
on Financial Markets 
Issue of 2016‒07‒30
ten papers chosen by 
By:  Ivan Petzev (University of Zurich); Andreas Schrimpf (Bank for International Settlements (BIS)); Alexander F. Wagner (University of Zurich, Centre for Economic Policy Research (CEPR), European Corporate Governance Institute (ECGI), and Swiss Finance Institute) 
Abstract:  We show that in recent years global factor models have been catching up significantly with their local counterparts in terms of explanatory power (R2) for international stock returns. This catchup is driven by a rise in global factor betas, not a rise in factor volatilities, suggesting that the effect is likely to be permanent. Yet, there is no conclusive evidence for a global factor model catchup in terms of pricing errors (alpha) or a convergence in countryspecific factor premia. These findings suggest that global financial markets have progressed surprisingly little towards fully integrated pricing, different from what should be expected under financial market integration. We discuss alternative explanations for these patterns and assess implications for practice. 
Keywords:  International Asset Pricing, Size, Value, Momentum, Financial Integration, Factor Models 
JEL:  F36 G12 G15 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1548&r=fmk 
By:  Paul SCHNEIDER (University of Lugano and Swiss Finance Institute) 
Abstract:  This paper develops an optimal trading strategy explicitly linked to an agent's preferences and assessment of the distribution of asset returns. The price of this strategy is a portfolio of implied moments, and its expected excess returns naturally accommodate compensation for higherorder moment risk. Variance risk and the equity premium approximate it to first order and it nests crosssectional asset pricing models such as the CAPM. An empirical study in the US index market compares the investment behavior of an agent with recursive longrun risk preferences to one who merely uses an i.i.d. time series model and takes market prices as given. The two agents exhibit very similar behavior during crises and can be distinguished mostly during calm periods. 
Keywords:  Predictability, pricing kernel, model risk, trading strategy, modelfree, variance premium, skew premium, kurtosispremium OR from SSRN: Preference trading, pricing kernel, model risk, trading strategy, modelfree, variance premium, equity premium, skew premium, kurtosis premium 
JEL:  C02 C23 C52 C61 G11 G12 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1429&r=fmk 
By:  Paul Schneider (University of Lugano, EPFL, Swiss Finance Institute, and Boston University) 
Abstract:  This paper introduces a decomposition of the market return in terms of higherorder realized, and optionimplied risk aversion, connecting it to level, slope, and curvature of the implied volatility surface. Empirically, secondorder risk aversion  loss aversion  explains most of the market return. Signals revealed by this risk anatomy provide predictive power outofsample for realized returns in particular for longer maturities. The decomposition also shows that compensation for disaster risk is not prominently featured in the market return. Furthermore it highlights that models with identically and independently distributed state variables are not suited to represent in particular longermaturity returns. 
Keywords:  equity premium, modelfree, risk aversion, skewness 
JEL:  C02 C23 C52 C61 G11 G12 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1561&r=fmk 
By:  Peter H. GRUBER (University of Lugano); Claudio TEBALDI (Bocconi University, IGIER and CAREFIN); Fabio TROJANI (University of Geneva and Swiss Finance Institute) 
Abstract:  In a tractable stochastic volatility model, we identify the price of the smile as the price of the unspanned risks traded in SPX option markets. The price of the smile reflects two persistent volatility and skewness risks, which imply a downward sloping term structure of lowfrequency variance risk premia in normal times. In periods of distress, the term structure is upward sloping and dominated by a highfrequency premium for jump variance. This dichotomy is consistent with the puzzling skew sensitivities of option markets with creditconstrained intermediaries and it builds a challenge for many reducedform and structural models of stochastic volatility. 
Keywords:  Price of the Smile, Price of Volatility, Option Pricing, Stochastic Volatility, Unspanned Skewness, Financial Constrains, Financial Intermediation, Financial Crisis, Factor Models, Matrix Jump Diffusions, Variance Swaps, Skew Swaps 
JEL:  G10 G12 G13 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1536&r=fmk 
By:  Andrea Morone; Simone Nuzzo 
Abstract:  We investigate traders’ behaviour in an experimental asset market where uninformed agents cannot be sure about the presence of insiders. In this framework we compare two trading institutions: the continuous double auction and the call market. The purpose of this comparison is to test which of the two trading mechanisms performs better in promoting a convergence towards the efficient equilibrium price. In a framework where the presence of insiders is neither certain nor common knowledge, inspired by Plott and Sunder (1982) and Camerer and Weigelt (1991), we first test whether a discrete time mechanism of trading, like the call market, might be able to prevent the occurrence of information mirages and promote a greater level of efficiency when no inside information is in the market. Second, we also compare the efficiency of the two trading institutions during periods when insiders are present in the market. 
Keywords:  Experimental Markets, Market Efficiency, Information Mirages, Trading Institutions. 
JEL:  D61 E02 G12 
Date:  2016–07–17 
URL:  http://d.repec.org/n?u=RePEc:eei:rpaper:eeri_rp_2016_17&r=fmk 
By:  Guilherme DEMOS (ETH Zurich); Qunzhi ZHANG (ETH Zurich); Didier SORNETTE (ETH Zurich and Swiss Finance Institute) 
Abstract:  Abreu and Brunnermeier (2003) have argued that bubbles are not suppressed by arbitrageurs because they fail to synchronise on the uncertain beginning of the bubble. We propose an indirect quantitative test of this hypothesis and confront it with the alternative according to which bubbles persist due to the difficulty of agreeing on the end of bubbles. We present systematic tests of the precision and reliability with which the beginning t_1 and end t_c of a bubble can be determined. For this, we use a specific bubble model, the logperiodic power law singularity (LPPLS) model, which represents a bubble as a transient noisy superexponential price trajectory decorated by accelerated volatility oscillations. Generalising the estimation procedure to endogenise the beginning of the fitting time interval, we quantify the uncertainty on the calibrated t_1 and t_c (as well as the other model parameters) via the eigenvalues of the Hessian matrix, which characterise the shape of the calibration cost function in the different directions in parameter space, on many synthetic data and four historical bubble cases. We find overwhelming evidence that the beginning of bubbles is much better constrained that their end. Our results are robust over all four empirical bubbles and many synthetic tests, as well as when changing the time of analysis (the "present") during the development of the bubbles. As a bonus, we find that the two structural parameters of the LPPLS model, the exponent m controlling the superexponential growth of price and the angular logperiodic frequency omega describing the logperiodic acceleration of volatility, are very "rigid" according the Hessian matrix analysis, which supports the LPPLS model as a reasonable candidate for describing the generating process of prices during bubbles. 
Keywords:  Financial bubbles, sloppiness, Hessian matrix, Time Series Analysis, Numerical Simulation 
JEL:  C32 C53 G01 G17 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1557&r=fmk 
By:  Annalisa Bucalossi (Bank of Italy); Antonio Scalia (Bank of Italy) 
Abstract:  Using estimates of the Basel III leverage ratio, we show the rapid convergence of banks in the euro area towards levels well above the preliminary 3 per cent threshold. Contrary to predictions that the new requirement might interfere with the conduct of monetary policy and its transmission via the money market, throughout 2014 we find that leverageconstrained banks have decreased neither Eurosystem refinancing nor trading volume on repo markets. We measure the extent to which banks in the euro area have until now benefited from improvements in their regulatory capital, the low reporting frequency of the leverage ratio, and the favourable treatment of repo and derivatives trades with central counterparties in calculating the ratio, achieving an average of 5 per cent at endJune 2015. This level is likely to fall to around 4.5 per cent by March 2017, as a consequence of the Eurosystem Asset Purchase Programme, which causes an expansion of banks’ balance sheets and, therefore, an increase in the denominator of the leverage ratio. 
Keywords:  Basel III, leverage ratio, central bank operations, European banks, repo market 
JEL:  E58 G21 G28 G1 
Date:  2016–07 
URL:  http://d.repec.org/n?u=RePEc:bdi:opques:qef_347_16&r=fmk 
By:  Ines CHAIEB (University of Zurich and Swiss Finance Institute); Vihang ERRUNZA (McGill University); Rajna GIBSON BRANDON (University of Geneva and Swiss Finance Institute) 
Abstract:  We examine time varying integration of developed (DM) and emerging (EM) market government bonds. Although we find an upward trend for most countries and maturity bands, we do observe reversals and negative trends among both DMs and EMs and for some maturities during the financial crisis. We examine potential factors that could explain the integration of the long vs. the short maturity bond segments and show that enhanced institutional quality, higher credit quality and better future investment opportunities would jointly contribute to a higher integration of the long vs. the short maturity bonds by about 15%. 
Keywords:  market integration, term structure of integration, sovereign bond markets, political risk, developed markets, emerging markets, sovereign risk 
JEL:  G15 G12 E44 F31 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1447&r=fmk 
By:  Peter S. SCHMIDT (University of Zurich); Urs VON ARX (ETH Zurich); Andreas SCHRIMPF (Bank for International Settlements); Alexander F. WAGNER (University of Zurich and Swiss Finance Institute); Andreas ZIEGLER (University of Kassel) 
Abstract:  We study the link between the profitability of momentum strategies and firm size, drawing on an extensive dataset covering 23 stock markets across the globe. We first present evidence of an “extreme” size premium in a large number of countries. These size premia, however, are most likely not realizable due to low stock market depth. We also show that international momentum profitability declines sharply with market capitalization. Momentum premiums are also considerably diminished by trading costs, when taking into account the actual portfolio turnover incurred when implementing this strategy. In contrast to strategies based on size, we find that momentum premia especially for mediumsized stocks still remain economically and statistically significant in most equity markets worldwide after adjusting for transaction costs. 
Keywords:  International equity markets; momentum; size; asset pricing anomalies; transaction costs 
JEL:  G12 G15 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1529&r=fmk 
By:  Didier Sornette (ETH Zurich and Swiss Finance Institute); Guilherme Demos (ETH Zurich); Qun Zhang (ETH Zurich and South China University of Technology); Peter Cauwels (ETH Zurich); Vladimir Filimonov (ETH Zurich); Qunzhi Zhang (ETH Zurich) 
Abstract:  The authors assess the performance of the realtime diagnostic, openly presented to the public on the website of the Financial Crisis Observatory (FCO) at ETH Zurich, of the bubble regime that developed in Chinese stock markets since mid2014 and that started to burst in June 2015. The analysis is based on (i) the economic theory of rational expectation bubbles, (ii) behavioural mechanisms of imitation and herding of investors and traders and (iii) the mathematical formulation of the LogPeriodic Power Law Singularity (LPPLS) that describes the critical approach towards a tipping point in complex systems. The authors document how the realtime predictions were presented in the automated analysis of the FCO, as well as in our monthly FCO Cockpit report of June 2015. A complementary postmortem analysis on the nature and value of the LPPLS methodology to diagnose the SSEC bubble and its termination is also given. 
Keywords:  Financial bubbles, Crashes, Probabilistic forecast, JohansenLedoitSornette model, Logperiodic power law singularity (LPPLS), Advanced warning, Chinese bubbles, Financial crisis observatory 
JEL:  F37 G01 G17 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1531&r=fmk 