nep-fmk New Economics Papers
on Financial Markets
Issue of 2011‒11‒14
eleven papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Global Financial Crises and Time-varying Volatility Comovement in World Equity Markets By Andrew Stuart Duncan; Alain Kabundi
  2. Volatility Spillovers between the Equity Market and Foreign Exchange Market in South Africa By Lumengo Bonga-Bonga; Jamela Hoveni
  3. Causality and contagion in peripheral EMU public debt markets: a dynamic approach By Marta Gómez-Puig; Simón Sosvilla-Rivero
  4. The Rise and Fall of S&P500 Variance Futures By Chia-Lin Chang; Juan-Ángel Jiménez-Martín; Michael McAleer; Teodosio Pérez-Amaral
  5. Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads Markets By Borgy, V.; Laubach, T.; Mésonnier, J-S.; Renne, J-P.
  6. When does financial sector (in)stability induce financial reforms? By Susie Lee; Ingmar Schumacher
  7. Risk aversion and Uncertainty in European Sovereign Bond Markets By Fourel, V.; Idier, J.
  8. Credit Derivative Pricing with Stochastic Volatility Models By Carl Chiarella; Samuel Chege Maina; Christina Nikitopoulos-Sklibosios
  9. Private Information, Human Capital, and Optimal "Home Bias" in Financial Markets By Ehrlich, Isaac; Shin, Jong Kook; Yin, Yong
  10. Sovereign spreads in the Euro area: Which prospects for a Eurobond? By Favero, Carlo A.; Missale, Alessandro
  11. On the scaling of the distribution of daily price fluctuations in Mexican financial market index By Lester Alfonso; Ricardo Mansilla; Cesar A. Terrero-Escalante

  1. By: Andrew Stuart Duncan; Alain Kabundi
    Abstract: This paper studies volatility comovement in world equity markets between 1994 and 2008. Global volatility factors are extracted from a panel of monthly volatility proxies relating to 25 developed and 20 emerging stock markets. A dynamic factor model (FM) is estimated using two-year rolling window regressions. The FMÂ’s time-varying variance shares of global factors map variations in volatility comovement over time and across countries. The results indicate that global volatility linkages are particularly strong during Â…nancial crises in Asia (1997-8), Russia (1998), and the United States (2007-8). Emerging markets are less syncrhonised with world volatility than are developed markets. In particular, we observe decoupling between emerging and world volatilities between 2001 and 2007. Recoupling occurs during 2008, thus identifying emerging market investments as a temporary hedge against volatility spillovers from the US subprime crisis.
    Keywords: Asset Market Linkages, Dynamic Factor Model, Financial Crisis, International DiversiÂ…cation, Volatility Comovement
    JEL: F36 G11 G15
    Date: 2011
  2. By: Lumengo Bonga-Bonga; Jamela Hoveni
    Abstract: This paper attempts to assess the extent of volatility spillovers between the equity market and the foreign exchange market in South Africa. The multi-step family of GARCH models are used for this end, whereby volatility shocks obtained from the mean equation estimation in each market are included in the conditional volatility of the other market, respectively. The appropriate volatility models for each market are selected, following criteria such as covariance stationarity, persistence in variance and leverage effects. The finding indicates that there is a unidirectional relationship in terms of volatility spillovers, from the equity market to the foreign exchange market. The paper supports the view that the extent of foreign participation in the South African equity market contributes to this pattern of volatility spillover.
    Keywords: equity market, foreign exchange market, spillover, GARCH models
    JEL: F31 G10 C10
    Date: 2011
  3. By: Marta Gómez-Puig (Universidad Complutense de Madrid, Instituto Complutense de Estudios Internacionales); Simón Sosvilla-Rivero (Universidad Complutense de Madrid, Instituto Complutense de Estudios Internacionales)
    Abstract: Our research aims to analyze the causal relationships in the behavior of public debt issued by peripheral member countries of the European Economic and Monetary Union (EMU), with special emphasis on the recent episodes of crisis triggered in the eurozone sovereign debt markets since 2009. With this goal in mind, we make use of a database of daily frequency of yields on 10-year government bonds issued by five EMU countries (Greece, Ireland, Italy, Portugal and Spain), covering the entire history of the EMU from its inception on 1 January 1999 until 31 December 2010. In the first step, we explore the pair-wise causal relationship between yields, both for the whole sample and for changing subsamples of the data, in order to capture the possible time-varying causal relationship. This approach allows us to detect episodes of contagion between yields on bonds issued by different countries. In the second step, we study the determinants of these contagion episodes, analyzing the role played by different factors, paying special attention to instruments that capture the total national debt (domestic and foreign) in each country.
    Abstract: Nuestra investigación tiene como objetivo analizar las relaciones causales en el comportamiento de la deuda pública emitida por países miembros periféricos de la Unión Económica y Monetaria (UEM), con especial énfasis en los recientes episodios de crisis desatados en los mercados de deuda soberana de la zona euro desde 2009. Con este objetivo, empleamos una base de datos de la frecuencia diaria de los rendimientos de los bonos gubernamentales a 10 años emitidos por cinco países de la UEM (Grecia, Irlanda, Italia, Portugal y España), que abarca toda la historia de la UEM desde su inicio el 1 de enero de 1999 al 31 diciembre de 2010. En la primera etapa, se explora la relación causal por pares entre los rendimientos, tanto para la muestra completa y para submuestras cambiantes de los datos, con el fin de capturar posible relación causal en función del tiempo. Este enfoque nos permite detectar episodios de contagio entre los rendimientos de los bonos emitidos por países distintos. En el segundo paso, se estudian los factores determinantes de estos episodios de contagio, el análisis del papel desempeñado por diferentes factores, prestando especial atención a los instrumentos que capturan la deuda nacional total (doméstica y extranjera) en cada país.
    Keywords: Sovereign bond yields, Causality, Time-varying contagion, Euro area, Peripheral EMU countries, Rendimientos bonos soberanos, Causalidad, Contagio variable en el tiempo, Eurozona, Países periféricos UEM.
    Date: 2011
  4. By: Chia-Lin Chang (Department of Applied Economics Department of Finance National Chung Hsing University Taichung, Taiwan); Juan-Ángel Jiménez-Martín (Department of Quantitative Economics Complutense University of Madrid); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, Complutense University of Madrid, and Institute of Economic Research, Kyoto University); Teodosio Pérez-Amaral (Department of Quantitative Economics Complutense University of Madrid)
    Abstract: Modelling, monitoring and forecasting volatility are indispensible to sensible portfolio risk management. The volatility of an asset of composite index can be traded by using volatility derivatives, such as volatility and variance swaps, options and futures. The most popular volatility index is VIX, which is a key measure of market expectations of volatility, and hence also an important barometer of investor sentiment and market volatility. Investors interpret the VIX cash index as a “fear” index, and of VIX options and VIX futures as derivatives of the “fear” index. VIX is based on S&P500 call and put options over a wide range of strike prices, and hence is not model based. Speculators can trade on volatility risk with VIX derivatives, with views on whether volatility will increase or decrease in the future, while hedgers can use volatility derivatives to avoid exposure to volatility risk. VIX and its options and futures derivatives has been widely analysed in recent years. An alternative volatility derivative to VIX is the S&P500 variance futures, which is an expectation of the variance of the S&P500 cash index. Variance futures are futures contracts written on realized variance, or standardized variance swaps. The S&P500 variance futures are not model based, so the assumptions underlying the index do not seem to have been clearly understood. As variance futures are typically thinly traded, their returns and volatility are not easy to model accurately using a variety of model specifications. This paper analyses the volatility in S&P500 3-month variance futures before, during and after the GFC, as well as for the full data period, for each of three alternative conditional volatility models and three densities, in order to determine whether exposure to risk can be incorporated into a financial portfolio without taking positions on the S&P500 index itself.
    Keywords: Risk management, financial derivatives, futures, options, swaps, 3-month variance futures, 12-month variance futures, risk exposure, volatility.
    JEL: C22 G32
    Date: 2011–11
  5. By: Borgy, V.; Laubach, T.; Mésonnier, J-S.; Renne, J-P.
    Abstract: This paper develops an arbitrage-free affine term structure model of potentially defaultable sovereign bonds to model a cross-section of eight euro area government bond yield curves since January 1999. The existence of a common monetary policy under European Monetary Union determines the short end of the yield curves, whereas decentralized debt policies drive expected default probabilities and thereby spreads towards Germany, assumed to be free of default risk. The pricing factors are three observable area-wide macroeconomic variables and measures of national fiscal sustainability, which we proxy by expected changes in debt/GDP ratios of the respective countries. Our model explains spreads both before and during the crisis to an impressive extent. The deterioration in public finances was the major driver of the widening in spreads since 2008 through both heightened compensations for default risk and increases in risk premia. We also present perceived probabilities of sovereign default at any maturity and assess their elasticity to shifts in expected changes in debt/GDP ratios.
    Keywords: Government debt, affine term structure models, default risk, yield spreads, fiscal projections.
    JEL: C32 E6 G12 H6
    Date: 2011
  6. By: Susie Lee (Lehrstuhl fur Kommunal - und Umweltokonomie - Universität Trier); Ingmar Schumacher (Department of Economics, Ecole Polytechnique - CNRS : UMR7176 - Polytechnique - X, Banque Centrale du Luxembourg - [-])
    Abstract: The article studies whether financial sector (in)stability had an effect on reforms in the financial sector in a large cross-country panel from 1990 to 2005. We forward the theory that countries are more likely to liberalize their financial sectors in times of financial stability. We argue that politicians are less likely to undertake financial reforms if they face a strong lobby in the financial sector which is able to block reforms that are not in its interest. Our empirical results suggest that financial instability leads to regulations, while financial stability is found to induce liberalizations. We also find that weaker financial lobbies are unable to block financial reforms while strong lobbies can effectively stop reforms.
    Keywords: Financial reforms; interest group theory; financial stability; financial crises
    Date: 2011–11–03
  7. By: Fourel, V.; Idier, J.
    Abstract: Risk aversion and uncertainty are often both at play in market price determination, but it is empirically challenging to disentangle one from the other. In this paper we set up a theoretical model particularly suited for opaque over-the-counter markets that is shown to be empirically tractable. Based on high frequency data, we thus propose an evaluation of risk aversion and uncertainty inherent to the government bond markets in the euro area between 2007 and 2011. We particularly examine the impact of the European Central Bank Securities Markets Programme [SMP] implemented in May 2010 and re- activated in August 2011 to ease the pressure on the European sovereign bond markets. We show how this programme has killed market uncertainty but raised risk aversion for all countries except Greece in a risk-pooling mechanism: this can therefore weaken the impact of market interventions over the long-term.
    Keywords: MES, systemic risk, tail correlation, balance sheet ratios, panel.
    JEL: D40 D81 E58
    Date: 2011
  8. By: Carl Chiarella (School of Finance and Economics, University of Technology, Sydney); Samuel Chege Maina (School of Finance and Economics, University of Technology, Sydney); Christina Nikitopoulos-Sklibosios (School of Finance and Economics, University of Technology, Sydney)
    Abstract: This paper proposes a framework for pricing credit derivatives within the defaultable Markovian HJM framework featuring unspanned stochastic volatility. Motivated by empirical evidence, hump-shaped level dependent stochastic volatility specifications are proposed, such that the model admits finite dimensional Markovian structures. The model also accommodates a correlation structure between the stochastic volatility, default-free interest rates and credit spreads. Default free and defaultable bonds are explicitly priced and an approach for pricing credit default swaps and swaptions is presented where the credit swap rates can be approximated by defaultable bond prices with varying maturities. A sensitivity analysis capturing the impact of the model parameters including correlations and stochastic volatility, on the credit swap rate and the value of the credit swaption is also presented.
    Keywords: stochastic volatility; Heath-Jarrow-Morton framework; defaultable bond prices; credit spreads; CDS rates
    Date: 2011–07–01
  9. By: Ehrlich, Isaac (University at Buffalo, SUNY); Shin, Jong Kook (University at Buffalo, SUNY); Yin, Yong (University at Buffalo, SUNY)
    Abstract: By allowing for imperfectly informed markets and the role of private information, we offer new insights about observed deviations of portfolio concentrations in domestic relative to foreign risky assets, or "home bias", from what standard finance models predict. Our model ascribes the "bias" to endogenous information acquisition bolstered by investors' human capital. We develop discriminating hypotheses about the influence of "specific" and "general" human capital endowments and direct and opportunity costs of managing risky assets in determining whether to hold these assets, and how the assets' portfolio shares vary across investors and financial markets. These hypotheses are supported by numerical and econometric analyses of panel data from the US over 1992-2007, and 23 international financial markets over 2001-2007. The results indicate the existence of differences across countries in the degree to which home asset prices are "information-revealing", which may be relevant for fully understanding the global financial crisis of 2007-09.
    Keywords: risky assets, financial markets, home bias, human capital, private information, global financial crisis
    JEL: D82 F30 G11 G12 G15 J24
    Date: 2011–10
  10. By: Favero, Carlo A.; Missale, Alessandro
    Abstract: In this paper, we provide new evidence on the determinants of sovereign yield spreads and contagion effects in the euro area in order to evaluate the rationale for a common Eurobond jointly guaranteed by euro-area Member States. We find that default risk is the main driver of yield spreads, suggesting small gains from greater liquidity. Fiscal fundamentals matter in the pricing of default risk but only as they interact with other countries’ yield spreads; i.e. with the global risk that the market perceives. More important, the impact of this global risk variable is not constant over time, a clear sign of contagion driven by shifts in market sentiment. This evidence points to a discontinuity in the disciplinary role of financial markets. If markets can stay irrational longer than a country can stay solvent, then the role of yield spreads on national bonds as a fiscal discipline device is considerably weakened, and issuing Eurobonds can be economically justified.
    Keywords: contagion; Eurobonds; sovereign debt crisis
    Date: 2011–11
  11. By: Lester Alfonso; Ricardo Mansilla; Cesar A. Terrero-Escalante
    Abstract: In this paper, a statistical analysis of log-return fluctuations of the IPC, the Mexican Stock Market Index is presented. A sample of daily data covering the period from $04/09/2000-04/09/2010$ was analyzed, and fitted to different distributions. Tests of the goodness of fit were performed in order to quantitatively asses the quality of the estimation. Special attention was paid to the impact of the size of the sample on the estimated decay of the distributions tail. In this study a forceful rejection of normality was obtained. On the other hand, the null hypothesis that the log-fluctuations are fitted to a $\alpha$-stable L\'evy distribution cannot be rejected at 5% significance level.
    Date: 2011–11

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