nep-fmk New Economics Papers
on Financial Markets
Issue of 2015‒08‒07
three papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Global Collateral: How Financial Innovation Drives Capital Flows and Increases Financial Instability By Ana Fostel; John Geanakoplos; Gregory Phelan
  2. Analogy Based Valuation of Currency Options By Siddiqi, Hammad
  3. Model Risk Analysis via Investment Structuring By Andrei N. Soklakov

  1. By: Ana Fostel (University of Virginia); John Geanakoplos (Yale University); Gregory Phelan (Williams College)
    Abstract: We show that cross-border financial flows arise when levels of financial innovation differ across countries. Financial integration is a way of sharing scarce collateral. The ability of one country to leverage and tranche assets provides attractive financial contracts to investors in the other country, and general equilibrium effects on prices create opportunities for investors in the sophisticated country to invest abroad. Foreign demand for collateral and for collateral-backed financial promises increases the collateral value of domestic assets, and cheap foreign assets provide attractive returns to investors who do not demand collateral to issue promises. Gross global flows respond dynamically to fundamentals, exporting and amplifying financial volatility.
    Date: 2015–07
  2. By: Siddiqi, Hammad
    Abstract: The two most intriguing anomalies in currency markets are: 1) the implied volatility smile in currency options, and 2) the forward discount bias in currency exchange rates. I show that if currency options are valued in analogy with the underlying currency and beliefs are heterogeneous, then the forward discount bias causes the smile. The analogy based currency option pricing formula is put forward, which converges to Garman-Kohlhagen formula if there is no forward discount bias. In the presence of the forward discount bias, an increase in belief dispersion increases the slope as well as the curvature of the smile.
    Keywords: Forward Discount Bias, Implied Volatility Smile, Analogy Making, Currency Options, Financial Economics,
    Date: 2015–02
  3. By: Andrei N. Soklakov
    Abstract: "What are the origins of risks?" and "How material are they?" -- these are the two most fundamental questions of any risk analysis. Quantitative Structuring -- a technology for building financial products -- provides economically meaningful answers for both of these questions. It does so by considering risk as an investment opportunity. The structure of the investment reveals the precise sources of risk and its expected performance measures materiality. We demonstrate these capabilities of Quantitative Structuring using a concrete practical example -- model risk in options on vol-targeted indices.
    Date: 2015–07

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