nep-fmk New Economics Papers
on Financial Markets
Issue of 2014‒06‒22
nine papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. A Robust Capital Asset Pricing Model By Ruffino, Doriana
  2. Decoding Stock Market Behavior with the Topological Quantum Computer By Ovidiu Racorean
  3. Hedge fund holdings and stock market efficiency By Cao, Charles; Liang, Bing; Lo, Andrew W.; Petrasek, Lubomir
  4. Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices By D'Amico, Stefania; Kim, Don H.; Wei, Min
  5. Calibration of a stock's beta using options prices By Sofiene El Aoud; Frédéric Abergel
  6. An Evaluation of Bank VaR Measures for Market Risk During and Before the Financial Crisis By O'Brien, James M.; Szerszen, Pawel J.
  7. Competition in lending and credit ratings By Ahmed, Javed I.
  8. Sovereign Debt Crises By Correa, Ricardo; Sapriza, Horacio
  9. Swedish Stock and Bond Returns, 1856–2012 By Waldenström, Daniel

  1. By: Ruffino, Doriana (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: We build a market equilibrium theory of asset prices under Knightian uncertainty. Adopting the mean-variance decisionmaking model of Maccheroni, Marinacci, and Ruffino (2013a), we derive explicit demands for assets and formulate a robust version of the two-fund separation theorem. Upon market clearing, all investors hold ambiguous assets in the same relative proportions as the assets' market values. The resulting uncertainty-return tradeoff is a robust security market line in which the ambiguous return on an asset is measured by its beta (systematic ambiguity). A simple example on portfolio performance measurement illustrates the importance of writing ambitious, robust asset-pricing models.
    Keywords: Model uncertainty; Mean-variance portfolio-selection theory; Two-fund separation theorem; Capital asset pricing model
    Date: 2013–12–17
  2. By: Ovidiu Racorean
    Abstract: A surprising image of the stock market arises if the price time series of all Dow Jones Industrial Average stock components are represented in one chart at once. The chart evolves into a braid representation of the stock market by taking into account only the crossing of stocks and fixing a convention defining overcrossings and undercrossings. The braid of stocks prices has a remarkable connection with the topological quantum computer. Using pairs of quasi-particles, called non-abelian anyons, having their trajectories braided in time, topological quantum computer can effectively simulate the stock market behavior encoded in the braiding of stocks. In a typically topological quantum computation process the trajectories of non-abelian anyons are manipulated according to the braiding of stocks and the outcome reflects the probability of the future state of stock market. The probability depends only on the Jones polynomial of the knot formed by plat closing the quantum computation. The Jones polynomial of the knotted stock market acts, making a parallel with the common financial literature, in a topological quantum computation as a counterpart of a classical technical indicator in trading the stock market. The type of knot stock market formed is an indicator of its future tendencies.
    Date: 2014–06
  3. By: Cao, Charles (Smeal College of Business, Penn State University); Liang, Bing (Isenberg School of Management, University of Massachusetts); Lo, Andrew W. (MIT Sloan School of Management); Petrasek, Lubomir (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: We examine the relation between changes in hedge fund stock holdings and measures of informational efficiency of equity prices derived from transactions data, and find that, on average, increased hedge fund ownership leads to significant improvements in the informational efficiency of equity prices. The contribution of hedge funds to price efficiency is greater than the contributions of other types of institutional investors, such as mutual funds or banks. However, stocks held by hedge funds experienced extreme declines in price efficiency during liquidity crises, most notably in the last quarter of 2008, and the declines were most severe in stocks held by hedge funds connected to Lehman Brothers and hedge funds using leverage.
    Keywords: Hedge funds; institutional investors; market efficiency
    Date: 2014–05–14
  4. By: D'Amico, Stefania (Federal Reserve Bank of Chicago); Kim, Don H. (Board of Governors of the Federal Reserve System (U.S.)); Wei, Min (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: TIPS are notes and bonds issued by the U.S. Treasury with coupons and principal payments indexed to inflation. Using no-arbitrage term structure models, we show that TIPS yields contained liquidity premiums as large as 100 basis points when TIPS were first issued, reflecting the newness of the instrument, and up to 350 basis points during the recent financial crisis, reflecting common funding constraints affecting a variety of financial markets. Applying our models to the U.K. data also reveals liquidity premiums in index-linked gilt yields that spiked to nearly 250 basis points at the height of the crisis. Ignoring TIPS liquidity premiums is shown to significantly distort the information content of TIPS yields and TIPS breakeven inflation rate, two widely-used empirical proxies for real rates and expected inflation.
    Keywords: TIPS; liquidity premium; no-arbitrage term structure model; TIPS breakeven inflation; expected inflation; inflation risk premium; survey forecasts
    Date: 2014–01–31
  5. By: Sofiene El Aoud (FiQuant - Chaire de finance quantitative - Ecole Centrale Paris, MAS - Mathématiques Appliquées aux Systèmes - EA 4037 - Ecole Centrale Paris); Frédéric Abergel (FiQuant - Chaire de finance quantitative - Ecole Centrale Paris, MAS - Mathématiques Appliquées aux Systèmes - EA 4037 - Ecole Centrale Paris)
    Abstract: We present in our work a continuous time Capital Asset Pricing Model where the volatilities of the market index and the stock are both stochastic. Using a singular perturbation technique, we provide approximations for the prices of european options on both the stock and the index. These approximations are functions of the model parameters. We show then that existing estimators of the parameter beta, proposed in the recent literature, are biased in our setting because they are all based on the assumption that the idiosyncratic volatility of the stock is constant. We provide then an unbiased estimator of the parameter beta using only implied volatility data. This estimator is a forward measure of the parameter beta in the sense that it represents the information contained in derivatives prices concerning the forward realization of this parameter, we test then its capacity of prediction of forward beta and we draw a conclusion concerning its predictive power.
    Date: 2014–02–28
  6. By: O'Brien, James M. (Board of Governors of the Federal Reserve System (U.S.)); Szerszen, Pawel J. (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: We study the performance and behavior of Value at Risk (VaR) measures used by a number of large banks during and before the financial crisis. Alternative benchmark VaR measures, including GARCH-based measures, are also estimated directly from the banks' trading revenues and help to explain the bank VaR performance results. While highly conservative in the pre-crisis period, bank VaR exceedances were excessive and clustered in the crisis period. All benchmark VaRs were more accurate in the pre-crisis period with GARCH VaR measures the most accurate in the crisis period having lower exceedance rates with no exceedance clustering. Variance decompositions indicate a limited ability of the banks' VaR methodologies to adjust to the crisis-period market conditions. Despite their weaker performance, the bank VaRs exhibited greater predictive power for a measure of realized PnL volatility than benchmark VaR measures. Benchmark Expected Shortfall measures are also considered.
    Keywords: Market risk; value at risk; backtesting; profit and loss; financial crisis
    Date: 2014–03–07
  7. By: Ahmed, Javed I. (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: This article relates corporate credit rating quality to competition in lending between the public bond market and banks. In the model, the monopolistic rating agency's choice of price and quality leads to an endogenous threshold separating low-quality bank-dependent issuers from higher-quality issuers with access to public debt. In a baseline equilibrium with expensive bank lending, this separation across debt market segments provides information, but equilibrium ratings are uninformative. A positive shock to private (bank) relative to public lending supply allows banks to compete with public lenders for high-quality issuers, which threatens rating agency profits, and informative ratings result to prevent defection of high-quality borrowers to banks. This prediction is tested by analyzing two events that increased the relative supply of private vs. public lending sharply: legislation in 1994 that reduced barriers to interstate bank lending and the temporary shutdown of the high-yield bond market in 1989. After each event, the quality of ratings (based on their impact on bond yield spreads) increased for affected issuers. The analysis suggests that strategic behavior by the rating agency in an issuer-pays setting dampens the influence of macroeconomic shocks, and explains the use of informative unsolicited credit ratings to prevent unrated bond issues, particularly during good times. Additionally, the controversial issuer-pays model of ratings leads to more efficient outcomes than investor-pays alternatives.
    Keywords: Issuer pays; credit rating; segmented markets; unsolicited rating
    Date: 2014–03–28
  8. By: Correa, Ricardo (Board of Governors of the Federal Reserve System (U.S.)); Sapriza, Horacio (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: Sovereign debt crises have been recurrent events over the past two centuries. In recent years, the timing of sovereign crises has coincided or has directly followed banking crises. The link between sovereigns and banks tightened as the contingent liability that the banking sector represents for the sovereign grew, as financial "safety nets" became more common. This chapter analyzes the transmission channels between sovereigns and banks, with a focus on the effect of sovereign distress on bank solvency and financing. It then highlights the notable cost to the real economy of the close connection between sovereigns and banks. Breaking the "feedback loop" between these two sectors should be an important policy priority.
    Keywords: Sovereign default; banking crises; government guarantees; financial safety net; bank regulation
    Date: 2014–05–21
  9. By: Waldenström, Daniel (Department of Economics, Uppsala University)
    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: 2014–06–10

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