New Economics Papers
on Financial Markets
Issue of 2014‒01‒17
thirteen papers chosen by

  1. Competition/fragmentation in equities markets: A literature survey By Gomber, Peter; Sagade, Satchit; Theissen, Erik; Weber, Moritz Christian; Westheide, Christian
  2. Mutual Information Rate-Based Networks in Financial Markets By Pawe{\l} Fiedor
  3. How to Identify and Forecast Bull and Bear Markets? By Kole, H.J.W.G.; van Dijk, D.J.C.
  4. When Finance Meets Physics: The Impact of the Speed of Light on Financial Markets and their Regulation By James J. Angel
  5. Return dispersion, stock market liquidity and aggregate economic activity By Stavros Degiannakis; Andreas Andrikopoulos; Timotheos Angelidis; Christos Floros
  6. The determinants of the volatility of returns on cross-border asset holdings By Faruk Balli; Syed Abul Basher; Faisal Rana
  7. Realized volatility risk By David E. Allen; Michael McAleer; Marcel Scharth
  8. Risk Modelling and Management: An Overview By Chang, C-L.; Allen, D.E.; McAleer, M.J.; Pérez-Amaral, T.
  9. Herding, Information Cascades and Volatility Spillovers in Futures Markets By McAleer, M.J.; Radalj, K.
  10. Systemic risk and sovereign debt in the Euro area By Radev, Deyan
  11. Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out By Fernando Broner; Aitor Erce; Alberto Martin; Jaume Ventura
  12. Credit spread modeling effects on counterparty risk valuation adjustments: a spanish case study By Alberto Fernández Muñoz de Morales
  13. The Impact of China on Stock Returns and Volatility in the Taiwan Tourism Industry By Chang, C-L.; Hsu, H-K.; McAleer, M.J.

  1. By: Gomber, Peter; Sagade, Satchit; Theissen, Erik; Weber, Moritz Christian; Westheide, Christian
    Abstract: Advances in technology and several regulatory initiatives have led to the emergence of a competitive but fragmented equity trading landscape in the US and Europe. While these changes have brought about several benefits like reduced transaction costs, regulators and market participants have also raised concerns about the potential adverse effects associated with increased execution complexity and the impact on market quality of new types of venues like dark pools. In this article we review the theoretical and empirical literature examining the economic arguments and motivations underlying market fragmentation, as well as the resulting implications for investors' welfare. We start with the literature that views exchanges as natural monopolies due to presence of network externalities, and then examine studies which challenge this view by focusing on trader heterogeneity and other aspects of the microstructure of equity markets. --
    Keywords: Market Structure,Competition,Fragmentation,Liquidity,Market Quality
    JEL: G10
    Date: 2013
  2. By: Pawe{\l} Fiedor
    Abstract: In the last years efforts in econophysics have been shifted to study how network theory can facilitate understanding of complex financial markets. Main part of these efforts is the study of correlation-based hierarchical networks. This is somewhat surprising as the underlying assumptions of research looking at financial markets is that they behave chaotically. In fact it's common for econophysicists to estimate maximal Lyapunov exponent for log returns of a given financial asset to confirm that prices behave chaotically. Chaotic behaviour is only displayed by dynamical systems which are either non-linear or infinite-dimensional. Therefore it seems that non-linearity is an important part of financial markets, which is proved by numerous studies confirming financial markets display significant non-linear behaviour, yet network theory is used to study them using almost exclusively correlations and partial correlations, which are inherently dealing with linear dependencies only. In this paper we introduce a way to incorporate non-linear dynamics and dependencies into hierarchical networks to study financial markets using mutual information and its dynamical extension: the mutual information rate. We estimate it using multidimensional Lempel-Ziv complexity and then convert it into an Euclidean metric in order to find appropriate topological structure of networks modelling financial markets. We show that this approach leads to different results than correlation-based approach used in most studies, on the basis of 15 biggest companies listed on Warsaw Stock Exchange in the period of 2009-2012 and 91 companies listed on NYSE100 between 2003 and 2013, using minimal spanning trees and planar maximally filtered graphs.
    Date: 2014–01
  3. By: Kole, H.J.W.G.; van Dijk, D.J.C.
    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: economic comparison, forecast evaluation, regime switching, stock market
    JEL: C52 C53 G11 G17 G3 M00
    Date: 2013–10–14
  4. By: James J. Angel
    Abstract: Modern physics has demonstrated that matter behaves very differently as it approaches the speed of light. This paper explores the implications of modern physics to the operation and regulation of financial markets. Information cannot move faster than the speed of light. The geographic separation of market centers means that relativistic considerations need to be taken into account in the regulation of markets. Observers in different locations may simultaneously observe different best prices. Regulators may not be able to determine which transactions occurred first, leading to problems with best execution and trade-through rules. Catastrophic software glitches can quantum tunnel through seemingly impregnable quality control procedures.
    Date: 2014–01
  5. By: Stavros Degiannakis (Bank of Greece); Andreas Andrikopoulos (University of the Aegean); Timotheos Angelidis (University of Peloponnese); Christos Floros (Technological Educational Institute of Crete and Hellenic Open University)
    Abstract: This paper examines the effect of return dispersion on the dynamics of stock market liquidity, risk and return. Moreover, the importance of return dispersion in forecasting aggregate economic activity is rediscovered in the context of a regime switching model that accounts for stock market fluctuations and their association with the state of the economy. We find that there is a bidirectional, Granger-causal association between illiquidity and return dispersion in the U.S. stock market. The empirical results show that stock returns can help us predict both realized volatility as well as return dispersion. We report that there is a significant relation between economic conditions and the risk measures (return dispersion and realized volatility).
    Keywords: Illiquidity; Aggregate Economic Activity; Realized Volatility; Regime Switching; Return Dispersion; Stock Market Liquidity.
    JEL: G10 C23 C32 C40 C51
    Date: 2013–11
  6. By: Faruk Balli; Syed Abul Basher; Faisal Rana
    Abstract: Using both panel and cross-sectional models for 28 industrialized countries observed from 2001 to 2009, we report a number of findings regarding the determinants of the volatility of returns on cross-border asset holdings (i.e., equity and debt). Greater portfolio concentration and an increase in assets held in emerging markets lead to an elevation in earning volatility, whereas more financial integration and a greater share held in Organization for Economic Cooperation and Development countries and by the household sector cause a reduction in the return volatility. Larger asset holdings by offshore financial corporations and non-bank financial institutions cause higher market volatility, although they affect volatility in the equity and bond markets in the opposite way. Overall, both panel and cross-sectional estimations provide very similar results (albeit of different magnitude) and are robust to the endogeneity problem.
    Keywords: Asset return volatility, financial integration, international portfolio choice, asset holdings, endogeneity bias
    JEL: E44 F36 G15
    Date: 2014–01
  7. By: David E. Allen (School of Accounting, Finance and Economics Edith Cowan University, Australia.); Michael McAleer (Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam and Tinbergen Institute, The Netherlands, Department of Quantitative Economics, Complutense University of Madrid, and Institute of Economic Research, Kyoto University.); Marcel Scharth (Department of Econometrics Faculty of Economics and Business Administration VU University Amsterdam De Boelelaan 1105 1081 HV Amsterdam The Netherlands)
    Abstract: In this paper we document that realized variation measures constructed from high-frequency returns reveal a large degree of volatility risk in stock and index returns, where we characterize volatility risk by the extent to which forecasting errors in realized volatility are substantive. Even though returns standardized by ex post quadratic variation measures are nearly gaussian, this unpredictability brings considerably more uncertainty to the empirically relevant ex ante distribution of returns. Explicitly modeling this volatility risk is fundamental. We propose a dually asymmetric realized volatility model, which incorporates the fact that realized volatility series are systematically more volatile in high volatility periods. Returns in this framework display time varying volatility, skewness and kurtosis. We provide a detailed account of the empirical advantages of the model using data on the S&P 500 index and eight other indexes and stocks.
    Keywords: Realized volatility, volatility of volatility, volatility risk, value-at-risk, forecasting, conditional heteroskedasticity.
    Date: 2013
  8. By: Chang, C-L.; Allen, D.E.; McAleer, M.J.; Pérez-Amaral, T.
    Abstract: The papers in this special issue of Mathematics and Computers in Simulation are substantially revised versions of the papers that were presented at the 2011 Madrid International Conference on “Risk Modelling and Management” (RMM2011). The papers cover the following topics: currency hedging strategies using dynamic multivariate GARCH, risk management of risk under the Basel Accord: A Bayesian approach to forecasting value-at-risk of VIX futures, fast clustering of GARCH processes via Gaussian mixture models, GFC-robust risk management under the Basel Accord using extreme value methodologies, volatility spillovers from the Chinese stock market to economic neighbours, a detailed comparison of Value-at-Risk estimates, the dynamics of BRICS's country risk ratings and domestic stock markets, U.S. stock market and oil price, forecasting value-at-risk with a duration-based POT method, and extreme market risk and extreme value theory.
    Keywords: BRICS, Basel Accord, VIX futures, country risk ratings, currency hedging strategies, extreme market risks, extreme value methodologies, fast clustering, forecasting, mixture models, risk management, value-at-risk, volatility spillovers
    JEL: C14 C32 C53 G11 G32
    Date: 2013–06–01
  9. By: McAleer, M.J.; Radalj, K.
    Abstract: Economists and financial analysts have begun to recognise the importance of the actions of other agents in the decision-making process. Herding is the deliberate mimicking of the decisions of other agents. Examples of mimicry range from the choice of restaurant, fashion and financial market participants, to academic research. Herding may conjure negative images of irrational agents sheepishly following the actions of others, but such actions can be rational under asymmetric information and uncertainty. This paper uses futures position data in nine different markets of the Commodity Futures Trading Commission (CFTC) to provide a direct test of herding behaviour, namely the extent to which small traders mimic the positions of large speculators. Evidence consistent with herding among small traders is found for the Canadian dollar, British pound, gold, S&P 500 and Nikkei 225 futures. Consistent with survey-based results on technical analysis, the positions are significantly correlated with both current and past market returns. Using various time-varying volatility models to accommodate conditional heteroskedasticity, the empirical results are found to be robust to alternative models and methods of estimation. When a test of causality-in-variance is used to analyse if volatility among small traders spills over into spot markets, it is found that spillovers occur only with Nikkei 225 futures. The policy implications of the findings are also discussed.
    Keywords: causality-in-variance, spillovers, currency and commodity markets, futures and spot markets, hedging, herding, noise traders, speculation, time-varying volatility
    JEL: D82 D84 G12 G14
    Date: 2013–06–01
  10. By: Radev, Deyan
    Abstract: We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability. --
    Keywords: Sovereign debt,Sovereign default,Financial distress,Systemic risk,Contagion,Banking stability,Tail risk
    JEL: C16 C61 G01 G21
    Date: 2013
  11. By: Fernando Broner; Aitor Erce; Alberto Martin; Jaume Ventura
    Abstract: In 2007, countries in the Euro periphery were enjoying stable growth, low deficits, and low spreads. Then the financial crisis erupted and pushed them into deep recessions, raising their deficits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sectors, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out effects. Creditor discrimination arises because, in turbulent times, sovereign debt offers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out effects arise because private borrowing is limited by financial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-fulfilling crises. It also shows how crowding-out effects can be transmitted to other countries in the Eurozone, and how they may be addressed by policies at the European level.
    Keywords: Sovereign debt;Europe;Spillovers;Financial crisis;Bond issues;Investment;Economic models;sovereign debt, rollover crises, secondary markets, economic growth
    Date: 2013–12–27
  12. By: Alberto Fernández Muñoz de Morales (Tecnología y Metodologías. BBVA)
    Abstract: We analyze the effects of the financial crisis in credit valuation adjustments (CVA's). Following the arbitrage-free valuation framework presented in Brigo et al. (2009), we consider a model with stochastic Gaussian interest rates and CIR++ default intensities. Departing from previous literature, we are able to calibrate default intensities profiting from Gaussian mapping techniques presented in Brigo and Alfonsi (2004), and reproduce the historically observed instantaneous covariances of CDS prices. To test the calibration procedure, we track the Spanish financial sector, who has behaved in a singular manner through the crisis, regarded among the safest in Europe at the beginning, and in need of a partial bailout a few years later. We calculate adjustments involving the two major Spanish banks and a generic European counterpart in these two situations for both interest rate and credit derivatives.
    Abstract: En este trabajo se analizan los efectos de la crisis financiera en los ajustes por valoración de riesgo de crédito. Siguiendo el marco de valoración libre de riesgo presentado en Brigo et al. (2009), se considera un modelo híbrido estocástico con tipos de interés gaussianos e intensidades de quiebra CIR++. A diferencia de literatura anterior, se calibran las intensidades de quiebra aprovechando las técnicas de mapeo gaussiano mostradas en Brigo y Alfonsi (2004), reproduciendo las covarianzas instantáneas históricas observadas de precios de permutas de incumplimiento crediticio. Este procedimiento de calibración se prueba sobre el sector financiero español, que ha seguido un comportamiento singular durante la crisis reciente, pasando de ser considerado de los más sólidos de Europa a necesitar un rescate parcial pocos años después. Se calculan ajustes involucrando a los dos mayores bancos españoles y a una contraparte europea genérica en ambas situaciones para derivados de tipos de interés y de crédito.
    Keywords: Riesgo de contraparte, Ajuste de valoración de crédito libre de riesgo, Permutas de incumplimiento crediticio, Volatilidad del spread de crédito, Counterparty Risk, Arbitrage-Free Credit Valuation Adjustment, Credit Default Swaps, Credit Spread Volatility.
    JEL: C15 C63 G12 G13
    Date: 2013
  13. By: Chang, C-L.; Hsu, H-K.; McAleer, M.J.
    Abstract: This paper investigates the stock returns and volatility size effects for firm performance in the Taiwan tourism industry, especially the impacts arising from the tourism policy reform that allowed mainland Chinese tourists to travel to Taiwan. Four conditional univariate GARCH models are used to estimate the volatility in the stock indexes for large and small firms in Taiwan. Daily data from 30 November 2001 to 27 February 2013 are used, which covers the period of Cross-Straits tension between China and Taiwan. The full sample period is divided into two subsamples, namely prior to and after the policy reform that encouraged Chinese tourists to Taiwan. The empirical findings confirm that there have been important changes in the volatility size effects for firm performance, regardless of firm size and estimation period. Furthermore, the risk premium reveals insignificant estimates in both time periods, while asymmetric effects are found to exist only for large firms after the policy reform. The empirical findings should be useful for financial managers and policy analysts as it provides insight into the magnitude of the volatility size effects for firm performance, how it can vary with firm size, the impacts arising from the industry policy reform, and how firm size is related to financial risk management strategy.
    Keywords: asymmetry, conditional volatility models, firm size, stock returns, tourism, tourism policy reforms, volatility size effects
    JEL: C22 G18 G22 G32 L83
    Date: 2013–08–01

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