk New Economics Papers
on Financial Markets
Issue of 2010‒12‒18
eight papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. The governance of financial regulation: reform lessons from the recent crisis By Ross Levine
  2. Recurrence quantification analysis of global stock markets By Joao A. Bastos; Jorge Caiado
  3. Modelling Overnight and Daytime Returns Using a Multivariate GARCH-Copula Model By Long Kang; Simon H. Babbs
  4. Adverse Selection, Liquidity, and Market Breakdown By Koralai Kirabaeva
  5. Leverage and risk in US commercial banking in the light of the current financial crisis By Nikolaos Papanikolaou; Christian Wolff
  6. Term Structure Models Can Predict Interest Rate Volatility. But How? By Hideyuki Takamizawa
  7. Why issue bonds offshore? By Susan Black; Anella Munro
  8. The impact of CDS trading on the bond market: evidence from Asia By Ilhyock Shim; Haibin Zhu

  1. By: Ross Levine
    Abstract: There was a systemic failure of financial regulation: senior policymakers repeatedly enacted and implemented policies that destabilised the global financial system. They maintained these policies even as they learned of the consequences of their policies during the decade before the crisis. The crisis does not primarily reflect an absence of regulatory power, unclear lines of regulatory authority, capital account imbalances, or a lack of information by regulators. Rather, it represents the unwillingness of the policy apparatus to adapt to a dynamic, innovating financial system. A new institution is proposed to improve the design, implementation and modification of financial regulations.
    Keywords: financial institutions, regulation, policy, financial crisis
    Date: 2010–12
  2. By: Joao A. Bastos (CEMAPRE, School of Economics and Management (ISEG), Technical University of Lisbon); Jorge Caiado (CEMAPRE, School of Economics and Management (ISEG), Technical University of Lisbon)
    Abstract: This study investigates the presence of deterministic dependencies in international stock markets using recurrence plots and recurrence quantification analysis (RQA). The results are based on a large set of free float-adjusted market capitalization stock indices, covering a period of 15 years. The statistical tests suggest that the dynamics of stock prices in emerging markets is characterized by higher values of RQA measures when compared to their developed counterparts. The behavior of stock markets during critical financial events, such as the burst of the technology bubble, the Asian currency crisis, and the recent subprime mortgage crisis, is analyzed by performing RQA in sliding windows. It is shown that during these events stock markets exhibit a distinctive behavior that is characterized by temporary decreases in the fraction of recurrence points contained in diagonal and vertical structures.
    Keywords: Recurrence plot, Recurrence quantification analysis, Nonlinear dynamics, International stock markets
    JEL: C14 G15
    Date: 2010–12
  3. By: Long Kang (The Options Clearing Corporation); Simon H. Babbs (The Options Clearing Corporation)
    Abstract: We introduce a multivariate GARCH-Copula model to describe joint dynamics of overnight and daytime returns for multiple assets. The conditional mean and variance of individual overnight and daytime returns depend on their previous realizations through a variant of GARCH specification, and two Student’s t copulas describe joint distributions of both returns respectively. We employ both constant and time-varying correlation matrices for the t copulas and with the time-varying case the dependence structure of both returns depends on their previous dependence structures through a DCC specification. We estimate the model by a two-step procedure, where marginal distributions are estimated in the first step and copulas in the second. We apply our model to overnight and daytime returns of SPDR ETFs of nine major sectors and briefly illustrate its use in risk management and asset allocation. Our empirical results show higher mean, lower variance, fatter tails and lower correlations for overnight returns than daytime returns. Daytime returns are significantly negatively correlated with previous overnight returns. Moreover, daytime returns depend on previous overnight returns in both conditional variance and correlation matrix (through a DCC specification). Most of our empirical findings are consistent with the asymmetric information argument in the market microstructure literature. With respect to econometric modelling, our results show a DCC specification for correlation matrices of t copulas significantly improves the fit of data and enables the model to account for time-varying dependence structure.
    Date: 2010–06
  4. By: Koralai Kirabaeva
    Abstract: This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.
    Keywords: Financial institutions; Financial markets; Financial stability
    JEL: G11 D82
    Date: 2010
  5. By: Nikolaos Papanikolaou (Luxembourg School of Finance, University of Luxembourg); Christian Wolff (Luxembourg School of Finance, University of Luxembourg)
    Abstract: In this paper we study the relationship between leverage and risk in commercial banking market. We employ a panel data set that consists of the biggest US commercial banks and which extends from 2002 to 2010 thus covering both the years before the outbreak of the current financial crisis as well as those followed. We make clear distinctions among different leverage types like on- and off-balance sheet leverage as well as short- and long-term leverage, which have never been made in the relevant literature. Our findings provide evidence that excessive leverage, both explicit and hidden off-the-balance sheet, rendered large banks vulnerable to financial shocks thus contributing to the fragility of the whole banking industry. In a similar vein, a direct link between short- and long-term leverage with risk is reported before the crisis, showing that leverage has been one of the key factors responsible for the serious liquidity shortages that were revealed after 2007 when the crisis erupted. We also demonstrate that banks which concentrate on traditional banking activities typically carry less risk exposure than those that are involved with modern financial instruments. Overall, our results provide a better understanding of the role of leverage in destabilizing the whole system whereas at the same time contribute to the current discussion on the resilience of the banking sector through the strengthening of the existing regulatory framework.
    Keywords: financial crisis; risk; leverage; commercial banking
    JEL: C23 D02 G21 G28
    Date: 2010
  6. By: Hideyuki Takamizawa
    Abstract: This paper attempts to predict the volatility of interest rates through dynamic term structure models. For this attempt, the models are improved, based on the three-factor Gaussian model, to have level-dependent volatilities supported by data. The empirical results show that the predictive power of the proposed models is higher than that of the affine models. Compared with time-series models, it is low for the four-week forecasting horizon but can be comparable for middle to long term rates by extending the horizon up to 32 weeks. The combination of these two different types of forecasts can lead to higher predictive power.
    Date: 2010–11
  7. By: Susan Black; Anella Munro
    Abstract: This paper asks why Asia-Pacific residents issue debt in offshore markets and considers the implications for domestic debt markets. We use unit record data for bond issuance by non-government residents of Australia, Hong Kong, Korea, Japan and Singapore to link the decision to issue offshore to potential benefits. The results suggest that residents of smaller markets issue bonds offshore to arbitrage price differentials; to access foreign investors; and to issue larger, lower-rated or longer-maturity bonds. These bond characteristics tend to be correlated with offshore bond market size. The results support the notions that (i) deviations from covered interest parity are actively arbitraged by residents of minor currency areas, as well as by internationally active borrowers, as established in the literature; and (ii) issuers benefit from the liquidity and diversification of larger "complete" offshore markets. Against the potential benefits to borrowers, we consider the risks for both borrowers and the domestic market, and lessons from the ongoing financial crisis such as the benefits of funding diversification.
    Keywords: offshore bonds, interest rate parity, local currency debt
    Date: 2010–12
  8. By: Ilhyock Shim; Haibin Zhu
    Abstract: This paper investigates the impact of CDS trading on the development of the bond market in Asia. In general, CDS trading has lowered the cost of issuing bonds and enhanced the liquidity in the bond market. The positive impact is stronger for smaller firms, non-financial firms and those firms with higher liquidity in the CDS market. These empirical findings support the diversification and information hypotheses in the literature. Nevertheless, CDS trading has also introduced a new source of risk. There is strong evidence that, at the peak of the recent global financial crisis, those firms included in CDS indices faced higher bond yield spreads than those not included.
    Keywords: credit default swaps, bond spreads, bond liquidity, CDS index, Asia
    Date: 2010–12

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