nep-fmk New Economics Papers
on Financial Markets
Issue of 2013‒04‒20
four papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Predictability on Complete Financial Markets By Gabriel Frahm
  2. Modeling stock price returns and pricing a European option with Le Cam's statistical experiments, without stochastic calculus By Yannis G. Yatracos
  3. Measuring the default risk of sovereign debt from the perspective of network By Hongwei Chuang; Hwai-Chung Ho
  4. “Measuring Sovereign Bond Spillover in Europe and the Impact of Rating News” By Peter Claeys; Borek Vašícek

  1. By: Gabriel Frahm
    Abstract: The following fundamental properties are proved to be true if a financial market is exhaustive: (i) Every event which is measurable by the price history at time T is independent of G_t conditional on the current price history H_t, where G_t is a superset of H_t, (ii) every event which is measurable by G_t is independent of H_T conditional on H_t. These properties are especially useful for asset valuation, portfolio optimization and risk management. An exhaustive market with respect to {F_t} is free of dominance and there are no free lunches with vanishing risk under {F_t}. Moreover, it is complete with respect to every information flow which is contained in {F_t} and the growth-optimal portfolio at time t is only determined by the past asset prices. This means any other information which is contained in F_t and available to the investor at time t is irrelevant.
    Date: 2013–04
  2. By: Yannis G. Yatracos
    Abstract: The embedding of the stock price return modeling problem in Le Cam's statistical experiments framework suggests strategies-probabilities, obtained from the traded stock prices in the time interval [t0, T], for the agent selling the stock's European call option at t_0 and for the buyer who may exercise it at T. The nature of these probabilities is justified by the slight dependence of stock returns and the weak Efficient Market Hypothesis (Fama, 1965). When the transaction times are dense in [t0, T] it is shown, with mild conditions, that under each of these probabilities log S_T/S_{t_0} has infnitely divisible distribution and in particular normal distribution for "calm" stock; S_t is the stock's price at time t. The price of the stock's European option is the expected cost of the agent at t_0 obtained using the distribution of log S_T/S_{t_0}. For calm stock, the price coincides with the Black-Scholes-Merton (B-S-M) price after translation. The strike price determined by the agent does not give arbitrage opportunity to the buyer. Additional results clarify volatility's role in the buyer's behavior and establish a connection between European option pricing and Bayes risk. The results justify the extensive use of the B-S-M price and provide traders with a new tool.
    Date: 2013–04
  3. By: Hongwei Chuang; Hwai-Chung Ho
    Abstract: Recently, there has been a growing interest in network research, especially in these fields of biology, computer science, and sociology. It is natural to address complex financial issues such as the European sovereign debt crisis from the perspective of network. In this article, we construct a network model according to the debt--credit relations instead of using the conventional methodology to measure the default risk. Based on the model, a risk index is examined using the quarterly report of consolidated foreign claims from the Bank for International Settlements (BIS) and debt/GDP ratios among these reporting countries. The empirical results show that this index can help the regulators and practitioners not only to determine the status of interconnectivity but also to point out the degree of the sovereign debt default risk. Our approach sheds new light on the investigation of quantifying the systemic risk.
    Date: 2013–04
  4. By: Peter Claeys (Faculty of Economics, University of Barcelona); Borek Vašícek (Czech Czech National Bank, Economic Research Department)
    Abstract: Although there is by now strong evidence that sovereign risk premia are driven by a common factor, little is known about the detailed linkages between sovereign bond markets. We employ the VAR method by Diebold and Yilmaz (2009) to analyse the strength and direction of bilateral linkages between EU sovereign bond markets using daily data on sovereign bond yield spreads and a common factor. The forecast-error variance decomposition of this FAVAR indicates a lot of heterogeneity in the bilateral spillover sent and received between bond markets. Spillover is more important than domestic factors for all eurozone countries. The CE countries mostly affect each other. Only Denmark, Sweden and the UK are rather insulated from spillover. The spillover has increased substantially since 2007, despite starting from a high level. We use this framework to measure the impact of sovereign rating news and analyse the dynamic linkages between spreads and the ratings of the main credit rating agencies. We find a two-sided relation between rating news and sovereign risk premia. The spillover of rating news is very heterogeneous, and it is substantially stronger for downgrades at lower grades. The impact is often weaker domestically than on bond spreads of other sovereigns.
    Keywords: Contagion, eurozone, FAVAR, financial crisis, fiscal policy, sovereign bond spreads, sovereign ratings, spillover. JEL classification: C14, E43, E62, G12, H62, H63
    Date: 2012–11

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