New Economics Papers
on Financial Markets
Issue of 2013‒12‒29
twelve papers chosen by

  1. Lessons from the Financial Crisis: Bank Performance and Regulatory Reform By Neville Arjani; Graydon Paulin
  2. Macroeconomic announcements and financial markets. By Hu, J.
  3. Does Realized Skewness Predict the Cross-Section of Equity Returns? By Diego Amaya; Peter Christoffersen; Kris Jacobs; Aurelio Vasquez
  4. Correlation Dynamics and International Diversification Benefits By Peter Christoffersen; Vihang R. Errunza; Kris Jacobs; Xisong Jin
  5. Coupled mode theory of stock price formation By Jack Sarkissian
  6. Price discovery in dual-class shares across multiple markets By Fernandes, Marcelo; Scherrer, Cristina M.
  7. “European Government Bond Markets and Monetary Policy Surprises: Returns, Volatility and Integration” By Pilar Abad; Helena Chuliá
  8. Modeling and predicting the CBOE market volatility index By Fernandes, Marcelo; Medeiros, Marcelo C.; Scharth, Marcel
  9. Illiquidity Premia in the Equity Options Market By Peter Christoffersen; Ruslan Goyenko; Kris Jacobs; Mehdi Karoui
  10. The Home Bias in Sovereign Ratings By Fuchs , Andreas; Gehring , Kai
  11. The Impact of Hedge Funds on Asset Markets By Matthias Kruttli; Andrew J. Patton; Tarun Ramadorai
  12. Risk and Return in Village Economies By Krislert Samphantharak; Robert Townsend

  1. By: Neville Arjani; Graydon Paulin
    Abstract: The financial systems of some countries fared materially better than others during the global financial crisis of 2007-09. The performance of the Canadian banking system during this period was relatively strong. Using a case study approach together with empirical analysis, we assess some of the factors that contributed to this favourable outcome with a view to drawing useful lessons for regulatory reform. We argue that an important contributor to positive bank performance was a solid approach to risk management on the part of the Canadian banking system, an approach that was actively fostered by the domestic authorities. Efforts to buttress risk management were favourably influenced by several stressful yet instructive episodes in Canadian financial history. The 2007-09 crisis experience suggests a need to make risk management a pervasive element of financial system culture and emphasizes the importance of robust liquidity management.
    Keywords: Financial institutions; Financial system regulation and policy
    JEL: G21 G28
    Date: 2013
  2. By: Hu, J. (Tilburg University)
    Abstract: The third and final study examines the causal relationship between uncertainty about macroeconomic fundamentals and return volatility. The underlying question is: does higher return volatility result in higher uncertainty in beliefs amongst analysts, or the other way around? Using daily data on analysts’ uncertainty and stock and bond volatility, this study shows evidence that uncertainty and volatility are not causally related.
    Date: 2013
  3. By: Diego Amaya (University of Quebec at Montreal (UQUAM)); Peter Christoffersen (University of Toronto and CREATES); Kris Jacobs (University of Houston); Aurelio Vasquez (Instituto Tecnológico Autónomo de México (ITAM))
    Abstract: We use intraday data to compute weekly realized variance, skewness, and kurtosis for equity returns and study the realized moments? time-series and cross-sectional properties. We investigate if this week?'s realized moments are informative for the cross-section of next week'?s stock returns. We ?find a very strong negative relationship between realized skewness and next week?'s stock returns. A trading strategy that buys stocks in the lowest realized skewness decile and sells stocks in the highest realized skewness decile generates an average weekly return of 24 basis points with a t-statistic of 3.65. Our results on realized skewness are robust across a wide variety of implementations, sample periods, portfolio weightings, and firm characteristics, and are not captured by the Fama-French and Carhart factors. We ?find some evidence that the relationship between realized kurtosis and next week?'s stock returns is positive, but the evidence is not always robust and statistically significant. We do not find a strong relationship between realized volatility and next week?'s stock returns.
    Keywords: Realized volatility, skewness, kurtosis, equity markets, cross-section of stock returns
    JEL: G11 G12 G17
    Date: 2013–02–21
  4. By: Peter Christoffersen (University of Toronto); Vihang R. Errunza (McGill University); Kris Jacobs (University of Houston); Xisong Jin (University of Luxembourg)
    Abstract: Forecasting the evolution of security co-movements is critical for asset pricing and portfolio allocation. Hence, we investigate patterns and trends in correlations over time using weekly returns for developed markets (DMs) and emerging markets (EMs) during the period 1973-2012. We show that it is possible to model co-movements for many countries simultaneously using BEKK, DCC, and DECO models. Empirically, we ?find that correlations have significantly trended upward for both DMs and EMs. Based on a time-varying measure of diversification benefit, we ?find that it is not possible in a long-only portfolio to circumvent the increasing correlations by adjusting the portfolio weights over time. However, we do find some evidence that adding EMs to a DM-only portfolio increases diversification benefits.
    Keywords: Asset pricing, asset allocation, dynamic conditional correlation (DCC), dynamic equicorrelation (DECO)
    JEL: G12
    Date: 2013–08–07
  5. By: Jack Sarkissian
    Abstract: We develop a theory of bid and ask price dynamics where the two prices form due to interaction of buy and sell orders. In this model the two prices are represented by eigenvalues of a 2x2 price operator corresponding to "bid" and "ask" eigenstates. Matrix elements of price operator fluctuate in time which results in phase jitter for eigenstates. We show that the theory reflects very important characteristics of bid and ask dynamics and order density in the order book. Calibration examples are provided for stocks at various time scales. Lastly, this model allows to quantify and measure risk associated with spread and its fluctuations.
    Date: 2013–12
  6. By: Fernandes, Marcelo; Scherrer, Cristina M.
    Abstract: We extend the standard price discovery analysis to estimate the informationshare of dual-class shares across domestic and foreign markets. By examining both commonand preferred shares, we aim to extract information not only about the fundamental valueof the rm, but also about the dual-class premium. In particular, our interest lies on theprice discovery mechanism regulating the prices of common and preferred shares in theBM&FBovespa as well as the prices of their ADR counterparts in the NYSE and in the Arcaplatform. However, in the presence of contemporaneous correlation between the innovations,the standard information share measure depends heavily on the ordering we attribute toprices in the system. To remain agnostic about which are the leading share class and market,one could for instance compute some weighted average information share across all possibleorderings. This is extremely inconvenient given that we are dealing with 2 share prices inBrazil, 4 share prices in the US, plus the exchange rate (and hence over 5,000 permutations!).We thus develop a novel methodology to carry out price discovery analyses that does notimpose any ex-ante assumption about which share class or trading platform conveys moreinformation about shocks in the fundamental price. As such, our procedure yields a singlemeasure of information share, which is invariant to the ordering of the variables in thesystem. Simulations of a simple market microstructure model show that our informationshare estimator works pretty well in practice. We then employ transactions data to studyprice discovery in two dual-class Brazilian stocks and their ADRs. We uncover two interesting ndings. First, the foreign market is at least as informative as the home market. Second,shocks in the dual-class premium entail a permanent e ect in normal times, but transitoryin periods of nancial distress. We argue that the latter is consistent with the expropriationof preferred shareholders as a class.
    Date: 2013–12–09
  7. By: Pilar Abad (University Rey Juan Carlos and University of Barcelona); Helena Chuliá (Faculty of Economics, University of Barcelona)
    Abstract: In this paper we investigate the response of bond markets to euro area and US monetary policy shocks. Specifically, we analyze the effect of unexpected changes in interest rates implemented by the European Central Bank (ECB) and the Federal Open Market Committee (FOMC) not only on the returns, but also on the volatility and the integration of European government bond markets. For all three characteristics our results show that the response to monetary policy surprises varies across groups of countries (EMU EU-15 central, EMU EU-15 peripheral, non-EMU EU-15 and non-EMU new EU). We also find that the effects of monetary policy announcements on the level of integration are more pronounced than those on returns and volatility. Finally, our results paint a complex picture of the effects of monetary policy news releases on the level of integration. The effect of ECB monetary policy surprises differs across old and new European Union members, while the effect of FOMC monetary policy surprises differs across EMU and non-EMU members.
    Keywords: Monetary policy announcements; Bond market integration; Interest rate surprises. JEL classification: E44; F36; G15.
    Date: 2013–12
  8. By: Fernandes, Marcelo; Medeiros, Marcelo C.; Scharth, Marcel
    Abstract: This paper performs a thorough statistical examination of the time-series properties of the daily market volatility index (VIX) from the Chicago Board Options Exchange (CBOE). The motivation lies not only on the widespread consensus that the VIX is a barometer of the overall market sentiment as to what concerns investors' risk appetite, but also on the fact that there are many trading strategies that rely on the VIX index for hedging and speculative purposes. Preliminary analysis suggests that the VIX index displays long-range dependence. This is well in line with the strong empirical evidence in the literature supporting long memory in both options-implied and realized variances. We thus resort to both parametric and semiparametric heterogeneous autoregressive (HAR) processes for modeling and forecasting purposes. Our main ndings are as follows. First, we con rm the evidence in the literature that there is a negative relationship between the VIX index and the S&P 500 index return as well as a positive contemporaneous link with thevolume of the S&P 500 index. Second, the term spread has a slightly negative long-run impact in the VIX index, when possible multicollinearity and endogeneity are controlled for. Finally, wecannot reject the linearity of the above relationships, neither in sample nor out of sample. As for the latter, we actually show that it is pretty hard to beat the pure HAR process because of thevery persistent nature of the VIX index.
    Date: 2013–12–09
  9. By: Peter Christoffersen (University of Toronto and CREATES); Ruslan Goyenko (McGill University); Kris Jacobs (University of Houston); Mehdi Karoui (McGill University)
    Abstract: Illiquidity is well-known to be a significant determinant of stock and bond returns. We report on illiquidity premia in the equity options market. An increase in option illiquidity decreases the current option price and implies higher expected option returns. This effect is statistically and economically signifi?cant. It is robust across different empirical approaches and when including various control variables. The illiquidity of the underlying stock affects the option return negatively, consistent with a hedging argument: When stock market illiquidity increases, the cost of replicating the option goes up, which increases the option price and reduces its expected return.
    Keywords: illiquidity, equity options, cross-section, option returns, option smile
    JEL: G12
    Date: 2013–03–15
  10. By: Fuchs , Andreas; Gehring , Kai
    Abstract: Credit rating agencies are frequently criticized for producing sovereign ratings that do not accurately reflect the economic and political fundamentals of rated countries. This article discusses how the home country of rating agencies could affect rating decisions as a result of political economy influences and culture. Using data from nine agencies based in six countries, we investigate empirically if there is systematic evidence for a home bias in sovereign ratings. Specifically, we use dyadic panel data to test whether, all else being equal, agencies assign better ratings to their home countries, as well as to countries economically, politically and culturally aligned with them. While most of the variation in ratings is explained by the fundamentals of rated countries, our results provide empirical support for the existence of a home bias in sovereign ratings. We find that the bias becomes more accentuated following the onset of the Global Financial Crisis and appears to be driven by economic and cultural ties, not geopolitics.
    Keywords: Sovereign debt ratings; credit rating agencies; home bias; international finance; cultural distance; bank exposure
    Date: 2013–12–23
  11. By: Matthias Kruttli; Andrew J. Patton; Tarun Ramadorai
    Abstract: While there has been enormous interest in hedge funds from academics, prospective and current investors, and policymakers, rigorous empirical evidence of their impact on asset markets has been difficult to find. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, and show that it has strong in- and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2011 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We construct a simple equilibrium model to rationalize our findings, and empirically verify auxiliary predictions of the model.
    Keywords: hedge funds, return predictability, liquidity, equities, bonds, currencies
    JEL: G11 G12 G14 G23
    Date: 2013
  12. By: Krislert Samphantharak; Robert Townsend
    Abstract: We present a framework for the study of risk and return of household enterprise in developing economies. We make predictions from two polar benchmarks: (1) an economy with Pareto optimal allocations under full risk sharing, and (2) an economy in which each autarky household absorbs risk in isolation. The full risk-sharing benchmark delivers the prediction that only aggregate covariate risk contributes to the risk premium of asset returns while idiosyncratic risk is fully diversified, consistent with analogous results derived from the Capital Asset Pricing Model (CAPM) in the finance literature. The economy with autarky households predicts that overall fluctuation at the household level is the only concern. Our framework allows us to empirically decompose the total risk in production technologies operated by households into aggregate and idiosyncratic components and provides us with a practical procedure to compute risk premium for each component separately. We apply the framework to monthly panel data from a household survey in rural Thailand where there are active risk-sharing and kinship networks. We find that there is nontrivial aggregate risk and there is a positive relationship between the expected returns on assets and the comovement of asset returns with the aggregate returns, as predicted by the full risk-sharing economy. There is residual idiosyncratic risk and it also contributes to the total risk premium, as predicted by the autarky benchmark. However, although idiosyncratic risk is the dominant factor in total risk, our study shows that it accounts for a much smaller share of total risk premium. Exposure to aggregate and idiosyncratic risk is heterogeneous across households as are the corresponding risk-adjusted returns, with important implications for vulnerability and productivity.
    JEL: D12 D13 G11 L23 L26 O12 O16 O17
    Date: 2013–12

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