nep-fmk New Economics Papers
on Financial Markets
Issue of 2016‒02‒29
three papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. Asset Returns and Financial Fragility By Yang Li
  2. Taming the Basel leverage cycle By Christoph Aymanns; Fabio Caccioli; J. Doyne Farmer; Vincent W.C. Tan
  3. Potential Climate Risks in Financial Markets: A Literature Overview By Hjort, Ingrid

  1. By: Yang Li (Department of Economics, Rutgers University)
    Abstract: What configuration of interest rates will make the banking system most susceptible to a self-fulfilling run? I study this question in a version of the model of Diamond and Dybvig (1983) with limited commitment and a non-trivial portfolio choice. I show that the relationship between the returns on banks' assets and financial fragility is often non-monotone: a higher interest rate may make banks either more or less susceptible to a run by depositors. The same is true for changes in the liquidation cost and the term premium. I derive precise conditions under which changes in each of these returns increase or decrease financial fragility.
    Keywords: Financial fragility, Bank runs, Excess liquidity
    JEL: G11 G21
    Date: 2016–02–15
  2. By: Christoph Aymanns; Fabio Caccioli; J. Doyne Farmer; Vincent W.C. Tan
    Abstract: Effective risk control must make a tradeoff between the microprudential risk of exogenous shocks to individual institutions and the macroprudential risks caused by their systemic interactions. We investigate a simple dynamical model for understanding this tradeoff, consisting of a bank with a leverage target and an unleveraged fundamental investor subject to exogenous noise with clustered volatility. The parameter space has three regions: (i) a stable region, where the system always reaches a fixed point equilibrium; (ii) a locally unstable region, characterized by cycles and chaotic behavior; and (iii) a globally unstable region. A crude calibration of parameters to data puts the model in region (ii). In this region there is a slowly building price bubble, resembling a “Great Moderation”, followed by a crash, with a period of approximately 10-15 years, which we dub the Basel leverage cycle. We propose a criterion for rating macroprudential policies based on their ability to minimize risk for a given average leverage. We construct a one parameter family of leverage policies that allows us to vary from the procyclical policies of Basel II or III, in which leverage decreases when volatility increases, to countercyclical policies in which leverage increases when volatility increases. We find the best policy depends critically on three parameters: The average leverage used by the bank; the relative size of the bank and the fundamentalist, and the amplitude of the exogenous noise. Basel II is optimal when the exogenous noise is high, the bank is small and leverage is low; in the opposite limit where the bank is large or leverage is high the optimal policy is closer to constant leverage. We also find that systemic risk can be dramatically decreased by lowering the leverage target adjustment speed of the banks.
    Keywords: Financial stability; capital regulation; systemic risk
    JEL: G11 G20
    Date: 2015–07
  3. By: Hjort, Ingrid (Dept. of Economics, University of Oslo)
    Abstract: This literature overview conducts a systematic study of how the climate related risks from global warming may aff ect fi nancial markets. The climate related risk is divided into three subcategories, the environmental uncertainty, the economic climate risk and the climate policy risk, which all of them may aff ect the markets directly or indirectly. The perspective is broad, including production possibilities, productivity, social disturbance, health, migration and trade. Stock prices are affected by beliefs about future path of expected return. Climate change signifi es possible disruptions in production and consumption possibilities, which may imply reduction in future asset values. Expectations of this will reduce asset values today. There are few studies in the research literature that explicitly attempt to identify mispricing. The survey compares di fferent event studies that may reflect how the financial market react to the climate related risks. The empirical evidence is mixed, and few general conclusions can be drawn. It is unclear whether the market reactions are consistent with rational market valuation of the climate risk.
    Keywords: climate change; climate risk; climate policy risk; fi nancial markets; stranded assets; divestment
    JEL: G11 G12 G14 G32 Q54 Q58
    Date: 2016–02–01

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