nep-fmk New Economics Papers
on Financial Markets
Issue of 2013‒10‒25
ten papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Frequency Effects on Predictability of Stock Returns By Pawe{\l} Fiedor
  2. How to Identify and Forecast Bull and Bear Markets? By Kole, H.J.W.G.; Dijk, D.J.C. van
  3. Modeling the coupled return-spread high frequency dynamics of large tick assets By Gianbiagio Curato; Fabrizio Lillo
  4. The Origin of Fat Tails By Martin Gremm
  5. Equity Premia Predictability in the EuroZone By Nuno Silva
  6. A Monthly Stock Exchange Index for Ireland, 1864-1930 By Richard S. Grossman; Ronan C. Lyone; Kevin Hjortshoj O'Rourke; Madalina A. Ursu
  7. Regime Switching and Bond Pricing. By Gouriéroux, C.; Monfort, A.; Pegoraro, F.; Renne, J-P.
  8. Bond Spreads and Economic Activity in Eight European Economies By Michael Bleaney; Paul Mizen; Veronica Veleanu
  9. The cost of firms' debt financing By Pianeselli, Daniele; Zaghini, Andrea
  10. Understanding Asset Prices By Committee, Nobel Prize

  1. By: Pawe{\l} Fiedor
    Abstract: We propose that predictability is a prerequisite for profitability on financial markets. We look at ways to measure predictability of price changes using information theoretic approach and employ them on all historical data available for Warsaw Stock Exchange. This allows us to determine whether frequency of sampling price changes affects the predictability of those. We also study the time evolution of the predictability of price changes on the sample of 20 biggest companies on Warsaw's market and investigate the relationships inside this group, as well as the time evolution of the predictability of those price changes. We also briefly comment on the complicated relationship between predictability of price changes and the profitability of algorithmic trading.
    Date: 2013–10
  2. By: Kole, H.J.W.G.; Dijk, D.J.C. van
    Abstract: The state of the equity market, often referred to as a bull or a bear market, is of key importance for financial decisions and economic analyses. Its latent nature has led to several methods to identify past and current states of the market and forecast future states. These methods encompass semi-parametric rule-based methods and parametric regime-switching models. We compare these methods by new statistical and economic measures that take into account the latent nature of the market state. The statistical measure is based directly on the predictions, while the economic mea- sure is based on the utility that results when a risk-averse agent uses the predictions in an investment decision. Our application of this framework to the S&P500 shows that rule-based methods are preferable for (in-sample) identification of the market state, but regime-switching models for (out-of-sample) forecasting. In-sample only the direction of the market matters, but for forecasting both means and volatilities of returns are important. Both the statistical and the economic measures indicate that these differences are significant.
    Keywords: forecast evaluation;regime switching;stock market;economic comparison
    Date: 2013–10–14
  3. By: Gianbiagio Curato; Fabrizio Lillo
    Abstract: Large tick assets, i.e. assets where one tick movement is a significant fraction of the price and bid-ask spread is almost always equal to one tick, display a dynamics in which price changes and spread are strongly coupled. We introduce a Markov-switching modeling approach for price change, where the latent Markov process is the transition between spreads. We then use a finite Markov mixture of logit regressions on past squared returns to describe the dependence of the probability of price changes. The model can thus be seen as a Double Chain Markov Model. We show that the model describes the shape of return distribution at different time aggregations, volatility clustering, and the anomalous decrease of kurtosis of returns. We calibrate our models on Nasdaq stocks and we show that this model reproduces remarkably well the statistical properties of real data.
    Date: 2013–10
  4. By: Martin Gremm
    Abstract: We propose a random walk model of asset returns where the parameters depend on market stress. Stress is measured by, e.g., the value of an implied volatility index. We show that model parameters including standard deviations and correlations can be estimated robustly and that all distributions are approximately normal. Fat tails in observed distributions occur because time series sample different stress levels and therefore different normal distributions. This provides a quantitative description of the observed distribution including the fat tails. We discuss simple applications in risk management and portfolio construction
    Date: 2013–10
  5. By: Nuno Silva (GEMF/ Faculty of Economics University of Coimbra, Portugal)
    Abstract: In this paper, we studied the equity premium predictability in eleven EuroZone countries. Besides some traditional predictive variables, we have also chosen two other that, to our knowledge, have never been previously used in this literature: the change in the OECD normalized composite leading indicator and the change in the OECD business confidence indicator. The OECD indicators have shown a good performance, in particular during the early stages of the recent financial crisis. We also computed the utility gains that a mean-variance investor would have obtained, if he has used these forecasting variables, and concluded that, for most countries, the utility gains would have been considerable.
    Keywords: Internation stock markets, Equity premia predictability, Asset allocation
    JEL: C22 C53 G11 G17
    Date: 2013–09
  6. By: Richard S. Grossman (Dept of Economics, Wesleyan University&Institute for Quantitiative Social Science, Harvard University); Ronan C. Lyone (Trinity College, Dublin&Balliol College, Oxford); Kevin Hjortshoj O'Rourke (All Souls College, Oxford, CEPR & NBER & IIIS, Trinity College Dublin); Madalina A. Ursu (London School of Economics, UK)
    Abstract: Information on the performance of equities during the latter part of the globalized long nineteenth century is scarce, particularly for smaller European economies such as Ireland. Using a dataset of over 35,000 price-year observations from the Investor’s Monthly Manual, this paper constructs new monthly Irish stock market price indices for the period 1864-1930, encompassing periods of significant economic and political turmoil in Irish history. In addition to a total marker index covering all 118 equity securities issued by 94 companies, sector-specific indices are present for railways, financial services, companies, and miscellaneous industrial and retail companies. Weighted for market capitalization, nominal equity prices were largely static in the 1860s, before increasing by almost 60% in normal terms between 1870 and 1878. Between 1878 and 1879, equity prices fell by one sixth in the space of a year, after which there was a spectacular rise in equity prices for two decades, with equity prices in 1899 twice what they had been in 1864. Between the turn of the century and the outbreak of the Great War, though, prices fell by 25%, a pattern that stands in stark contrast to returns on the London exchange, which were greater during 1894-1913 then during the preceding two decades. The period from 1914 and 1929 saw a number of boom-bust cycles, concurrent with the war and other political events affecting Ireland, including its independence movement. Railway equities, which had trebled between the mid-1860s and the turn of the century, fell sharply during the 1910s and 1920s. In contrast financial equity prices – which were just 20% higher in 1920 than in 1864 – rose strongly during the 1920s. Overall, the average annual gain in equity prices over the period was just 0.9%, well bellow levels associated with an equity premium puzzle.
    Keywords: Irish stock exchange; Investor's Monthly Manual; long-run stock returns; 19th Century; 20th Century; Ireland
    JEL: E3 G12 N23 N24
    Date: 2013–10–13
  7. By: Gouriéroux, C.; Monfort, A.; Pegoraro, F.; Renne, J-P.
    Abstract: This article proposes an overview of the usefulness of the regime switching approach for building various kinds of bond pricing models and of the roles played by the regimes in these models. Both default-free and defaultable bonds are considered. The regimes can be used to capture stochastic drifts and/or volatilities, to represent discrete target rates, to incorporate business cycles or crises, to introduce contagion, to reproduce zero lower bound spells, or to evaluate the impact of standard or nonstandard monetary policies. From a technical point of view, we stress the key role of Markov chains, Compound Autoregressive (Car) processes, Regime Switching Car processes and multihorizon Laplace transforms.
    Keywords: term structure, regime switching, affine models, car process, multi-horizon Laplace transform, contagion, default risk, monetary policy.
    JEL: E43 G12
    Date: 2013
  8. By: Michael Bleaney; Paul Mizen; Veronica Veleanu
    Abstract: This paper provides a new insight into the relationship between financial market tightness and real activity using a unique new database extracted from Bloomberg to construct a credit spread index from 500 corporate bonds issued in eight European countries. We find that European bond spread measures have a significant negative relationship with four real activity measures at horizons of one quarter to two years ahead. The relationship is robust to inclusion of measures of monetary policy tightness, other leading indicator variables and factors extracted from a large macro dataset, as well as alternative measures of the bond spreads. These results provide strong support for models previously only evaluated on US data. We find that a sub-set of northern European countries have similar sensitivity of real GDP to bond spreads, but others have higher spreads and greater sensitivity to these spreads, which reveals a diverse response in Europe to financial market tightness.
    Keywords: corporate bond spreads, external bond premium, economic activity
  9. By: Pianeselli, Daniele; Zaghini, Andrea
    Abstract: We provide an assessment of the determinants of the risk premia paid by non-financial corporations on long-term bonds. By looking at 5,500 issues over the period 2005-2012, we find that in recent years the sovereign debt market turbulence has been a major driver of corporate risk. Compared with the three-year period 2005-07 before the global financial crisis, in the years 2010-12 Italian, Spanish and Portuguese firms paid on average between 70 and 120 basis points of additional premium due to the negative spillovers from the sovereign debt crisis, while German firms got a discount of 40 basis points. --
    Keywords: Corporate bonds,Risk-premium,Too big to fail, Sovereign debt crisis
    JEL: G38 G32
    Date: 2013
  10. By: Committee, Nobel Prize (Nobel Prize Committee)
    Abstract: The behavior of asset prices is essential for many important decisions, not only for professional investors but also for most people in their daily life. The choice between saving in the form of cash, bank deposits or stocks, or perhaps a single-family house, depends on what one thinks of the risks and returns associated with these different forms of saving. Asset prices are also of fundamental importance for the macroeconomy because they provide crucial information for key economic decisions regarding physical investments and consumption. While prices of financial assets often seem to reflect fundamental values, history provides striking examples to the contrary, in events commonly labeled bubbles and crashes. Mispricing of assets may contribute to financial crises and, as the recent recession illustrates, such crises can damage the overall economy. Given the fundamental role of asset prices in many decisions, what can be said about their determinants?
    Keywords: asset prices;
    JEL: G12
    Date: 2013–10–14

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