New Economics Papers
on Financial Markets
Issue of 2014‒06‒14
seven papers chosen by

  1. Equity Return Predictability, Time Varying Volatility and Learning About the Permanence of Shocks By Daniel L. Tortorice
  2. The OTC derivatives markets after financial reforms By Amariei, Cosmina; Valiante, Diego
  3. The Stock of External Sovereign Debt: Can We Take the Data at ‘Face Value’? By Dias, Daniel A.; Richmond, Christine; Wright, Mark L. J.
  4. Historical Backtesting of Local Volatility Model using AUD/USD Vanilla Options By Timothy G. Ling; Pavel V. Shevchenko
  5. Changing Times, Changing Values: A Historical Analysis of Sectors within the US Stock Market 1872-2013 By Oliver D. Bunn; Robert J. Shiller
  6. Swedish stock and bond returns, 1856–2012 By Waldenström, Daniel
  7. Basel Accords and Islamic banking: A critical evaluation By Hasan, Zubair

  1. By: Daniel L. Tortorice (International Business School, Brandeis University)
    Abstract: I consider a consumption based asset pricing model where the consumer does not know if shocks to dividends are stationary (temporary) or non-stationary (permanent). The agent uses a Bayesian learning algorithm with a bias towards recent observations to assign probability to each process. While the true process is stationary, the consumer's beliefs change as he misinterprets a drift in dividends from their steady state value as an increased likelihood that the dividend process is non-stationary. Belief changes result in large swings in asset prices which are subsequently reversed. The model then is consistent with a broad array of asset pricing puzzles. It predicts the negative correlation between current returns and future returns and the PE ratio and future returns. Consistent with the data, I also find that consumption growth negatively correlates with future returns and the PE ratio and consumption growth forecast future consumption growth. The model amplifies return volatility over the benchmark rational expectations case and exactly matches the standard deviation of consumption. Finally, the model generates time varying volatility consistent with the data on quarterly equity returns.
    Keywords: Consumption, Savings, Asset Pricing, Learning, Expectations
    JEL: D83 D84 E21 G12
    Date: 2014–05
  2. By: Amariei, Cosmina; Valiante, Diego
    Abstract: Over the past five years, the OTC derivatives market showed an impressive resilience in levels of market activity, which are now above pre-crisis levels in outstanding notional value. This confirms its systemic importance. Current volatility of the gross market values and gross credit exposures can be attributed to the uncertain market conditions for the global economy. Distribution of derivatives instruments has remained relatively constant over the past decade. Central clearing and portfolio compression is developing fast for interest rate and credit derivatives, while progress in other asset classes is fairly slow. The OTC derivatives market is structured with a highly interconnected system of financial institutions. But composition is changing from a dealer-driven business to a more diversified environment, with other financial institutions (such as CCPs and investment funds) playing a greater role. Uncollateralised exposure is estimated in constant decline as a result of better collateralization of OTC derivatives exposures, either through bilateral collateral agreements or the use of CCPs, and improvement of market conditions. A structural shift of OTC derivatives to organised trading platforms is still not happening. Despite high volumes of on-exchange commodity derivatives and increasing volumes of interest rate derivatives traded on organized platforms, the market for OTC derivatives continues to be bigger than the exchange-traded side of the market, but the situation may rapidly change as the trading obligations gradually enter into force across key jurisdictions.
    Date: 2014–05
  3. By: Dias, Daniel A. (University of Illinois at Urbana-Champaign); Richmond, Christine (University of Illinois at Urbana-Champaign); Wright, Mark L. J. (Federal Reserve Bank of Chicago)
    Abstract: The stock of sovereign debt is typically measured at face value. Defined as the undiscounted sum of future principal repayments, face values are misleading when debts are issued with different contractual forms or maturities. In this paper, we construct alternative measures of the stock of external sovereign debt for 100 developing countries from 1979 through 2006 that correct for differences in contractual form and maturity. We show that our alternative measures: (1) paint a very different quantitative, and in some cases also qualitative, picture of the stock of developing country external sovereign debt; (2) often invert rankings of indebtedness across countries, which historically defined eligibility for debt forgiveness; (3) indicate that the empirical performance of the benchmark quantitative model of sovereign debt deteriorates by roughly 50% once model-consistent measures of debt are used; (4) show how the spread of aggregation clauses in debt contracts that award creditors voting power in proportion to the contractual face value may introduce inefficiencies into the process of restructuring sovereign debts; and (5) illustrate how countries have manipulated their debt issuance to meet fiscal targets written in terms of face values.
    Keywords: Stocks; Sovereign debts
    JEL: E01 F30 F34 H63
    Date: 2014–05–09
  4. By: Timothy G. Ling; Pavel V. Shevchenko
    Abstract: The Local Volatility model is a well-known extension of the Black-Scholes constant volatility model whereby the volatility is dependent on both time and the underlying asset. This model can be calibrated to provide a perfect fit to a wide range of implied volatility surfaces. The model is easy to calibrate and still very popular in FX option trading. In this paper we address a question of validation of the Local Volatility model. Different stochastic models for the underlying can be calibrated to provide a good fit to the current market data but should be recalibrated every trading date. A good fit to the current market data does not imply that the model is appropriate and historical backtesting should be performed for validation purposes. We study delta hedging errors under the Local Volatility model using historical data from 2005 to 2011 for the AUD/USD implied volatility. We performed backtests for a range of option maturities and strikes using sticky delta and theoretically correct delta hedging. The results show that delta hedging errors under the standard Black-Scholes model are no worse than that of the Local Volatility model. Moreover, for the case of in and at the money options, the hedging error for the Back-Scholes model is significantly better.
    Date: 2014–06
  5. By: Oliver D. Bunn (Barclays Bank PLC); Robert J. Shiller (Cowles Foundation, Yale University)
    Abstract: We construct a price, dividend, and earnings series for the Industrials sector, the Utilities sector, and the Railroads sector from the beginning of the 1870s until the beginning of the year 2013 from primary sources. To infer about mispricings in the sector markets over more than a century, we investigate the forecasting power of the Cyclically Adjusted Price-Earnings (CAPE) ratio1 for these sectors. With regard to the CAPE ratio, which has originally been devised and employed by Campbell and Shiller (1988, 1998, 2001) as well as Shiller (2005), we define a methodological improvement to this ratio to not only be robust to inflationary changes, but also to changes in corporate payout policy. We then update the original evidence from Campbell and Shiller (1998, 2001) of the return predictability of the CAPE ratio for the overall stock market and furthermore extend this evidence to the three aforementioned sectors individually. Whereas this part of our analysis focuses on each sector of the US economy in isolation, we subsequently construct an indicator from the CAPE ratio that enables us to perform valuation comparisons across sectors. In addition to establishing the prediction of subsequent return differences based on differences in the CAPE-based valuation indicator, we also suggest a hypothetical, historical, and simple value investment strategy that rotates between the three sectors based on the valuation signals derived from the CAPE-based indicator, generating slightly more than 1:09% annualized, inflation-adjusted excess total return over the market benchmark during a period of nearly 110 years.
  6. By: Waldenström, Daniel (Department of Economics)
    Abstract: This chapter presents historical evidence about Swedish stock prices, dividends, and yields on government fixed-interest securities. Monthly returns are presented since 1901 for stocks, since 1874 for government long-term bonds and since 1856 for short-term Treasury bills or central bank discount rates. Annual stock price and returns indices from 1870 are also presented. Altogether, these series comprise the longest financial asset price database for Sweden to date. An important ambition is to provide information about the quality of the financial data, how they are constructed and how they are modified so as to ensure consistency across time. The chapter also outlines the basic institutional and economic framework of the Swedish stock and money markets. Research has shown that asset prices are influenced by the extent of trading activity as well as by the legal setting and microstructural characteristics. Finally, the chapter offers some initial analysis of the new evidence: calculation of returns for different periods, examination of trends and trend breaks in returns, dividends, volatility and cross-country returns correlations, and computation of equity risk premia across holding periods and historical eras.
    Keywords: Historical stock returns; Historical bond yields; Stockholm Stock Exchange; Equity risk premium
    JEL: G12 N23 N24
    Date: 2014–06–02
  7. By: Hasan, Zubair
    Abstract: The worldwide colossal failures of financial institutions in the wake of the 2007–2010 financial turmoil the yesteryear advocates of liberalization and privatization converted almost overnight into vocal supporters of raising the safety walls around the interests of various stakeholders, especially the depositors. Admittedly, it was the heightened lure of leverage gains that led the financial institutions to expand credit beyond what the volume and quality of their capital assets warranted without crossing the limits of safety. The devastation led to a paradigm shift, so to say, at the national and international level in finance focusing on liquidity coverage of obligations that financial institutions must maintain for their own safety as also in the wider social interest. Stringent and regular watch was needed; it was felt, to ensure the compliance. The Basel Committee on Banking Supervision (BCBS), an organ of the Bank for International Settlements (BIS) developed what are known as Accords i.e. agreements defining capital and its adequacy for banks to keep the risk they could take within limits of safety. It is interesting to find that Malaysia was in a sense predictive of events that unfolded to revamp and strengthen its own regulatory framework. Also, the IFSB was alert to announce some new standards. This paper attempts a critical appraisal of these developments with a view to assess how far Islamic banks really need Basel Accords and are likely to absorb them without being cumbersome.
    Keywords: Key words: Islamic finance; Capital Adequacy; Basel Accords; Shari’ah compliance; Bank Negara action.
    JEL: G21 G32 G38
    Date: 2014–06–05

General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.