What drives volatility persistence in the foreign exchange market?

We propose a new empirical specification of volatility that links volatility to the information flow, measured as the order flow in the market, and to the price sensitivity to that information. The time-varying market sensitivity to information is estimated from high-frequency data, and movements in volatility can therefore be directly related to movements in order flow and market sensitivity. Empirically, the model explains a large share of the long-run variation in volatility. Importantly, the time variation in the market's sensitivity to information is at least as relevant in explaining the persistence of volatility as the rate of information arrival itself. This may be evidence of a link between changes over time in the aggregate behavior of market participants and the time-series properties of realized volatility.     

Two Paradigms and Nobel Prizes in Economics: a Contradiction or Coexistence?

Abstract Markowitz and Sharpe won the Nobel Prize in Economics for the development of Mean‐Variance (M‐V) analysis and the Capital Asset Pricing Model (CAPM). Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximisation in the face of risk aversion. Kahneman and Tversky suggest Prospect Theory (PT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximise the expectation of an S‐shaped value function, which contains a risk‐seeking segment. Can these two apparently contradictory paradigms coexist? We show in this paper that although CPT (and PT) is in conflict to EUT, and violates some of the CAPM's underlying assumptions, the Security Market Line Theorem (SMLT) of the CAPM is intact in the CPT framework. Therefore, the CAPM is intact also in CPT framework.     

Stochastic risk premiums,stochastic skewness in currency options,and stochastic discount factors in international economies

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each economy but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.     

Stochastic skew in currency options

We analyze the behavior of over-the-counter currency option prices across moneyness, maturity, and calendar time on two of the most actively traded currency pairs over the past eight years. We find that, on any given date, the conditional risk-neutral distribution of currency returns can show strong asymmetry. This asymmetry varies greatly over time and often switches signs. We develop and estimate a class of models that captures this stochastic skew behavior. Model estimation shows that our stochastic skew models significantly outperform traditional jump-diffusion stochastic volatility models both in sample and out of sample.     

Volume and skewness in international equity markets

We examine the relation between trading volume and skewness in 11 international stock markets using daily and monthly data from January 1980 to August 2004. We construct single equation and VAR models of the relation between the first three moments of market returns and trading volumes. Our results show hitherto unrecognised channels of influence, and support the investor heterogeneity approach to explaining return asymmetries.     

Is Financial Flexibility a Priced Factor in the Stock Market?

This paper develops a factor analysis–based measure for shifts in corporate financial flexibility (FFLEX) that can be observed from public accounting information. Companies that experience positive shifts in FFLEX are associated with higher future investment growth opportunities. We show that FFLEX is a robust determinant of future stock returns. Firms that have increased their financial flexibility are associated with lower stock returns in the subsequent period. A zero‐cost return portfolio produces a significant positive monthly premium of 0.69%, which is driven by covariance (risk). Risk inherent in the flexibility factor is not explained away by either prominent pricing characteristics or factors.     

Are exchange rates serially correlated? New evidence from the Euro FX markets

This paper examines the serial uncorrelatedness hypothesis in the Euro FX markets by testing for autocorrelation in daily FX returns of 82 countries over the period of 1999–2010. We use three newly developed tests that are robust to conditional heteroskedasticity of unknown forms and that do not choose a lag parameter arbitrarily. They are Escanciano &; Lobato (2009)'s automatic Box–Pierce Q_p test, Nankervis &; Savin (2010)'s generalized Andrews–Ploberger test and Deo (2000)'s robust Durlauf test. We find no significant autocorrelation in the FX returns of around 58 to 62 countries, suggesting that majority of the Euro FX markets are weak-form efficient.     

Have European Stocks become More Volatile? An Empirical Investigation of Idiosyncratic and Market Risk in the Euro Area

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the 12 euro area stock markets over the period 1974–2004. Similarly to Campbell et al. (2001) , we find a rise in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to the US, however, market risk is trended upwards in Europe and correlations are not trended downwards. Both the volatility and correlation measures are pro‐cyclical, and they rise during times of low market returns. Market and average idiosyncratic volatility jointly predict market wide returns, and the latter impact upon both market and idiosyncratic volatility. This has asset pricing and risk management implications.     

Which Fundamentals Drive Exchange Rates? A Cross‐Sectional Perspective

Standard present‐value models suggest that exchange rates are driven by expected future fundamentals, implying that exchange rates contain information about future fundamentals. We test this key empirical prediction of present‐value models in a sample of 35 currency pairs ranging from 1900 to 2009. Employing a variety of tests, we find that exchange rates have strong and significant predictive power for nominal fundamentals (inflation, money balances, nominal GDP), whereas predictability of real fundamentals and risk premia is much weaker and largely confined to the post–Bretton Woods era. Overall, we uncover ample evidence that future macrofundamentals drive current exchange rates.     

From the bird's eye to the microscope: A survey of new stylized facts of the intra-daily foreign exchange markets

This paper presents stylized facts concerning the spot intra-daily foreign exchange markets. It first describes intra-daily data and proposes a set of definitions for the variables of interest. Empirical regularities of the foreign exchange intra-daily data are then grouped under three major topics: the distribution of price changes, the process of price formation and the heterogeneous structure of the market. The stylized facts surveyed in this paper shed new light on the market structure that appears composed of heterogeneous agents. It also poses several challenges such as the definition of price and of the time-scale, the concepts of risk and efficiency, the modeling of the markets and the learning process.     

Valuing Government Obligations When Markets Are Incomplete

We simulate a 10‐period overlapping generations model with aggregate shocks to price safe and risky government obligations using consumption‐asset pricing. Agents cannot trade with future generations to hedge the model's productivity and depreciation shocks, and can only invest in one‐period bonds and risky capital. We find that the pricing of short‐ and long‐dated riskless obligations is anchored to the prevailing risk‐free return. The prices of obligations whose values are proportional to the prevailing wage are essentially identical to those of safe obligations, notwithstanding large macro shocks. On the contrary, government obligations in the form of options entail significant risk adjustment.