nep-fmk New Economics Papers
on Financial Markets
Issue of 2012‒04‒17
ten papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Information and the Equity Premium. By Gollier, Christian; Schlee, Edward
  2. Applying approximate entropy (ApEn) to speculative bubble in the stock market By Saumitra, Bhaduri
  3. Stock Price Expectations and Stock Trading By Michael D. Hurd; Susann Rohwedder
  4. Patience and Impatience of Stock Traders By Peter Lerner
  5. Experimental Based, Agent Based Stock Market By Grazzini, J.
  6. A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks By Leonid Kogan; Dimitris Papanikolaou
  7. Mutual funds performance appraisal using stochastic multicriteria acceptability analysis By Babalos, Vassilios; Philippas, Nikolaos; Doumpos, Michael; Zompounidis, Constantin
  8. Commonality in hedge fund returns: driving factors and implications By Bussiere, M.; Hoerova, M.; Klaus, B.
  9. Hedging through a Limit Order Book with Varying Liquidity By Rossella Agliardi; Ramazan Gençay
  10. Model Implied Credit Spreads By Gunnar Grass

  1. By: Gollier, Christian; Schlee, Edward
    JEL: D8 D9 G12
    Date: 2011
  2. By: Saumitra, Bhaduri
    Abstract: In contrast to the traditional duration dependence test, the paper introduces an order statistic known as Approximate Entropy to investigate the presence of speculative bubbles for a cross country sample. Using Approximate Entropy, the article examines four major crash in the US, Japan, Hong Kong and India. In addition, the paper also investigate the 1997 Asian crisis using weekly data for seven major Asian indices which includes Hong Kong, Malaysia, Singapore, Korea, Taiwan, Indonesia and Japan. The results confirm that there are strong “tale-tell” signs characterized by low Approximate Entropy (ApEn) level during many of these crash events. All the evidences using yearly as well as time series data (both discrete and rolling window analysis) point to a substantially lower level of ApEn during the crash.
    Keywords: Approximate Entropy, Bubble, India, stock Market
    JEL: G0 G01
    Date: 2012–04–10
  3. By: Michael D. Hurd; Susann Rohwedder
    Abstract: Background: The fact that many individuals inexplicably fail to buy stocks, despite the historical evidence for a good return on investment has been referred to as the stock market puzzle. However, measurements of the subjective probability of a gain show that people are more pessimistic than historical outcomes would suggest. Further, expectations of future stock price increases apparently depend on old information, which would seem to be at odds with rational expectations in the context of efficient markets. To shed light on these apparent paradoxes, we analyzed the relationships between actual stock market price changes and the subjective probability of price changes, and between the subjective probability of price changes and the likelihood of engaging in stock trading. Approach: Drawing on 31 waves of longitudinal data on investment behavior from the American Life Panel surveys from November 2008 to the present, we tracked high frequency changes in expectations at the individual level and related them to high frequency changes in stock market prices. We analyzed both individuals who held stock in retirement accounts and those who held stocks outside of these accounts. Results: Changes in the subjective probability for one-year and 10-year gains in stock prices correlated with the Standard and Poor 500 Index with lags ranging from changes during the most recent week to changes more than a month before. This relationship was stronger among those who professed to follow the stock market and to have good knowledge than among those whose understanding is poor. Among individuals who held stock outside of retirement accounts, the likelihood of buying and selling stock was more strongly associated with recent stock behavior than among those who held stocks only within retirement accounts. Conclusions: On average, subjective expectations of stock market behavior depend on stock price changes. Furthermore, stock trading responds to changes in expectations even when the change in expectations was several weeks before the trade. These results suggest that expectations and trading are related to stock price changes in an intertemporally complex manner. Our findings also confirm that expectations about stock market gains are pessimistic, which would imply that many people simply view savings accounts as a better investment. We conclude that we need a better understanding of expectation formation and how those expectations are translated into choice.
    JEL: D83 D84 G11
    Date: 2012–04
  4. By: Peter Lerner
    Abstract: I derive asymptotic distribution of the bids/offers as a function of proportion between patient and impatient traders using my modification of Foucault, Kadan and Kandel dynamic Limit Order Book (LOB) model. Distribution of patient and impatient traders asymptotically obeys rather simple PDE, which admits numerical solutions. My modification of LOB model allows stylized but sufficiently realistic representation of the trading markets. In particular, dynamic LOB allows simulating the distribution of execution times and spreads from high-frequency quotes. Significant analytic progress is made towards future empirical study of trading as competition for immediacy of execution between traders. The results are qualitatively compared with empirical volumeat- price distribution of liquid stocks.
    Date: 2012–04
  5. By: Grazzini, J. (University of Turin)
    Abstract: This paper builds an agent based model to reproduce the results of an experimental stock market that studies how the market aggregates private information. The aim is to contribute to the relationship between experiments and agent-based modeling and to understand the behavior of the agents. Using the experimental environment and results, it is possible to formulate a hypothesis about the behavior of the subjects and thereby formalize (algorithmically) the behavior of the traders. This allows a better understanding of how the market converges toward the equilibrium and the mechanism that allows for the dissemination of private information in the market.
  6. By: Leonid Kogan; Dimitris Papanikolaou
    Abstract: We provide a theoretical model linking firm characteristics and expected returns. The key ingredient of our model is technological shocks embodied in new capital (IST shocks), which affect the profitability of new investments. Firms' exposure to IST shocks is endogenously determined by the fraction of firm value due to growth opportunities. In our structural model, several firm characteristics - Tobin's Q, past investment, earnings-price ratios, market betas, and idiosyncratic volatility of stock returns – help predict the share of growth opportunities in the firm's market value, and are therefore correlated with the firm's exposure to IST shocks and risk premia. Our calibrated model replicates: i) the predictability of returns by firm characteristics; ii) the comovement of stock returns on firms with similar characteristics; iii) the failure of the CAPM to price portfolio returns of firms sorted on characteristics; iv) the time-series predictability of market portfolio returns by aggregate investment and valuation ratios; and v) a downward sloping term structure of risk premia for dividend strips. Our model delivers testable predictions about the behavior of firm-level real variables – investment and output growth – that are supported by the data.
    JEL: E22 E32 G12
    Date: 2012–04
  7. By: Babalos, Vassilios; Philippas, Nikolaos; Doumpos, Michael; Zompounidis, Constantin
    Abstract: Mutual fund investors are concerned with the selection of the best fund in terms of performance among the set of alternative funds. This paper proposes an innovative mutual funds performance evaluation measure in the context of multicriteria decision making. We implement a multicriteria methodology using stochastic multicriteria acceptability analysis, on Greek domestic equity funds for the period 2000–2009. Combining a unique dataset of risk-adjusted returns such as Carhart’s alpha with funds’ cost variables,we obtain a multicriteria performance evaluation and ranking of the mutual funds, by means of an additive value function model. The main conclusion is that among employed variables, the sophisticated Carhart’s alpha plays the most important role in determining fund rankings. On the other hand, funds’ rankings are affected only marginally by operational attributes. We believe that our results could have serious implications either in terms of a fund rating system or for constructing optimal combinations of portfolios.
    Keywords: Mutual funds;Performance appraisal;Multicriteria analysis Simulation
    JEL: G11 G23 C02 G10
    Date: 2011
  8. By: Bussiere, M.; Hoerova, M.; Klaus, B.
    Abstract: We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.
    Keywords: Hedge funds, commonality, financial stability.
    JEL: G01 G12 G23
    Date: 2012
  9. By: Rossella Agliardi (Dipartimento di Matematica, Università di Bologna, Italy; IMATI - CNR, Italy); Ramazan Gençay (Department of Economics, Simon Fraser University, Canada; The Rimini Centre for Economic Analysis (RCEA), Italy)
    Abstract: We relax the classical price-taking assumption and study the impact of orders of arbitrary size on price when the availability of liquidity is a concern in hedging. Our paper extends the earlier literature, suggesting that an environment with a permanent impact can be viewed as a special case with zero resilience, whereas an environment with a temporary impact can be viewed as a limit case with infinite resilience speed. Furthermore, our results hold for more general stochastic processes for the underlying asset: for example, for a generic Lévy process.
    Keywords: hedging, large traders, limited liquidity, resilience, limit order book
    JEL: G13 C22
    Date: 2012–04
  10. By: Gunnar Grass
    Abstract: I propose a new measure of credit risk, model implied credit spreads (MICS), which can be extracted from any structural credit risk model in which debt values are a function of asset risk and the payout ratio. I implement MICS assuming a barrier option framework nesting the Merton (1974) model of capital structure. MICS are the increase in the payout to creditors necessary to offset the impact of an increase in asset variance on the option value of debt. Endogenizing asset payouts, my measure (i) predicts higher credit risk for safe firms and lower credit risk for firms with high volatility and leverage than a standard distance to default (DD) measure and (ii) clearly outperforms the DD measure when used to predict corporate default or to explain variations in credit spreads.
    Keywords: Structural Credit Risk Models, Bankruptcy Prediction, Risk-Neutral Pricing
    JEL: G33 G13 G32
    Date: 2012

This nep-fmk issue is ©2012 by Kwang Soo Cheong. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
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.