nep-fmk New Economics Papers
on Financial Markets
Issue of 2012‒04‒10
ten papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Why is Price Discovery in Credit Default Swap Markets News-Specific? By Ian W. Marsh; Wolf Wagner
  2. Stock prices under pressure; How tax and interest rates drive returns at the turn of the tax year By JOhnny Kang; Tapio Pekkala; Christopher Polk; Ruy Ribeiro
  3. Anticipated and Repeated Shocks in Liquid Markets By Hongjun Yan; Jinfan Zhang; Dong Lou
  4. Bond Variance Risk Premia By Philippe Mueller; Andrea Vedolin; Yu-min Yen
  5. Short Run Bond Risk Premia By Philippe Mueller; Andrea Vedolin; Hao Zhou
  6. Debt Financing in Asset Markets By Zhiguo He; Wei Xiong
  7. CDS Auctions By Mikhail Chernov; Alexander S.Gorbenko; Igor Makarov
  8. Repo Runs By Antoine Martin; David Skeie; Ernst-Ludig von Thadden
  9. Dynamic Hedging in Incomplete Markets: A Simple Solution By Suleyman Basak; Georgy Chabakauri
  10. Business credit information sharing and default risk of private firms By Maik Dierkes; Carsten Erner; Thomas Langer; Lars Norden

  1. By: Ian W. Marsh (Cass Business School); Wolf Wagner (Tilburg University, and Duisenberg school of finance)
    Abstract: We analyse daily lead-lag patterns in US equity and credit default swap (CDS) returns. We first document that equity returns robustly lead CDS returns. However, we find that the CDS-lag is due to <I>common</I> (and not firm-specific) news and arises predominantly in response to <I>positive</I> (instead of negative) equity market news. We provide an explanation for this news-specific price discovery based on dealers in the CDS market exploiting their informational advantage vis-à-vis institutional investors with hedging demands. In support of this explanation we find that the CDS-lag and its news-specificity are related to various firm-level proxies for hedging demand in the cross-section as well measures for economy-wide informational asymmetries over time.
    Keywords: G1; G12; G14
    Date: 2012–04–02
  2. By: JOhnny Kang; Tapio Pekkala; Christopher Polk; Ruy Ribeiro
    Abstract: We show that the level of interest rates determines the magnitude of mispricing at the turn of the tax year, as investors face the trade-o¤ between selling a temporarily depressed stock this year and selling next year, but delaying tax implications by one year. Interest rates do explain the predictable variation in US returns and selling behaviour around the turn of the year. Similar results in the UK provide out-of-sample confirmation, as tax and calendar years di¤er. Moreover, part of the variation in the risks and abnormal returns of size, value, and momentum factors can be linked to tax-motivated trading.
    Date: 2011–02
  3. By: Hongjun Yan; Jinfan Zhang; Dong Lou
    Abstract: We show that Treasury security prices in the secondary market decrease significantly before subsequent auctions and recover shortly after. This price pattern implies a large issuance cost for the Treasury Department, which is estimated to be between 9 and 18 basis points of the auction size. For example, this cost amounts to over half a billion dollars for issuing Treasury notes alone in 2007. Our results appear to be consistent with the hypothesis of primary dealers’ limited risk-bearing capacity and the imperfect capital mobility of end investors in the Treasury market (e.g., federal agencies, sovereign wealth funds, pension funds, and etc.), highlighting the important role of capital mobility even in the most liquid financial markets.
    Date: 2011–06
  4. By: Philippe Mueller; Andrea Vedolin; Yu-min Yen
    Abstract: Using data from 1983 to 2010, we propose a new fear measure for Treasury markets, akin to the VIX for equities, labeled TIV. We show that TIV explains one third of the time variation in fund- ing liquidity and that the spread between the VIX and TIV captures flight to quality. We then construct Treasury bond variance risk premia as the difference between the implied variance and an expected variance estimate using autoregressive models. Bond variance risk premia display pronounced spikes during crisis periods. We show that variance risk premia encompass a broad spectrum of macroeconomic uncertainty. Uncertainty about the nominal and the real side of the economy increase variance risk premia but uncertainty about monetary policy has a strongly neg- ative effect. We document that bond variance risk premia predict excess returns on Treasuries, stocks, corporate bonds and mortgage-backed securities, both in-sample and out-of-sample. Fur- thermore, this predictability is not subsumed by other standard predictors.
    Date: 2012–01
  5. By: Philippe Mueller; Andrea Vedolin; Hao Zhou
    Abstract: In the short-run, bond risk premia exhibit pronounced spikes around major economic and financial crises. In contrast, long-term bond risk premia feature cyclical swings. We empirically examine the predictability of the market variance risk premium—a proxy of economic uncertainty—for bond risk premia and we show the strong predictive power for the one month horizon that almost entirely disappears for horizons above one year. The variance risk premium is largely orthogonal to well-established bond return predictors—forward rates, jumps, yield curve factors, and macro variables. We rationalize our empirical findings in an equilibrium model of uncertainty about consumption and inflation which is coupled with recursive preferences. We show that the model can quantitatively explain the levels of bond and variance risk premia as well as the predictive power of the variance risk premium while jointly matching salient features of other asset prices.
    Date: 2011–06
  6. By: Zhiguo He; Wei Xiong
    Abstract: We study rollover risk and collateral value in a dynamic asset pricing model with endogenous debt financing by extending the framework of Geanakoplos (2009) with a generic binomial tree and time-varying heterogeneous beliefs. Optimistic borrowers face rollover risk if the belief dispersion between the borrowers and the pessimistic lenders widens after interim bad news. We demonstrate the optimality of the maximum riskless short-term debt financing for optimistic borrowers even in the presence of the rollover risk. We also highlight the role of interim trading which, by allowing creditors to sell seized collateral to other optimists with saved cashes, boosts the asset’s collateral value and equilibrium price.
    JEL: G01 G1 G32
    Date: 2012–03
  7. By: Mikhail Chernov; Alexander S.Gorbenko; Igor Makarov
    Abstract: We analyse credit default swap settlement auctions theoretically and evaluate them empirically. In our theoretical analysis, we show that the current auction design may not result in the fair bond price and suggest modifications to the auction design to minimize mispricing. In our empirical study, we find support for our theoretical predictions. We show that an auction undervalues bonds by 10%, on average, on the day of the auction and link this undervaluation to the number of bonds that are exchanged during the auction. We also document a V-shaped pattern in underpricing during the days surrounding the auction: in the days leading up to the auction, the extent to which bonds are underpriced declines, while after the auction, the extent to which they are underpriced increases, with the smallest underpricing coming on the day of the auction.
    Date: 2011–07
  8. By: Antoine Martin; David Skeie; Ernst-Ludig von Thadden
    Abstract: This paper develops a dynamic model of financial institutions that borrow short-term and invest into long-term marketable assets. Because such intermediaries performmaturity transformation, they are subject to potential runs. We derive distinct liquidity and collateral constraints that characterize the fragility of such institutions as a result of changing market expectations. The liquidity constraint depends on the intermediary’s endogenous liquidity position that acts as a buffer against runs. The collateral constraint depends crucially on the microstructure of particular funding markets that we examine in detail. In particular, our model provides insights into the fragility and differences of the tri-party repo market and the bilateral repo market that were at the heart of the recent financial crisis.
    Date: 2011–07
  9. By: Suleyman Basak; Georgy Chabakauri
    Abstract: Despite much work on hedging in incomplete markets, the literature still lacks tractable dynamic hedges in plausible environments. In this article, we provide a simple solution to this problem in a general incomplete-market economy in which a hedger, guided by the traditional minimum-variance criterion, aims at reducing the risk of a non-tradable asset or a contingent claim. We derive fully analytical optimal hedges and demonstrate that they can easily be computed in various stochastic environments. Our dynamic hedges preserve the simple structure of complete-market perfect hedges and are in terms of generalized \Greeks," familiar in risk management applications, as well as retaining the intuitive features of their static counterparts. We obtain our time-consistent hedges by dynamic programming, while the extant literature characterizes either static or myopic hedges, or dynamic ones that minimize the variance criterion at an initial date and from which the hedger may deviate unless she can pre-commit to follow them. We apply our results to the discrete hedging problem of derivatives when trading occurs infrequently. We determine the corresponding optimal hedge and replicating portfolio value, and show that they have structure similar to their complete market counterparts and reduce to generalized Black-Scholes expressions when specialized to the Black-Scholes setting. We also generalize our results to richer settings to study dynamic hedging with Poisson jumps, stochastic correlation and portfolio management with benchmarking.
    Date: 2011–05
  10. By: Maik Dierkes (Finance Center Mnster, University of Mnster); Carsten Erner (Finance Center Mnster, University of Mnster); Thomas Langer (Finance Center Mnster, University of Mnster); Lars Norden (Rotterdam School of Management, Erasmus University)
    Abstract: We investigate whether and how business credit information sharing helps to better assess the default risk of private firms. Private firms represent an ideal testing ground because they are smaller, more informationally opaque, riskier, and more dependent on trade credit and bank loans than public firms. Based on a representative panel dataset that comprises private firms from all major industries, we find that business credit information sharing substantially improves the quality of default predictions. The improvement is stronger for older firms and those with limited liability, and depends on the sharing of firms' payment history and the number of firms covered by the local credit bureau office. The value of soft business credit information is higher for smaller and less distant firms. Furthermore, in spatial and industry analyses we show that the higher the value of business credit information the lower the realized default rates. Our study highlights the channel through which business credit information sharing adds value and the factors that influence its strength.
    Keywords: Asymmetric information, Credit bureau, Credit risk, Hard and soft information, Private firms
    JEL: D82 G21 G32 G33
    Date: 2012–03

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