RATING BASED LÉVY LIBOR MODEL

In this paper, we consider modeling of credit risk within the Libor market models. We extend the classical definition of the default‐free forward Libor rate and develop the rating based Libor market model to cover defaultable bonds with credit ratings. As driving processes for the dynamics of the default‐free and the predefault term structure of Libor rates, time‐inhomogeneous Lévy processes are used. Credit migration is modeled by a conditional Markov chain, whose properties are preserved under different forward Libor measures. Conditions for absence of arbitrage in the model are derived and valuation formulae for some common credit derivatives in this setup are presented.     

Affine multiple yield curve models

We provide a general and tractable framework under which all multiple yield curve modeling approaches based on affine processes, be it short rate, Libor market, or Heath–Jarrow–Morton modeling, can be consolidated. We model a numéraire process and multiplicative spreads between Libor rates and simply compounded overnight indexed swap rates as functions of an underlying affine process. Besides allowing for ordered spreads and an exact fit to the initially observed term structures, this general framework leads to tractable valuation formulas for caplets and swaptions and embeds all existing multicurve affine models. The proposed approach also gives rise to new developments, such as a short rate type model driven by a Wishart process, for which we derive a closed‐form pricing formula for caplets. The empirical performance of two specifications of our framework is illustrated by calibration to market data.     

BIVARIATE SUPPORT OF FORWARD LIBOR AND SWAP RATES

Based on a certain notion of "prolific process," we find an explicit expression for the bivariate (topological) support of the solution to a particular class of 2 × 2 stochastic differential equations that includes those of the three-period "lognormal" Libor and swap market models. This yields that in the lognormal swap market model (SMM), the support of the 1 × 1 forward Libor   L * _t   equals  [ l * _t , ∞)  for some semi-explicit  −1 ≤ l * _t ≤ 0  , sharpening a result of Davis and Mataix-Pastor (2007) that forward Libor rates (eventually) become negative with positive probability in the lognormal SMM. We classify the instances   l * _t < 0  , and explicitly calculate the threshold time at or before which   L * _t   remains positive a.s.     

Multiple curve Lévy forward price model allowing for negative interest rates

In this paper, we develop a framework for discretely compounding interest rates that is based on the forward price process approach. This approach has a number of advantages, in particular in the current market environment. Compared to the classical as well as the Lévy Libor market model, it allows in a natural way for negative interest rates and has superb calibration properties even in the presence of extremely low rates. Moreover, the measure changes along the tenor structure are significantly simplified. These properties make it an excellent base for a postcrisis multiple curve setup. Two variants for multiple curve constructions based on the multiplicative spreads are discussed. Time‐inhomogeneous Lévy processes are used as driving processes. An explicit formula for the valuation of caps is derived using Fourier transform techniques. Relying on the valuation formula, we calibrate the two model variants to market data.     

Options on federal funds futures and interest rate volatility

This study examines the response of the spot and futures interest rates on the fed funds, Eurodollar, and Libor to the listing of CME fed funds options. With the exception of the Libor futures, the introduction of options is associated with a decrease in the conditional volatility of the interest rates in the sample. There is also evidence that the volume of options trading has a negative effect on the fed funds and the Eurodollar spot rates. In contrast, the fed funds and the Eurodollar futures rates respond positively to the volume of options trading. Overall, strong generalization of the effects of options listing and options trading across the markets is not possible. These results remain robust even after controlling for several exogenous variables including changes in the Fed's target for the fed funds rate, the TED spread, the 9/11 terrorist attacks, and day‐of‐the‐week effects.     

英国Libor 丑闻的实质及中国金融改革开放 的适应之策

正在披露的Libor操纵丑闻本质上是美英金融业的市场机制失灵与其政府监管部门的政府失灵的共同产物,更是美英为了维护其全球金融霸权的必然结果。有鉴于Libor的教训,我国需要进一步加快上海国际金融中心建设,使其成为全球人民币金融中心;完善金融业的监管体制,尤其强化对外资银行业的监管;确保Shibor权威公正性,使其成为全球人民币金融产品定价的标杆利率。     

Exchange Rates and FDI: Goods versus Capital Market Frictions

Changes in exchange rates affect countries through their impact on cross‐border activities such as trade and foreign direct investment (FDI). With increasing activities of multinational firms, the FDI channel is likely to gain in importance. Economic theory provides two main explanations why changes in exchange rates can affect FDI. According to the first explanation, FDI reacts to exchange rate changes if there are information frictions on capital markets and if investment depends on firms’ net worth (capital market friction hypothesis). According to the second explanation, FDI reacts to exchange rate changes if output and factor markets are segmented, and if firm‐specific assets are important (goods market friction hypothesis). We provide a unified theoretical framework of these two explanations. We analyse the implications of the model empirically using a dataset based on detailed German firm‐level data. We find greater support for the goods market than for the capital market friction hypothesis.     

Forecasting oil price movements: Exploiting the information in the futures market

Relying on the cost of carry model, the long‐run relationship between spot and futures prices is investigated and the information implied in these cointegrating relationships is used to forecast out of sample oil spot and futures price movements. To forecast oil price movements, a vector error correction model (VECM) is employed, where the deviations from the long‐run relationships between spot and futures prices constitute the equilibrium error. To evaluate forecasting performance, the random walk model (RWM) is used as a benchmark. It was found that (a) in‐sample, the information in the futures market can explain a sizable portion of oil price movements; and (b) out‐of‐sample, the VECM outperforms the RWM in forecasting price movements of 1‐month futures contracts. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:34–56, 2008     

Closed‐form option pricing formulas with extreme events

This paper explores the effect of extreme events or big jumps downwards and upwards on the jump‐diffusion option pricing model of Merton (1976). It starts by obtaining a special case of the jump‐diffusion model where there is a positive probability of a big jump downwards. Then, it obtains a new limiting case where there is an asymptotically big jump upwards. The paper extends these models to allow both types of jumps. In some cases these formulas nest Samuelson's (1965) formulas. This simple analysis leads to several closed‐form solutions for calls and puts, which are able to generate smiles, and skews with similar shapes to those observed in the marketplace. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:213–230, 2008     

Informed trading in the index option market: The case of KOSPI 200 options

This study examines if informed trading is present in the index option market by analyzing the KOSPI 200 options, the most actively traded derivative product in the world. The spread decomposition model developed by Madhavan, Richardson, and Roomans (1997) is utilized and the adverse‐selection cost component of the spread estimated by the model is then used as a proxy for the degree of informed trading. We find that adverse‐selection costs constitute a nontrivial portion of the transaction costs in index options trading. Approximately one‐third of the spread can be accounted for by information asymmetry costs. A further analysis indicates that adverse‐selection costs are positively related with option delta. Our regression analysis shows that option‐related variables are significantly associated with estimated information asymmetry costs, even when controlling for proxies for informed trading in the index futures market. Finally, we find the evidence that foreign investors are better informed compared to domestic investors and that domestic institutions have an edge in terms of information over domestic individuals. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:1118–1146, 2008     

The compatibility of one‐factor market models in caps and swaptions markets: Evidence from their dynamic hedging performance

This study examines the dynamic hedging performance of the one‐factor LIBOR and swap market models in both caps and swaptions markets, using a procedure similar to the way that these models are used in practice. The effects of different calibration methods on model performance are investigated as well. The LIBOR market models and the swap market models are calibrated to the cross‐sectional Black implied volatilities for caps and swaptions respectively; the test is based on their effectiveness in hedging floors and swaptions that are not used in the calibration. We find that the LIBOR market models outperform the swap market models in hedging floors and perform as well as the swap market models in hedging swaptions. Our results also show that incorporating a humped volatility structure into these models does not significantly improve their hedging performance. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:109–130, 2008     

ON THE DYBVIG‐INGERSOLL‐ROSS THEOREM

The Dybvig‐Ingersoll‐Ross (DIR) theorem states that, in arbitrage‐free term structure models, long‐term yields and forward rates can never fall. We present a refined version of the DIR theorem, where we identify the reciprocal of the maturity date as the maximal order that long‐term rates at earlier dates can dominate long‐term rates at later dates. The viability assumption imposed on the market model is weaker than those appearing previously in the literature.     

SOCIAL DISCOUNTING AND THE LONG RATE OF INTEREST

The well‐known theorem of Dybvig, Ingersoll, and Ross shows that the long zero‐coupon rate can never fall. This result, which, although undoubtedly correct, has been regarded by many as surprising, stems from the implicit assumption that the long‐term discount function has an exponential tail. We revisit the problem in the setting of modern interest rate theory, and show that if the long “simple” interest rate (or Libor rate) is finite, then this rate (unlike the zero‐coupon rate) acts viably as a state variable, the value of which can fluctuate randomly in line with other economic indicators. New interest rate models are constructed, under this hypothesis and certain generalizations thereof, that illustrate explicitly the good asymptotic behavior of the resulting discount bond systems. The conditions necessary for the existence of such “hyperbolic” and “generalized hyperbolic” long rates are those of so‐called social discounting, which allow for long‐term cash flows to be treated as broadly “just as important” as those of the short or medium term. As a consequence, we are able to provide a consistent arbitrage‐free valuation framework for the cost‐benefit analysis and risk management of long‐term social projects, such as those associated with sustainable energy, resource conservation, and climate change.     

The valuation of inflation‐indexed and FX convertible bonds

This paper derives a valuation model of inflation‐indexed convertible bonds that incorporates the firm's stock price, inflation indexing and the firm's credit risk. The pricing of inflation‐indexed convertible bonds traded on the Tel‐Aviv Stock Exchange (TASE) was empirically tested by using a comprehensive database. The study is the first to empirically test the pricing of convertibles in emerging markets. It was found that the theoretical values for the bonds are, on average, 1.94% higher than the observed market prices. Unlike previous studies, it was found that the underpricing increases with the moneyness of the convertible. It was found that as the maturity lengthens, the underpricing increases. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:634–655, 2008     

Is the KOSPI 200 Options Market Efficient? Parametric and Nonparametric Tests of the Martingale Restriction

A number of studies on the S&P 500 index options market claim that the no‐arbitrage assumption cannot be rejected for this market because either the martingale restriction defined in Longstaff (1995) cannot be rejected by the data, or, even when it is rejected, a large proportion of the violation can be explained by market friction factors. The present study singles out the effect of market inefficiency from market friction by testing the martingale restriction for the KOSPI 200 index options market, which is the most liquid and active options market in the world. Not only using the parametric methods adopted in previous studies but also using the nonparametric methods that enable us to avoid the model misspecification problem, we empirically present clear evidence of a violation of the martingale restriction. In addition, in contrast to the S&P 500 options market, regression analyses and robustness tests indicate that market friction factors can explain only a small portion of the percentage differences between option‐implied and market‐observed index prices. Overall, the results do not support the basic no‐arbitrage assumption or the market efficiency in the KOSPI 200 options market.     

Does adverse selection affect bid–ask spreads for options?

This study examines two different option markets to test whether differences in the level of adverse selection faced by market makers affect the size of bid–ask spreads. The data are from bank‐issued options that trade on EuWax, where market makers face little adverse selection and traditional options that trade on EuRex. The results support the hypothesis that the adverse selection component of the bid–ask spread is important, as options on EuWax have lower bid–ask spreads than comparable options on EuRex. The results show that the adverse selection component represents at least half of the overall bid–ask spreads on the traditional EuRex. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:417–437, 2008     

Pricing vulnerable options in incomplete markets

This paper follows the framework of P. Klein (1996) to price vulnerable options when the market is incomplete. Vulnerable options, which are usually traded in the over‐the‐counter market, may not only face the risk of default but also the risk of illiquidity. Thus, pricing such options under the assumption of market completeness, as was done by H. Johnson and R. Stulz (1987) and P. Klein (1996), seems to be a mistake. Accordingly, the proposed model uses the methodology proposed by J. H. Cochrane and J. Saá‐Requejo (2000) to price vulnerable options under both deterministic and stochastic interest rates in an incomplete market. The model is found to perform well when the interest rate is stochastic. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:135–170, 2005     

Mobil Oil: Defending market leadership in synthetic lubricants in China. Comment on Mobil Oil: Defending market leadership in synthetic lubricants in China

China's lubricant market was dominated by PetroChina and Sinopec. Foreign brands together controlled about 25% of the market, and these brands offered the higher‐grade lubricants. Most vehicle lubricants used in China were low‐grade lubricants. However, this was expected to change. Continued economic growth and rising incomes had led to increased demand for cars. New models and luxury cars would likely stimulate demand for higher‐grade lubricants. The case focused on synthetic lubricants of which Mobil was the market leader. Mobil's leadership position here was being threatened. Local brands were gradually improving in quality, and a few have secured rights to supply joint venture car manufacturers. Armed with deep pockets, their aggressive advertising had helped their brands gain prominence. The case required some recommendations on how Mobil should respond. © 2008 Wiley Periodicals, Inc.     

Asymmetric cultural discounting and pattern of trade in cultural products: Empirical evidence in motion pictures

We extend the seminal home market effect model of Helpman and Krugman (Market structure and foreign trade, MIT Press, Cambridge, MA, 1985) by incorporating asymmetric cultural discounting. In addition to the home market effect, our model predicts that a country subject to a relatively lower cultural discount factor becomes a net exporter as trade liberalisation accelerates. Using international box office revenues in the motion picture industry and developing a measure of asymmetric cultural discount based on tourist‐arrival statistics, we find empirical support for this hypothesis. Our model provides an explanation for the continued cultural dominance of smaller English‐speaking countries in larger non‐English‐speaking countries, which cannot be explained by the home market effect alone.     

Intraday volatility in the bond,foreign exchange,and stock index futures markets

Intraday volatility for the Eurodollar, the Euro/dollar foreign exchange rate, and the E‐mini S&P 500 futures contracts traded on a continuous 23‐hour schedule on the Chicago Mercantile Exchange Globex electronic platform is studied. Volatility transmission in a single market across different regions is mainly explained by intraregion volatility (heat waves); interregion volatility (meteor showers) plays a secondary role. The joint impact of liquidity variables such as volume and open interest on volatility is also analyzed. Volume tends to increase volatility, but open interest does not affect it. The results are explained by the type of trading venue. Unlike floor‐based trading systems, in electronic markets open interest does not seem to provide additional information on market liquidity and its relation to volatility beyond any information contributed by volume. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:313– 334, 2008