Some recent developments in capital market theory: A survey

This paper surveys some recent developments in the theory of capital markets. Particular emphasis is given to two strands of the literature. The first covers some recent and fundamental extensions to the theory of risk aversion and the demand for risky assets. These papers are concerned with the effect of non-hedgeable background risk on risk attitudes. The important implications for finance are for the size of the risk premium (the equity premium puzzle) and for the demand for and pricing of contingent claims. For example, background risk may help to explain the apparent over-pricing of options on equity indices. The second topic is interest rate term structure models. Stochastic term structure models try to capture the possible future shapes of the term structure of interest rates. This is relevant for the pricing of contingent claims, in particular for the pricing of interest rate derivatives such as American-style swaptions. The paper will survey the most important recent models in the literature, each of which satisfies the fundamental no-arbitrage property. It will discuss the implications of the models for the pricing of both European-style and American-style options.     

Intraday return and volatility relationships between the Ibex 35 spot and futures markets

This paper analyses the intraday lead-lag relationships between returns and volatilities in the Ibex 35 spot and futures markets. Using hourly data, we jointly analyze the interactions between markets, estimating a bivariate error correction model with GARCH perturbations which captures stochastically the presence of an intraday U-shaped curve for both spot and futures market volatility. Our findings show a bidirectional causal relationship between market volatilities, with a positive feedback. This two-way transmission of volatility is consistent with market prices evolving according to a long-run equilibrium relationship, and shocks affecting both markets in the same direction. Our empirical results also support a unidirectional cross interaction from futures to spot market returns. This pattern suggests that the futures market leads the spot market in order to incorporate the arrival of new information.     

Incomplete markets,liquidation risk,and the term structure of interest rates

We analyse the term structure of interest rates in a general equilibrium model with incomplete markets, borrowing constraint, and positive net supply of government bonds. Uninsured idiosyncratic shocks generate bond trades, while aggregate shocks cause fluctuations in the trading price of bonds. Long bonds command a “liquidation risk premium” over short bonds, because they may have to be liquidated before maturity – following a bad idiosyncratic shock – precisely when their resale value is low – due to the simultaneous occurrence of a bad aggregate shock. Our framework endogenously generates limited cross-sectional wealth heterogeneity among the agents (despite the presence of uninsured idiosyncratic shocks), which allows us to characterise analytically the shape of the entire yield curve, including the yields on bonds of arbitrarily long maturities. Agents? desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms implies that a greater bond supply raises the level of the yield curve, while an increase in the relative supply of long bonds raises its slope.     

Nonlinear adjustment in US bond yields: An empirical model with conditional heteroskedasticity

Starting from the work by Campbell and Shiller (Campbell, J.Y. and Shiller, R.J. (1987). Cointegration and tests of present value models. Journal of Political Economy, 95(5):1062–1088.), empirical analysis of interest rates has been conducted in the framework of cointegration. However, parts of this approach have been questioned recently, as the adjustment mechanism may not follow a simple linear rule; another line of criticism points out that stationarity of the spreads is difficult to maintain empirically.     

Cyclical wage movements in emerging markets compared to developed economies: The role of interest rates

This paper documents that, at the aggregate level, (i) real wages are positively correlated with output and, on average, lag output by about one quarter in emerging markets, while there are no systematic patterns in developed economies, and (ii) real wage volatility (relative to output volatility) is about twice as high in emerging markets compared with developed economies. We then present a small open economy model with productivity shocks and countercyclical interest rates. The model incorporates a working capital requirement and the Jaimovich and Rebelo (2009) preference that allows for flexible parameterization of the strength of income effects on labor supply. The model can account for the high volatility of wage and consumption relative to output and countercyclical trade balances that characterize emerging-market economies. During economic downturns, rising interest rates in emerging markets induce relatively large income effects on labor supply, so households would not reduce their labor input as much even though wages drop significantly.     

Conditional volatility and correlations of weekly returns and the VaR analysis of 2008 stock market crash

Modelling of conditional volatilities and correlations across asset returns is an integral part of portfolio decision making and risk management. Over the past three decades there has been a trend towards increased asset return correlations across markets, a trend which has been accentuated during the recent financial crisis. We shall examine the nature of asset return correlations using weekly returns on futures markets and investigate the extent to which multivariate volatility models proposed in the literature can be used to formally characterize and quantify market risk. In particular, we ask how adequate these models are for modelling market risk at times of financial crisis. In doing so we consider a multivariate t version of the Gaussian dynamic conditional correlation (DCC) model proposed by Engle (2002), and show that the t-DCC model passes the usual diagnostic tests based on probability integral transforms, but fails the value at risk (VaR) based diagnostics when applied to the post 2007 period that includes the recent financial crisis.     

The recent boom–bust cycle: The relative contribution of capital flows, credit supply and asset bubbles

We use an estimated open economy DSGE model with financial frictions for the US and the rest of the world to evaluate various competing explanations about the recent boom–bust cycle. We find that the savings glut hypothesis is insufficient for explaining all aspects of the boom in the US. Relatively strong TFP growth and expansionary monetary policy are also not able to explain fully the volatility of corporate and in particular residential investment. We identify bubbles in the stock and housing market as crucial. Concerning the downturn in 2008/2009, the fall in house prices and residential investment only plays a minor role. Mortgage defaults have more explanatory power, especially in a specification of the model with a segregated equity market. Finally, the bursting of the stock market bubble was at least as important in this recession as in 2001. Because of various negative shocks hitting the economy at the same time in 2008/2009 and continued positive technology growth, not only the real interest rate declined but inflation fell rapidly and left insufficient room for monetary policy to play a similar stabilising role as in previous recessions.     

Competition among banks and the pass-through of monetary policy

This paper introduces monopolistically competitive financial intermediaries into the New Keynesian DSGE setting. Modelling bank market power explicitly contributes to understanding two empirical facts: (i) The short-run transmission of changes in money market rates to bank retail rates is far from complete and heterogeneous. (ii) Stiffer competition among commercial banks implies that loan rates correlate more tightly with the policy rate. In my model, the degree of monopolistic competition in the banking sector has a sizeable impact on the pass-through of changes in the policy rate. In particular, a more competitive market for bank credit amplifies the efficiency of monetary policy.     

Interest-Rate Reforms and Financial Deepening in Botswana: An Empirical Investigation

In this paper, we examine the impact of interest-rate reforms on financial deepening in Botswana, one of Africa's economic development success stories. We employ three proxies of financial deepening against deposit rate, a proxy for interest-rate reforms. The financial deepening in this study is defined as the increase in the relative size and role of the financial system in an economy. The empirical results of our study show that the impact of interest-rate reforms on financial deepening is sensitive to the variable used as a proxy for financial deepening. When the ratio of bank deposits to GDP (BD/GDP) is used as a proxy for financial deepening, the interest-rate reforms impact positively on the level of financial deepening. However, when the monetization variable (M2/GDP) and the ratio of the private sector credit to GDP (DCP/GDP) are used, the coefficient of the deposit rate in the financial deepening model turns out to be statistically insignificant. Overall, our results show that the positive impact of interest-rate reforms on financial deepening in Botswana is minimal. This outcome, though contrary to our expectations, is not surprising given the high level of population dependency in Botswana. Our results show that there is a strong negative relationship between the dependency ratio and financial deepening in Botswana.     

A further investigation of unemployment persistence in European transition economies

This paper analyses the dynamics of the unemployment rate in the eight countries from Central and Eastern Europe which joined the EU in 2004. Unit root tests allowing for nonlinearities and structural changes suggest that the unemployment rate is not stationary in most of the sample countries. Tests allowing for fractional integration, however, reveal that shocks are highly persistent, implying a slow rate of convergence to the natural rate of unemployment. The unemployment rate is least persistent in Hungary and Slovenia, more persistent in the Czech Republic, Slovakia and the Baltic States and extremely persistent in Poland. The degree of persistence appears to reflect the different levels of economic and institutional development in the countries and possibly also the role of the government.     

Estimation of the business cycle: A modified Hodrick-Prescott filter

Hodrick-Prescott (HP) filtering of (most often, seasonally adjusted) quarterly series is analysed. Some of the criticism to the filter are adressed. It is seen that, while filtering strongly affects autocorrelations, it has little effect on crosscorrelations. It is argued that the criticism that HP filtering induces a spurious cycle in the series is unwarranted. The filter, however, presents two serious drawbacks: First, poor performance at the end periods, due to the size of the revisions in preliminary estimators, and, second, the amount of noise in the cyclical signal, which seriously disturbs its interpretation. We show how the addition of two model-based features (in particular, applying the filter to the series extended with proper ARIMA forecasts and backcasts, and using as input to the filter the trend-cycle component instead of the seasonally adjusted series) can considerably improve the filter performance. Throughout the discussion, we use a computationally and analytically convenient alternative derivation of the HP filter, and illustrate the results with an example consisting of 4 Spanish economic indicators.     

Long-term recurrence patterns in the late 2000 economic crisis: Evidences from entropy analysis of the Dow Jones index

The depth (4.5% US GDP decline and 9.5% stable unemployment) and duration (more than two years) of the present global economic recession have suggested to many researchers and practitioners to think that it is singular relative to previous recession that occurred in the aftermath of the World War II. It has been argued that the singularity of the late 2000 crises arises from non-precedent components, such as globalization and a dominant financial system equipped with exotic instruments (e.g., derivatives) designed from highly specialized mathematical theories. This paper uses the historic (1928–2010) Dow Jones index analyzed with informational entropy methods to show the presence of recurrent cycles with dominant periods of 4.5 and 22 years. For time series, entropy is a measure of the diversity of patterns for given time scales. In this form, the higher the entropy, the more complex the underlying system dynamics. It is shown that the present economic downturn coincides with the occurrence of a 22-year cycle in the entropy dynamics of the Dow Jones index. It suggests that the crisis is not singular, but its origin can be also explained from recurrent long-term patterns. Implications of the empirical results for the evolution of the late 2000 crisis and the potential aftermath courses of the global economy are discussed.     

有限理性下中美投资者对财富和消费偏好的比较研究

投资和消费是人们最重要的经济决策,而投资和消费的选择是由对财富和消费的偏好决定的。在效用最大化的前提下,构建有限理性的效用函数,来比较中国和美国投资者对于消费和财富的偏好。研究的结果表明,相对中国人而言美国人是更加偏好消费的,而中国人更偏重于财富。这样的差异形成的原因可能在于中国的金融市场发达程度不如美国,中国的社会保障体系不如美国完善。     

Money and prices: U.S. Data 1869–1914 (A study with directed graphs)

This paper reconsiders empirical evidence on relationships among money, income, nominal prices, and wheat prices. Error correction and directed acyclic graphs are used to study both lagged and contemporaneous relations in late 19^th and early 20^th century U.S. data. We summarize evidence supporting the view that money was a causal actor in price movement in this period. In the long run (at a five year horizon), over twenty percent of the movement in price is explained by earlier movements in money supply; whereas, wheat price accounts for less than ten percent of this movement. There is also evidence that money supply was not exogenous, as it was determined, in contemporaneous time, by movements in the general price level and income. About forty percent of the variation in money is explained by current or lagged prices and income. There remains considerable uncertainty with respect to role of wheat prices in this period. Innovations in wheat price explain over twenty five percent of the uncertainty in real income at the five year forecast horizon – suggesting wheat price as either causal or proxying for more fundamental causal forces in the U.S. economy over our period of analysis. First version received: December 1999/Final version received: February 2001     

Evaluating the carbon-macroeconomy relationship: Evidence from threshold vector error-correction and Markov-switching VAR models

This paper studies the nonlinear adjustment between industrial production and carbon prices – coined as ‘the carbon-macroeconomy relationship’ – in the EU 27. We model carbon price returns and industrial production as nonlinear and state-dependent, with dynamics depending on the sign and magnitude of past realization of returns and the growth of industrial production. Our findings show that (i) macroeconomic activity is likely to affect carbon prices with a lag, due to the specific institutional constraints of this environmental market; (ii) the joint dynamics of industrial production and carbon prices seem adequately captured by two-regime threshold vector error-correction and two-regime Markov-switching VAR models compared to linear models as main competitors. The regime-switching models proposed are profoundly checked for their economic content and statistical congruency, and are found to provide a sound statistical framework for a comprehensive analysis of the carbon-macroeconomy relationship.     

Implementing and interpreting indicators of core inflation: the case of France

This paper presents a comparison of alternative indicators of underlying or “core” inflation in the French case. Four broad measures are considered and implemented. The first two are inflation excluding food and energy, and the trimmed inflation indicator. We then implement two methods relying on time-series models: the Dynamic Factor Index and the structural VAR approach.  Each indicator stresses on a particular type of shock on the inflation rate, so that no simple ranking of the measures emerges. Combining the various indicators conveys valuable information for appraising short term inflation developments. As regards theoretical interpretation, no indicator is fully satisfactory, lacking an explicit representation of monetary policy. However, comparing forecast performance with respect to inflation provides some specific support in favor of trimmed mean indicators. First version received: January 2000/Final version received: March 2001     

Non-linear causality between the stock and real estate markets of Western European countries: Evidence from rank tests

Using the non-parametric rank tests proposed by Breitung (2001), we set out in this study to determine whether any non-linear long-run equilibrium relationship exists between the stock and real estate markets of Western European countries. We go on to adopt the threshold error-correction model (TECM) to determine whether a similar relationship is discernible possibly non-linear functions of the log-price of these two markets. The findings clearly point to the existence of long-run unidirectional and bidirectional causality between the real estate market and the stock market in regions both above and below the threshold level. Finally, we find the existence of both wealth and credit price effects in the real estate markets and stock markets of Western European countries, which thereby offer financial institutions and individual investors in their construction of long-term investment portfolios within these two asset markets.     

Exploiting old customers and attracting new ones: The case of bank deposit pricing

Recent theoretical contributions suggest that deposit interest rates should be higher in geographic areas characterized by greater in-migration and lower for depositors at banks with greater shares of existing (or so-called “locked-in”) depositors. These hypotheses are tested using a rich data set obtained for the Spanish banking industry. Results confirm that, all else equal, banks offer higher deposit rates in territories characterized by greater in-migration, and also that they tend to offer lower rates, the larger the number of their locked-in depositors. These findings confirm the existence of the trade-off between exploiting old customers and attracting new ones.     

A First Assessment of Some Measures of Core Inflation for the Euro Area

Abstract. Core inflation plays an important role in the deliberations of monetary policy-makers. In this paper we evaluate a number of measures of core inflation constructed using euro-area data. In addition to the traditional exclusion-type core measures, we examine two newer ones, documenting their properties and evaluating their performance in terms of their ability to track underlying or trend inflation in real time. We focus on core measures derived from the Harmonized Index of Consumer Prices (HICP) as the European Central Bank has chosen to define its mandate for price stability in terms of this index, and because this is the only index of consumer prices that is compiled in a comparable manner across all members of the European Union. We document significant excess kurtosis in the cross-section distribution of price changes in the euro area, and show that several categories of prices are more volatile than those typically excluded from traditional measures of core inflation. Contrary to what one might expect, traditional measures of core inflation are not significantly less volatile than headline measures. We document the superior performance of alternative measures of core inflation in tracking trend inflation on average, but show that none of the various measures of core gave significant advance warning of the pickup in trend inflation at the beginning of 1999.