New Economics Papers
on Financial Markets
Issue of 2014‒06‒02
ten papers chosen by

  1. Lehman Brothers: What Did Markets Know? By Gehrig, Thomas; Haas, Marlene
  2. The Stock Market Crash Really Did Cause the Great Recession By Farmer, Roger E A
  3. Regime Switches in the Risk-Return Trade-off By Ghysels, Eric; Guérin, Pierre; Marcellino, Massimiliano
  4. Learning from Experience in the Stock Market By Nakov, Anton; Nuño, Galo
  5. Runs on Money Market Funds By Schmidt, Lawrence; Timmermann, Allan G; Wermers, Russ
  6. Assessing Credit Risk in Money Market Fund Portfolios By Collins, Sean; Gallagher, Emily
  7. Speculation, Risk Premia and Expectations in the Yield Curve By Barillas, Francisco; Nimark, Kristoffer P
  8. The Impact of News and the SMP on Realized (Co)Variances in the Eurozone Sovereign Debt Market By Beetsma, Roel; de Jong, Frank; Giuliodori, Massimo; Widijanto, Daniel
  9. Price Effects of Sovereign Debt Auctions in the Euro-zone: The Role of the Crisis By Beetsma, Roel; de Jong, Frank; Giuliodori, Massimo; Widijanto, Daniel
  10. Sovereign credit ratings in the European Union: a model-based fiscal analysis By Polito, Vito; Wickens, Michael R.

  1. By: Gehrig, Thomas; Haas, Marlene
    Abstract: On September 15, 2008, Lehman Brothers Inc. announced their filing for bankruptcy. The reaction of Lehman's competitors and market participants to this bankruptcy filing announcement provides a unique field experiment of how the insolvency spills over to other financial institutions and how interconnectedness might trigger a financial crisis. Specifically, we analyze transaction prices of major U.S. investment and commercial banks prior to and after the bankruptcy. By decomposing their equity bid-ask spreads, we find evidence that the bankruptcy contributed to increasing adverse selection risk as well as inventory holding risk. Moreover, we find supporting evidence that the degree of competition among market makers did decline. All three components did contribute to a significant rise in transaction costs. Interestingly, the relative contribution of each channel has remained roughly constant. Finally, there is little evidence about insider information within the banking industry just prior to the bankruptcy. In the case of Lehman's stocks the adverse selection component rises in the last days of trading prior to the bankruptcy filing announcement. Moreover, we find no evidence of an increase in the adverse selection component of potential bidders, from which we interpret that the market did not expect a take-over or merger. We explore the robustness of our decomposition by employing volume-synchronized probability of informed trading-measures and impact regressions on prices, quantities, and their respective innovations. In general, we find that information effects are rather short-lived except for the three days prior to the Lehman insolvency.
    Keywords: adverse selection costs; bid ask spreads; contagion; systemic risk
    JEL: D53 G12 G14
    Date: 2014–03
  2. By: Farmer, Roger E A
    Abstract: This note shows that a big stock market crash, in the absence of central bank intervention, will be followed by a major recession one to four quarters later. I establish this fact by studying the forecasting ability of three models of the unemployment rate. I show that the connection between changes in the stock market and changes in the unemployment rate has remained structurally stable for seventy years. My findings demonstrate that the stock market contains significant information about future unemployment.
    Keywords: stock market; unemployment
    JEL: E24 E27 E32
    Date: 2013–09
  3. By: Ghysels, Eric; Guérin, Pierre; Marcellino, Massimiliano
    Abstract: This paper deals with the estimation of the risk-return trade-off. We use a MIDAS model for the conditional variance and allow for possible switches in the risk-return relation through a Markov-switching specification. We find strong evidence for regime changes in the risk-return relation. This finding is robust to a large range of specifications. In the first regime characterized by low ex-post returns and high volatility, the risk-return relation is reversed, whereas the intuitive positive risk-return trade-off holds in the second regime. The first regime is interpreted as a "flight-to-quality" regime.
    Keywords: conditional variance; Markov-switching; MIDAS; Risk-return trade-off
    JEL: G10 G12
    Date: 2013–10
  4. By: Nakov, Anton; Nuño, Galo
    Abstract: New evidence suggests that individuals "learn from experience," meaning they learn from events occurring during their own lifetimes as opposed to the entire history of events. Moreover, they weigh more heavily the more recent events compared to events occurring in the more distant past. This paper analyzes the implications of such learning for stock pricing in a model with finitely-lived agents. Individuals learn about the rate of change of the stock price and of dividends using a weighted decreasing-gain algorithm. Information is dispersed across age cohorts with older agents having larger information sets than younger ones. In the model, the stock price exhibits stochastic fluctuations around the rational expectations equilibrium due to successive waves of optimism and pessimism. We demonstrate how this heterogeneous-beliefs model can be approximated by an economy with a representative agent who updates his beliefs following a constant-gain learning scheme. The aggregate gain parameter of the approximation is a nonlinear function of the survival rate and of the individual gain parameters.
    Keywords: asset pricing; constant-gain learning; dispersed beliefs; heterogeneous beliefs; OLG
    JEL: D83 D84 G12
    Date: 2014–02
  5. By: Schmidt, Lawrence; Timmermann, Allan G; Wermers, Russ
    Abstract: We study daily money market mutual fund flows at the individual share class level during the crisis of September 2008. The empirical approach that we apply to this fine granularity of data brings new insights into the investor and portfolio holding characteristics that are conducive to run-risk in cash-like asset pools, as well as providing evidence on the time-series dynamics of runs and the equilibria that develop. We find that outflows during the crisis are concentrated among those money funds with higher promised yields, less liquid portfolios, low implicit sponsor backing, and higher prior flow volatility that cater to very large-scale institutional investors. Our data uniquely allows us to study the strategic redemption behavior of investors with differing levels of sophistication by studying flows to different share classes of the same money fund, thus holding constant the quality of the underlying portfolio. Our results are consistent with the most sophisticated (largest scale) institutional investors exhibiting the greatest level of strategic redemptions during the crisis, which created significant negative externalities for more passive institutional investors.
    Keywords: bank runs; money market mutual funds; quantile regression; strategic complementarities
    JEL: G01 G21 G23
    Date: 2014–03
  6. By: Collins, Sean; Gallagher, Emily
    Abstract: This paper measures credit risk in prime money market funds (MMFs), studies how such credit risk evolved in 2011-2012, and tests the efficacy of the Securities and Exchange Commission’s (SEC) January 2010 reforms. To accomplish this, we estimate the credit default swap premium (CDS) needed to insure each fund’s portfolio against credit losses. We also calculate by Monte Carlo the cost of insuring a fund against losses amounting to over 50 basis points. We find that credit risk of prime MMFs rose from June to December 2011 before receding in 2012. Contrary to common perceptions, this did not primarily reflect funds’ credit exposure to eurozone banks. Instead, credit risk in prime MMFs rose because of the deteriorating credit outlook of banks in the Asia-Pacific region. Finally, we find evidence that the SEC’s 2010 liquidity and weighted average life (WAL) requirements reduced the credit risk of prime MMFs.
    Keywords: Money market funds, credit risk, SEC, eurozone, CDS
    JEL: G01 G15 G18 G22 G23 G28
    Date: 2014–05–27
  7. By: Barillas, Francisco; Nimark, Kristoffer P
    Abstract: An affine asset pricing model in which agents have rational but heterogeneous expectations about future asset prices is developed. We estimate the model using data on bond yields and individual survey responses from the Survey of Professional Forecasters and perform a novel three-way decomposition of bond yields into (i) average expectations about short rates (ii) risk premia and (iii) a speculative component due to heterogeneous expectations about the resale value of a bond. We prove that the speculative term must be orthogonal to public information in real time and therefore statistically distinct from risk premia. Empirically, the speculative component is quantitatively important, accounting for up to one percentage point of US yields. Furthermore, estimates of historical risk premia from the heterogeneous information model are less volatile than, and negatively correlated with, risk premia estimated using a standard Affine Gaussian Term Structure model.
    Keywords: Heterogenous information; Speculation; Survey data; Term structure of interest rates
    JEL: G12 G14
    Date: 2013–11
  8. By: Beetsma, Roel; de Jong, Frank; Giuliodori, Massimo; Widijanto, Daniel
    Abstract: We use realized variances and covariances based on intraday data from Eurozone sovereign bond market to measure the dependence structure of eurozone sovereign yields. Our analysis focuses on the impact of news, obtained from the Eurointelligence newsflash, on the dependence structure. More news raises the volatility of interest rates of financially distressed countries and decreases the covariance of distressed countries' yields with German bond yields, suggesting a flight-to-quality effect. Common news about the euro crisis and news about specific countries itself tend to raise the covariance of yields between distressed countries, indicating potential crisis spill-over effects. However, we do not detect spillover effects from news about third countries to the covariance between other country pairs. Bond purchases by the ECB under its Securities Markets Programme (SMP) mitigate the negative crisis spillovers among the distressed countries and reduce the flight-to-safety from the distressed countries to Germany.
    Keywords: crisis; Eurozone; realized covariances; SMP; sovereign debt; spillovers
    JEL: E62 G01 G12 G15 H63
    Date: 2014–02
  9. By: Beetsma, Roel; de Jong, Frank; Giuliodori, Massimo; Widijanto, Daniel
    Abstract: Exploring the period since the inception of the euro, we show that secondary-market yields on Italian public debt increase in anticipation of auctions of new issues and decrease after the auction, while no or a smaller such effect is present for German public debt. However, these yield movements on the Italian debt are largely confined to the period of the crisis since mid-2007. We also find that there is some tendency of the yield movements to be larger when the demand for the new issue is smaller relative to its supply. Our results are consistent with a framework in which a small group of primary dealers require compensation for inventory risk and this compensation needs to be higher when market uncertainty is larger. We also find that the secondary-market behaviour of series with a maturity close to the auctioned series, but for which there is no auction, is very similar to the secondary-market behaviour of the auctioned series. These findings support an explanation of yield movements based on the behaviour of primary dealers with limited risk-bearing capacity.
    Keywords: auctions; bid-to-cover ratio; crisis; euro-zone; event study; Germany; Italy; primary dealers; public debt; yield movements
    JEL: G12 G18
    Date: 2013–09
  10. By: Polito, Vito; Wickens, Michael R.
    Abstract: We propose a model-based measure of sovereign credit ratings derived solely from the fiscal position of a country: a forecast of its future debt liabilities, and its potential to use tax policy to repay these. We use this measure to calculate credit ratings for fourteen European countries over the period 1995-2012. This measure identifies a European sovereign debt crisis almost two years before the official ratings of the credit rating agencies.
    Keywords: credit risk; default probability; fiscal policy; sovereign risk
    JEL: E62 H30 H60
    Date: 2013–09

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