New Economics Papers
on Risk Management
Issue of 2006‒10‒21
eight papers chosen by

  1. Using Option Pricing Theory to Infer About Equity Premiums By Aase, Knut K.
  2. Identifying the interdependence between US monetary policy and the stock market By Bjørnland , Hilde; Leitemo, Kai
  3. Pricing risky bank loans in the new Basel II environment By Hasan, Iftekhar; Zazzara, Cristiano
  4. Financial Distress and Idiosyncratic Volatility: An Empirical Investigation By Chen, Jing; Chollete, Lorán
  5. Individual Investor Sentiment and Stock Returns - What Do We Learn from Warrant Traders? By Schmitz, Philipp; Glaser, Markus; Weber, Martin
  6. Frequent Turbulence? A Dynamic Copula Approach By Chollete, Lorán; Heinen, Andreas
  7. A wavelet analysis of scaling laws and long-memory in stock market volatility By Vuorenmaa , Tommi
  8. The art of fitting financial time series with Levy stable distributions By Scalas, Enrico; Kim, Kyungsik

  1. By: Aase, Knut K. (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: In this paper we make use of option pricing theory to infer about historical equity premiums. This we do by comparing the prices of an American perpetual put option computed using two different models: The first is the standard one with continuous, zero expectation, Gaussian noise, the second is a strikingly similar model, except that the zero expectation noise is of Poissonian type. The interesting fact that makes this comparison worthwhile, is that the probability distribution under the risk adjusted measure turns out to depend on the equity premium in the Poisson model, while this is not so for the standard, Brownian motion version. This difference is utilized to find the intertemporal, equilibrium equity premium. We apply this technique to the US equity data of the last century and find that, if the risk free short rate was around one per cent, this corresponds to a risk premium on equity about two and a half per cent. On the other hand, if the risk free rate was about four per cent, we find that this corresponds to an equity premium of around four and a half per cent. The advantage with our approach is that we only need equity data and option pricing theory, no consumption data was necessary to arrive at these conclusions. We round off the paper by investigating if the procedure also works for incomplete models.
    Keywords: Historical equity premiums; perpetual American put option; equity premium puzzle; risk free rate puzzle; geometric Brownian motion; geometric Poisson process; CCAPM
    JEL: G00
    Date: 2005–11–30
  2. By: Bjørnland , Hilde (University of Oslo, Department of Economics); Leitemo, Kai (Department of Economics, Norwegian School of Management BI)
    Abstract: We estimate the interdependence between US monetary policy and the S&P 500 using structural VAR methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative proper-ties of a monetary policy shock found in the established literature (CEE 1999). We find great interde-pendence between interest rate setting and stock prices. Stock prices immediately fall by 1.5 per cent due to a monetary policy shock that raises the federal funds rate by ten basis points. A stock price shock in-creasing stock prices by one per cent leads to an increase in the interest rate of five basis points. Stock price shocks are orthogonal to the information set in the VAR model and can be interpreted as non-fundamental shocks. We attribute a major part of the surge in stock prices at the end of the 1990s to these non-fundamental shocks.
    Keywords: VAR; monetary policy; asset prices; identification
    JEL: E43 E52 E61
    Date: 2005–07–11
  3. By: Hasan, Iftekhar (Rensselaer Polytechnic Institute and Bank of Finland); Zazzara, Cristiano (CAPITALIA Banking Group, University “Luiss-Guido Carli”, École Polytechnique Fédérale de Lausanne)
    Abstract: Recently, banking literature has had a quest for appropriate pricing of bank loans under the new Basel II rules and has been in pursuit of possible outcomes for undertaking such credit risk. In this paper, we propose a simplified formula to price bank’s corporate loans, aiming at making bank managers aware of the creation/destruction of shareholder value. We show that the mathematical treatability of the proposed formula and its easy feeding with internal and market inputs allow simple implementation by the final user.
    Keywords: Basel II; rating; pricing; exposure at default; EVA
    JEL: C63 G12 G21 G28
    Date: 2006–04–18
  4. By: Chen, Jing (Columbia University, Graduate School of Business); Chollete, Lorán (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)
    Abstract: We address the twin puzzles of anomalously low returns for high idiosyncratic volatility and high distress risk stocks, documented by Ang, Hodrick, Xing and Zhang (2006) and Campbell, Hilscher and Szilagyi (2005), respectively. We accomplish two objectives in this study. First, we investigate the link between idiosyncratic volatility and distress risk and find that the idiosyncratic volatility effect exists only conditionally on high distress risk. Second, using a corrected single-beta CAPM model, we provide a rational explanation for the twin puzzles. Joint statistical tests cannot reject the null hypothesis of zero abnormal returns across the idiosyncratic volatility and distress risk portfolios, for the corrected model.
    Keywords: Distress risk; idiosyncratic volatility; single-beta CAPM
    JEL: C12
    Date: 2006–08–04
  5. By: Schmitz, Philipp (Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre); Glaser, Markus (Sonderforschungsbereich 504); Weber, Martin (Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre)
    Abstract: In this paper, we propose a measure of individual investor sentiment that is derived from the market for bank-issued warrants. Due to a unique warrant transaction data set from a large discount broker we are able to calculate a daily sentiment measure and test whether individual investor sentiment is related to daily stock returns by using vector autoregressive models and Granger causality tests. We find that there exists a mutual influence of sentiment and stock market returns, but only in the very short-run (one and two trading days). Returns have a negative influence on sentiment, while the influence of sentiment on returns is positive for the next trading day. The influence of stock market returns on sentiment is stronger than vice versa. Our sentiment measure simultaneously avoids problems that are associated with existing sentiment measures, which are based on the closed-end fund discount, stock market transactions, the put-call ratio or investor surveys.
    Date: 2006–10–05
  6. By: Chollete, Lorán (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration); Heinen, Andreas (Dept. of Statistics and Econometrics, Universidad Carlos III de Madrid)
    Abstract: How common and how persistent are turbulent periods? We address these questions by developing and applying a dynamic dependence framework. In order to answer the first question we estimate an unconditional mixture model of normal copulas, based on both economic and econometric justification. In order to answer the second question, we develop and estimate a hidden markov model of copulas, which allows for dynamic clustering of correlations. These models permit one to infer the relative importance of turbulent and quiescent periods in international markets. Empirically, the three most striking findings are as follows. First, for the unconditional model, turbulent regimes are more common. Second, the conditional copula model dominates the unconditional model. Third, turbulent regimes tend to be more persistent.
    Keywords: International Markets; Turbulence; Hidden Markov Model; Copula
    JEL: C14 C22 C50 F30 G15
    Date: 2006–10–11
  7. By: Vuorenmaa , Tommi (Department of Economics, University of Helsinki)
    Abstract: This paper investigates the dependence of average stock market volatility on the timescale or on the time interval used to measure price changes, which dependence is often referred to as the scaling law. Scaling factor, on the other hand, refers to the elasticity of the volatility measure with respect to the timescale. This paper studies, in particular, whether the scaling factor differs from the one in a simple random walk model and whether it has remained stable over time. It also explores possible underlying reasons for the observed behaviour of volatility in terms of heterogeneity of stock market players and periodicity of in-traday volatility. The data consist of volatility series of Nokia Oyj at the Helsinki Stock Exchange at five minute frequency over the period from January 4, 1999 to December 30, 2002. The paper uses wavelet methods to decompose stock market volatility at different timescales. Wavelet methods are particularly well motivated in the present context due to their superior ability to describe local properties of times se-ries. The results are, in general, consistent with multiscaling in Finnish stock markets. Furthermore, the scaling factor and the long-memory parameters of the volatility series are not constant over time, nor con-sistent with a random walk model. Interestingly, the evidence also suggests that, for a significant part, the behaviour of volatility is accounted for by an intraday volatility cycle referred to as the New York effect. Long-memory features emerge more clearly in the data over the period around the burst of the IT bubble and may, consequently, be an indication of irrational exuberance on the part of investors.
    Keywords: long-memory; scaling; stock market; volatility; wavelets
    JEL: C14 C22
    Date: 2005–10–11
  8. By: Scalas, Enrico; Kim, Kyungsik
    Abstract: This paper illustrates a procedure for fitting financial data with alpha-stable distributions. After using all the available methods to evaluate the distribution parameters, one can qualitatively select the best estimate and run some goodness-of-fit tests on this estimate, in order to quantitatively assess its quality. It turns out that, for the two investigated data sets (MIB30 and DJIA from 2000 to present), an alpha-stable fit of log-returns is reasonably good.
    Keywords: finance; statistical methods; stable distributions
    JEL: C14 C16 G00
    Date: 2006–08–23

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