nep-fmk New Economics Papers
on Financial Markets
Issue of 2019‒10‒28
eight papers chosen by

  1. Fragmentation in global financial markets: good or bad for financial stability? By Stijn Claessens
  2. Debt Collateralization, Structured Finance, and the CDS Basis By Feixue Gong; Gregory Phelan
  3. The Life of the Counterparty: Shock Propagation in Hedge Fund-Prime Broker Credit Networks By Mathias Kruttli; Phillip Monin; Sumudu Watugala
  4. Cross-Asset Market Order Flow, Liquidity, and Price Discovery By Robert Garrison; Pankaj Jain; Mark Paddrik
  5. Corporate social responsibility and M&A uncertainty By Mohamed Arouri; Mathieu Gomes; Kuntara Pukthuanthong
  6. Pricing and Hedging Performance on Pegged FX Markets Based on a Regime Switching Model By Samuel Drapeau; Yunbo Zhang
  7. Credit Rating Dynamics: Evidence from a Natural Experiment By Abidi, Nordine; Falagiarda, Matteo; Miquel-Flores, Ixart
  8. Sector Neutral Portfolios: Long memory motifs persistence in market structure dynamics By Jeremy Turiel; Tomaso Aste

  1. By: Stijn Claessens
    Abstract: The many regulatory reforms following the Great Financial Crisis of 2007-09 have most often been designed and adopted through an international cooperative process. As such, actions have tended to harmonise national approaches and diminish inconsistencies. Nevertheless, some market participants and policymakers have recently raised concerns over an unwanted and unnecessary degree of fragmentation in financial markets globally, with possibly adverse effects for financial stability. This paper reviews the degree of fragmentation in various markets and classifies its possible causes. It then reviews whether fragmentation is necessarily detrimental to financial stability, suggesting that, as is more likely, various trade-offs exist. To identify and assess the scope for Pareto improvements, it concludes by outlining areas for further analysis.
    Keywords: financial stability, fragmentation, segmentation, financial integration, regulation, international cooperation
    JEL: G15 F30 G11 G12
    Date: 2019–10
  2. By: Feixue Gong (Massachusetts Institute of Technology); Gregory Phelan (Williams College)
    Abstract: Tranching an asset increases its basis; tranching a CDS, as occurs with the CDX index, increases the CDS basis on the underlying asset. We study how the ability to use financial contracts as collateral affects the CDS basis using a general equilibrium model with collateralized financial promises and multiple states of uncertainty. A positive basis emerges when risky assets and their derivative debt contracts can be used as collateral for financial promises. We provide an empirical test of our theory using inclusion in the CDX and find that inclusion in the CDX increases the CDS basis.
    Keywords: Collateral, securitized markets, cash-synthetic basis, credit default swaps, asset prices, credit spreads.
    JEL: D52 D53 G11 G12
    Date: 2019–09
  3. By: Mathias Kruttli (Board of Governors of the Federal Reserve System, Oxford-Man Institute of Quantitative Finance); Phillip Monin (Office of Financial Research); Sumudu Watugala (Cornell University, Office of Financial Research)
    Abstract: The collapse of Lehman Brothers illustrated the importance of managing prime broker counterparty risks for hedge funds. Liquidity shocks to prime brokers can lead to cycles of deleveraging that produce losses at funds and potentially have harmful effects on financial market function and credit provision. While the hedge fund-prime broker credit network is highly concentrated, the average hedge fund in our sample borrows from three prime brokers and has a total credit exposure of $2.15 billion. We show that hedge fund borrowing tends to be overcollateralized and most of the collateral is allowed to be rehypothecated. Using a within fund-quarter empirical strategy, we identify the effects of an idiosyncratic liquidity shock to a major creditor. Such a shock results in significantly reduced borrowing due to the prime broker reducing credit supply instead of a precautionary reduction in credit demand from connected hedge funds. Borrowing by funds with more rehypothecable collateral is less affected because such collateral improves the constrained creditor's liquidity situation. Even large hedge funds simultaneously borrowing from multiple creditors see a significant reduction in their aggregate borrowing following the shock. Larger, more connected and better-performing hedge funds and those that do less OTC trading are better able to compensate for this loss.
    Keywords: hedge funds, prime brokers, credit networks, rehypothecation, collateral
    Date: 2019–10–01
  4. By: Robert Garrison (Office of Financial Research); Pankaj Jain (University of Memphis, Office of Financial Research); Mark Paddrik (Office of Financial Research)
    Abstract: Cross-asset market activity can be a channel through which illiquidity risks originating in one market can propagate to others. This paper examines the complex intra-day linkages between the U.S. equity securities market and the equity derivatives market using high-frequency data on S&P 500 index exchange-traded funds and E-mini futures contracts. The paper finds a positive, but short-lived, relationship between the two markets' order flow activities, which relates to the supply, demand, and withdrawal of liquidity between the two markets. The paper also finds that cross-asset market order flow is a key component of liquidity and price discovery, particularly during periods of market volatility.
    Keywords: cross-market arbitrage, order flow, liquidity, market structure, automated markets
    Date: 2019–10–23
  5. By: Mohamed Arouri (GRM - Groupe de Recherche en Management - EA 4711 - UNS - Université Nice Sophia Antipolis - UCA - Université Côte d'Azur); Mathieu Gomes (CleRMa - Clermont Recherche Management - Clermont Auvergne - École Supérieure de Commerce (ESC) - Clermont-Ferrand - UCA - Université Clermont Auvergne); Kuntara Pukthuanthong
    Abstract: We contribute to the corporate social responsibility (CSR) literature by investigating whether the CSR of acquirers impacts mergers and acquisitions (M&A) completion uncertainty. Using arbitrage spreads following initial acquisition announcements as a measure of deal uncertainty, we document-for an international sample of 726 M&A operations spanning the 2004-2016 period-a negative association between arbitrage spreads and acquirers' CSR. Specifically, we show arbitrage spreads are reduced by 1.10 percentage points for each standard deviation unit-increase in the acquirer's CSR score. Findings are qualitatively similar when we focus on individual CSR dimensions (environmental, social, and governance). Our results suggest the CSR of acquirers is an important determinant of the way market participants assess the outcome of M&As worldwide.
    Keywords: Corporate Social Responsibility (CSR),Mergers and Acquisitions (M&A),Risk
    Date: 2019–06
  6. By: Samuel Drapeau; Yunbo Zhang
    Abstract: This paper investigates the hedging performance of pegged foreign exchange market in a regime switching (RS) model introduced in a recent paper by Drapeau, Wang and Wang (2019). We compare two prices, an exact solution and first order approximation and provide the bounds for the error. We provide exact RS delta, approximated RS delta as well as mean variance hedging strategies for this specific model and compare their performance. To improve the efficiency of the pricing and calibration procedure, the Fourier approach of this regime-switching model is developed in our work. It turns out that: 1 -- the calibration of the volatility surface with this regime switching model outperforms on real data the classical SABR model; 2 -- the Fourier approach is significantly faster than the direct approach; 3 -- in terms of hedging, the approximated RS delta hedge is a viable alternative to the exact RS delta hedge while significantly faster.
    Date: 2019–10
  7. By: Abidi, Nordine; Falagiarda, Matteo; Miquel-Flores, Ixart
    Abstract: The paper investigates the behaviour of credit rating agencies (CRAs) using a natural experiment in monetary policy. Specifically, it exploits the corporate QE of the Eurosystem and its rating-based specific design which generates exogenous variation in the probability for a bond of becoming eligible for outright purchases. The authors show that after the launch of the policy, rating upgrades were mostly noticeable for bonds initially located below, but close to, the eligibility frontier. In line with the theory, rating activity is concentrated precisely on the territory where the incentives of market participants are expected to be more sensitive to the policy design. Complementing the evidence on the activeness of non-standard measures, the findings contribute to better assessing the consequences of the explicit (but not exclusive) reliance on CRAs ratings by central banks when designing monetary policy.
    Date: 2019–06
  8. By: Jeremy Turiel; Tomaso Aste
    Abstract: We study soft persistence (existence in subsequent temporal layers of motifs from the initial layer) of motif structures in Triangulated Maximally Filtered Graphs (TMFG) generated from time-varying Kendall correlation matrices computed from stock prices log-returns over rolling windows with exponential smoothing. We observe long-memory processes in these structures in the form of power law decays in the number of persistent motifs. The decays then transition to a plateau regime with a power-law decay with smaller exponent. We demonstrate that identifying persistent motifs allows for forecasting and applications to portfolio diversification. Balanced portfolios are often constructed from the analysis of historic correlations, however not all past correlations are persistently reflected into the future. Sector neutrality has also been a central theme in portfolio diversification and systemic risk. We present an unsupervised technique to identify persistently correlated sets of stocks. These are empirically found to identify sectors driven by strong fundamentals. Applications of these findings are tested in two distinct ways on four different markets, resulting in significant reduction in portfolio volatility. A persistence-based measure for portfolio allocation is proposed and shown to outperform volatility weighting when tested out of sample.
    Date: 2019–10

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