nep-fmk New Economics Papers
on Financial Markets
Issue of 2015‒05‒22
eight papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Secondary Market Liquidity and the Optimal Capital Structure By Arseneau, David M.; Rappoport, David; Vardoulakis, Alexandros
  2. Portfolio optimization for heavy-tailed assets: Extreme Risk Index vs. Markowitz By Georg Mainik; Georgi Mitov; Ludger R\"uschendorf
  3. Estimating rational stock-market bubbles with sequential Monte Carlo methods By Benedikt Rotermann; Bernd Wilfling
  4. The Supply and Demand of S&P 500 Put Options By George M. Constantinides; Lei Lian
  5. Outsourcing vs. Integration in the Mutual Fund Industry: An Incomplete Contracting Perspective By Debaere, Peter; Evans, Richard B.
  6. Dynamics of Order Positions and Related Queues in a Limit Order Book By Xin Guo; Zhao Ruan; Lingjiong Zhu
  7. An Over-the-Counter Approach to the FOREX Market By Geromichalos, Athanasios; Jung, Kuk Mo
  8. Emergence of Sovereign Wealth Funds By Jean-Francois Carpantier; Wessel Vermeulen

  1. By: Arseneau, David M. (Board of Governors of the Federal Reserve System (U.S.)); Rappoport, David (Board of Governors of the Federal Reserve System (U.S.)); Vardoulakis, Alexandros (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: We present a model where endogenous liquidity generates a feedback loop between secondary market liquidity and firms' financing decisions in primary markets. The model features two key frictions: a costly state verification problem in primary markets, and search frictions in over-the-counter secondary markets. Our concept of liquidity depends endogenously on illiquid assets put up for sale relative to the resources available for buying those assets in the secondary market. Liquidity determines the liquidity premium, which affects issuance in the primary market, and this effect feeds back into secondary market liquidity by changing the composition of investors' portfolios. We show that the privately optimal allocations are inefficient because investors and firms fail to internalize how their behavior affects secondary market liquidity. These inefficiencies are established analytically through a set of wedge expressions for key efficiency margins. Our analysis provide s a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy.
    Keywords: Capital structure; market liquidity; quantitiative easing; secondary markets
    JEL: E44 G18 G30
    Date: 2015–05–12
  2. By: Georg Mainik; Georgi Mitov; Ludger R\"uschendorf
    Abstract: Using daily returns of the S&P 500 stocks from 2001 to 2011, we perform a backtesting study of the portfolio optimization strategy based on the extreme risk index (ERI). This method uses multivariate extreme value theory to minimize the probability of large portfolio losses. With more than 400 stocks to choose from, our study seems to be the first application of extreme value techniques in portfolio management on a large scale. The primary aim of our investigation is the potential of ERI in practice. The performance of this strategy is benchmarked against the minimum variance portfolio and the equally weighted portfolio. These fundamental strategies are important benchmarks for large-scale applications. Our comparison includes annualized portfolio returns, maximal drawdowns, transaction costs, portfolio concentration, and asset diversity in the portfolio. In addition to that we study the impact of an alternative tail index estimator. Our results show that the ERI strategy significantly outperforms both the minimum-variance portfolio and the equally weighted portfolio on assets with heavy tails.
    Date: 2015–05
  3. By: Benedikt Rotermann; Bernd Wilfling
    Abstract: Considering the present-value stock-price model, we propose a new rational parametric bubble specification that is able to generate periodically recurring and stochastically deflating trajectories. Our bubble model is empirically more plausible than its predecessor variants and has neatly interpretable parameters. We transform our entire stock-price-bubble framework into a nonlinear state-space form and implement a fully-fledged estimation framework based on sequential Monte Carlo methods. This particle-filtering approach, originally stemming from the engineering literature, enables us (a) to obtain accurate parameter estimates, and (b) to reveal the (unobservable) trajectories of arbitrary rational bubble specifications. We fit our new bubble process to artificial and real-world data and demonstrate how to use parameter estimates to compare important characteristics of historical bubbles having emerged in different stock-markets with each other.
    Keywords: Present-value model, rational bubble nonlinear state space model, particle-filter estimation, EM algorithm
    JEL: C15 C32 C58 G10 G12
    Date: 2015–05
  4. By: George M. Constantinides; Lei Lian
    Abstract: We document that the implied volatility skew of S&P 500 index puts is non-decreasing in the disaster index and risk-neutral variance, contrary to the implications of a broad class of no-arbitrage models. The key to the puzzle lies in recognizing that, as the disaster risk increases, customers demand more puts as insurance while market makers become more credit-constrained in writing puts. The resulting increase in the equilibrium price is more pronounced in out-of-the-money than in-the-money puts, thereby steepening the implied volatility skew and resolving the puzzle. Consistent with the data, the model also implies that the equilibrium net buy of puts is decreasing in the disaster index, variance, and their price. The data shows a significant decreasing relationship between the IV skew and the net buy and no relationship in other periods, also explained by the model.
    JEL: G10 G12 G13 G23
    Date: 2015–05
  5. By: Debaere, Peter; Evans, Richard B.
    Abstract: With detailed product- and firm-level data for mutual funds, we study why mutual fund families relinquish control of fund management (advising) and outsource to non-affiliated entities and why those entities agree to manage for the fund family. Fund families and fund advisors cannot write enforceable contracts over the return earned by the fund (task of the advisor) and the size of the fund to be raised (task of the fund family). Our empirics confirm key tenets of the incomplete contracting view of the firm’s boundaries. Expertise drives the fund family’s decision to manage funds internally or not. The closer the fund is to its core expertise, the more critical the fund family is for the operation of the fund, and the more likely the fund is managed internally. Access to investors drives the advisor’s decision to manage assets for an unaffiliated fund family. Consistent with sharing marginal revenue under outsourcing, outsourced funds on average are smaller and also have lower returns than internally managed funds. At the same time, from the perspective of the fund family and the advisor, once the selection bias of the family of fund’s decision to outsource and the advisor’s decision to agree to that outsourced arrangement are controlled for, the difference in size and returns between internally and externally managed funds disappear. In other words, because of their lack of expertise, the fund family would not be able to earn a higher return by managing the outsourced funds internally and because of their lack of access to investors, the advisor could not raise a larger fund.
    Keywords: boundaries of the firm; outsourcing
    JEL: F2 G2
    Date: 2015–05
  6. By: Xin Guo; Zhao Ruan; Lingjiong Zhu
    Abstract: Motivated by various optimization problems and models in algorithmic trading, this paper analyzes the limiting behavior for order positions and related queues in a limit order book. In addition to the fluid and diffusion limits for the processes, fluctuations of order positions and related queues around their fluid limits are analyzed. As a corollary, explicit analytical expressions for various quantities of interests in a limit order book are derived.
    Date: 2015–05
  7. By: Geromichalos, Athanasios; Jung, Kuk Mo
    Abstract: The FOREX market is an over-the-counter market (in fact, the largest in the world) characterized by bilateral trade, intermediation, and significant bid-ask spreads. The existing international macroeconomics literature has failed to account for these stylized facts largely due to the fact that it models the FOREX as a standard Walrasian market, therefore overlooking some important institutional details of this market. In this paper, we build on recent developments in monetary theory and finance to construct a dynamic general equilibrium model of intermediation in the FOREX market. A key concept in our approach is that immediate trade between ultimate buyers and sellers of foreign currencies is obstructed by search frictions (e.g., due to geographic dispersion). We use our framework to compute standard measures of FOREX market liquidity, such as bid-ask spreads and trade volume, and to study how these measures are affected both by macroeconomic fundamentals and the FOREX market microstructure. We also show that the FOREX market microstructure critically affects the volume of international trade and, consequently, welfare. Hence, our paper highlights that modeling the FOREX as a frictionless Walrasian market is not without loss of generality.
    Keywords: FOREX market, over-the-counter markets, search frictions, bargaining, monetary-search models
    JEL: D4 E31 E52 F31
    Date: 2015
  8. By: Jean-Francois Carpantier; Wessel Vermeulen
    Abstract: This paper tests the theoretically founded hypothesis that the surge of SWF establishments is determined by three main factors: 1) the existence of natural resources profits, 2) the government structure and 3) the ability to invest usefully in the domestic economy.We test this hypothesis on a sample of 20 countries that established an SWF in the period 1998-2008 by comparing them to the roughly 100 countries that did not set up a fund in the same period. We find evidence for all three factors. The results suggest that SWFs tend to be established in countries that run an autocratic regime and have difficulties finding suitable opportunities for domestic investments. We do not find the net foreign asset position of a country to be similarly related to the explanatory variables, indicating that the establishment of an SWF is distinct from a national accounting result. We argue that our results indicate that it is relevant to study how an SWF interacts with the domestic economy and government policy.
    Keywords: Sovereign Wealth Fund, Institutions, natural resources
    JEL: E21 E62 F39 G23 H52
    Date: 2014

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