A general HJM framework for multiple yield curve modelling

We propose a general framework for modelling multiple yield curves which have emerged after the last financial crisis. In a general semimartingale setting, we provide an HJM approach to model the term structure of multiplicative spreads between FRA rates and simply compounded OIS risk-free forward rates. We derive an HJM drift and consistency condition ensuring absence of arbitrage and, in addition, we show how to construct models such that multiplicative spreads are greater than one and ordered with respect to the tenor’s length. When the driving semimartingale is an affine process, we obtain a flexible and tractable Markovian structure. Finally, we show that the proposed framework allows unifying and extending several recent approaches to multiple yield curve modelling.     

The existence and persistence of household financial hardship: A Bayesian multivariate dynamic logit framework

We investigate the existence and persistence of financial hardship at the household level using data from the British Household Panel Survey. Our modelling strategy makes three important contributions to the existing literature on household finances. Firstly, we model nine different types of household financial problems within a joint framework, allowing for correlation in the random effects across the nine equations. Secondly, we develop a dynamic framework in order to model the persistence of financial problems over time by extending our multi-equation framework to allow the presence or otherwise of different types of financial problems in the previous time period to influence the probability that the household currently experiences such problems. Our third contribution relates to the possibility that experiencing financial problems may be correlated with sample attrition. We model missing observations in the panel in order to allow for such attrition. Our modelling framework allows us to identify any persistence in financial problems over time as well as any interdependence that may exist between different types of financial problems. Our findings reveal interesting variations in the determinants of experiencing different types of financial problems including demographic and regional differences. Our findings also highlight persistence in experiencing financial problems over time as well as the role that saving on a regular basis can play in mitigating current financial problems.     

Modelling gold futures: should the level of speculation inform our choice of variables?

Prior literature provides conflicting evidence about the impact of speculation on gold futures returns, volatility, and the relationship between market fundamentals and prices. In this paper, we exploit trade volume information to determine the most appropriate family of factors to adopt when modelling gold futures. Using the Disaggregated Commitment of Traders report, we find that extreme levels of speculation are informative in that they signify a shift in the relative modelling accuracy of macroeconomic and latent factors. A simple composite prediction framework, incorporating the changing level of speculation, empirically demonstrates the uncovered phenomenon and offers improved predictive accuracy for gold futures prices. Furthermore, our findings are shown to be robust to alternative latent and macroeconomic model specifications.     

Modelling household finances: A Bayesian approach to a multivariate two-part model

We contribute to the empirical literature on household finances by introducing a Bayesian multivariate two-part model, which has been developed to further our understanding of household finances. Our flexible approach allows for the potential interdependence between the holding of assets and liabilities at the household level and also encompasses a two-part process to allow for differences in the influences on asset or liability holding and on the respective amounts held. Furthermore, the framework is dynamic in order to allow for persistence in household finances over time. Our findings endorse the joint modelling approach and provide evidence supporting the importance of dynamics. In addition, we find that certain independent variables exert different influences on the binary and continuous parts of the model thereby highlighting the flexibility of our framework and revealing a detailed picture of the nature of household finances.     

Time‐changed Lévy jump processes with GARCH model on reverse convertibles

For decades, financial institutions have been very motivated in creating structured high-yield financial products, especially in the economic environment of lower interest rates. Reverse convertible notes (RCNs) are the type of financial instruments, which in recent years first in Europe and then in the US – have become highly desirable financial structured products. They are complex financial structured products because they are neither plain bonds nor stocks. Instead, they are structured products embedding equity options, which involve a significant amount of asset returns' uncertainty. Given this fact, pricing of reverse convertible notes becomes a really big challenge, where both the general Black–Scholes option pricing model and the compound Poisson jump model which are designed to catch large crashes, are not suitable in valuing these kinds of products. In this paper, we propose a new asset-pricing framework for reverse convertible notes by extending the pure Brownian increments to Lévy jump risks for the underlying stock return movements. Our framework deals with time-changing volatilities of stock options with Lévy jump processes by considering the stocks' infinite-jump possibilities. We then use a discrete-time GARCH with time-changed dynamics Lévy Jump processes in order to derive the assets' valuations. The results from our new model are close to the market's valuations, especially with the normal-inverse-Gaussian model of the Lévy jump family.     

Modelling mean reversion of asset prices towards their fundamental value

In this paper we extend the study of mean reversion behavior by modelling the fundamental value as a stochastic process. The market value of the asset is then modelled as a mean reverting Ornstein Uhlenbeck process towards the fundamental value. Solving backwards, we determine the functional form of the regression equation of changes in asset prices and returns to changes to the fundamental value. Using earnings and dividends as proxies for the fundamental value we test our model empirically. In general, other than the shortest horizon of 1-year, our model shows good explanatory power. Since our model is compatible with Campbell and Shiller (1988) framework in the earnings case and Fama and French (1988) model in the dividend case, the performance of our model has been compared with those two models. In comparison, the performance of our model is comparable to that of Campbell and Shiller and compares favorably with Fama and French.     

On the Information in the Interest Rate Term Structure and Option Prices

We examine whether the information in cap and swaption prices is consistent with realized movements of the interest rate term structure. To extract an option-implied interest rate covariance matrix from cap and swaption prices, we use Libor market models as a modelling framework. We propose a flexible parameterization of the interest rate covariance matrix, which cannot be generated by standard low-factor term structure models. The empirical analysis, based on US data from 1995 to 1999, shows that option prices imply an interest rate covariance matrix that is significantly different from the covariance matrix estimated from interest rate data. If one uses the latter covariance matrix to price caps and swaptions, one significantly underprices these options. We discuss and analyze several explanations for our findings.     

Modelling as a Tool for Cross‐border Analysis of the Position of Insolvency Office Holders

This paper presents a framework and a model applied to make a cross‐border analysis of the position of Insolvency Office Holders. Both the framework and the model were developed in the course of an assignment to design Principles and Best Practices for Insolvency Office Holders for INSOL Europe. The framework is developed by induction from a variety of sources of rules and regulations regarding Insolvency Office Holders, while the model subsequently has been derived by deduction from the framework. Finally, the paper shows how this method assisted in determining the issues to be covered by Principles and Best Practices. The authors argue that commencing international legal comparison with abstract reasoning and modelling may lessen the effect of researcher's academic or professional blind spots and cultural bias and has the potential to enhance the value of cross‐border analysis in terms of coherence, consistency and completeness. Copyright © 2016 INSOL International and John Wiley & Sons, Ltd     

Financial and monetary policy responses to oil price shocks: evidence from oil-importing and oil-exporting countries

In this study, we investigate the financial and monetary policy responses to oil price shocks using a Structural VAR framework. We distinguish between net oil-importing and net oil-exporting countries. Since the 80s, a significant number of empirical studies have been published investigating the effect of oil prices on macroeconomic and financial variables. Most of these studies though, do not make a distinction between oil-importing and oil-exporting economies. Overall, our results indicate that the level of inflation in both net oil-exporting and net oil-importing countries is significantly affected by oil price innovations. Furthermore, we find that the response of interest rates to an oil price shock depends heavily on the monetary policy regime of each country. Finally, stock markets operating in net oil-importing countries exhibit a negative response to increased oil prices. The reverse is true for the stock market of the net oil-exporting countries. We find evidence that the magnitude of stock market responses to oil price shocks is higher for the newly established and/or less liquid stock markets.     

Capital market equilibrium in a mean-lower partial moment framework

In this paper, we develop a Capital Asset Pricing Model (CAPM) using a mean-lower partial moment framework. We explicitly derive formulae for the equilibrium values of risky assets that hold for arbitrary probability distributions. We show that when the probability distributions and portfolio returns are either normal, stable (with the same characteristic exponent between 1 and 2 and the same skewness parameter, not necessarily zero), or Student-t distributions, our CAPM reduces to the traditional mean-scale CAPM's. Consequently, since the traditional equilibrium models are special cases of our model, the mean-lower partial moment framework is guaranteed to do at least as well in explaining market data. As an application of our theory, we derive an acceptance criterion for capital investment projects and note that corporate finance theory results developed, for example, in the well-known mean- variance framework carry over to the mean-lower partial moment framework.     

Evaluating the effectiveness of the new EU bank regulatory framework: A farewell to bail-out?

In response to the economic and financial crisis, the EU has adopted a new regulatory framework of the banking sector. Its central elements consist of new capital requirements, the single rulebook, and rules for bank recovery and resolution. These legislations have been adopted to reduce the call for government bail-out of distressed banks in future crises.The present study performs a detailed quantitative assessment of the reduction in public finance costs brought about by the introduction of these rules. We use a microsimulation portfolio model, which implements the Basel risk assessment framework, to estimate the joint distribution of bank losses at EU level. The approach incorporates the complete safety-net set up in EU legislation to absorb these losses, explicitly modelling enhanced Basel III capital rules, the bail-in tool and the resolution funds.Using a near-full sample of commercial, cooperative and savings banks in the EU, we quantify the cumulative effects of this safety-net and the contribution of each individual tool to the total effect. Considering a crisis of a similar magnitude as the recent one, our results show that potential costs for public finances decrease from roughly 3.7% of EU GDP (before the introduction of any new tool) to 1.4% with bail-in, and finally to 0.5% when all the elements we model are in place. This latter amount is very close to our estimate of leftover resolution funds and the size of the Deposit Guarantee Scheme.This exercise extends the quantitative analyses performed by the European Commission in its Economic Review of the Financial Regulation Agenda by developing additional scenarios, crucial robustness checks, simulations for different annual data vintages, and by implementing some methodological improvements.     

Effects of exchange rate variations on bilateral trade with a vehicle currency: Evidence from China and Singapore

Using a testable gravity-type bilateral trade model derived from an underlying demand and supply model, this paper explores the effects of exchange rate variations on bilateral trade in an exchange rate regime with a vehicle currency. The introduction of the vehicle currency allows us to figure out whether variations in the trade volume due to the fluctuation of the bilateral exchange rate are primarily due to changes in demand or in supply, or both. More specifically, in this theoretical framework, the appreciation of one country's currency against the vehicle currency is expected to promote its imports, but the effect of revaluation of the country's currency against the vehicle currency on its exports is ambiguous. Moreover, high volatility of the exchange rate of one country's currency against the vehicle currency is also expected to depress its import volume. From the empirical point of view, the decomposition of the bilateral exchange rate of two currencies into the bilateral rates of these two currencies against the vehicle currency provides a new alternative to avoid the econometric problem of potential reverse causality in assessing the effects. Through compiling a novel monthly bilateral-trade dataset between China and Singapore over 21 years or 252 months, we empirically test the predictions of our model, which get robust support from the results.     

The spot–forward relationship revisited: an ERM perspective

We re-examine the relationship between spot and forward exchange rates using Hansen's stability tests for co-integrating equations. Two numeraire currencies are used: the DM as the ERM's nth currency and the US$ as a ‘control’. The striking feature is that while the spot–forward relationship displays broad stability against the dollar, precisely the opposite is true against the DM. We investigate whether this result can be interpreted as evidence that the ERM target zones lacked credibility. Using the general-to-specific modelling framework, we develop dynamic relationships that can be readily used to interpret the source of the Hansen instability. Our results also have implications for the appropriate way to test the unbiasedness of the forward exchange rate.     

How Investment Opportunities Affect Optimal Capital Structure

This article addresses the question of how competition for investments among companies in a certain industry affects their capital structure. The authors develop a new modelling framework that simulates financial variables of a set of firms in a given sector, and uses the framework to analyze how such firms compete for new investments. The leverage of companies affects their flexibility to react to and take advantage of investment opportunities, and the authors show how such flexibility can be optimized to maximize the firm’s growth. As an illustration, they apply the model to a set of European airlines and global pharmaceutical companies. The novelty introduced by this paper is the explicit modelling of the interaction between several companies. The literature on optimal capital structure focuses on individual companies optimizing their capital structure in a world in which the actions of their competitors are exogenous. The authors’ results show how to incorporate the competitive position of the firm as well as the availability of investment opportunities into the capital structure decison.     

Who is unhappy for Brexit? A machine-learning,agent-based study on financial instability

In this paper, we assess the happiness cost of Brexit in the UK and the EU, using data from the Gallup World Poll. We implement a two-stage learning machine, using a naive Bayes classifier to extract happiness preferences of the population and then passing these onto an artificial neural network of attributes to generate dynamic happiness functions for each household, on an agent-based modelling framework. We find that there is a significant long-run cost in terms of both happiness and unemployment, which primarily affects the most vulnerable portion of the population. In addition, despite the expected instability in City's financial centre, the UK financial sector seems to be well equipped to deal with the repercussions, thus minimising the welfare costs for the country. Our findings extend the discussion of the economic costs of Brexit, by adding the welfare cost of the ensuing financial instability.     

Gram–Charlier densities: a multivariate approach

This paper introduces a new family of multivariate distributions based on Gram–Charlier and Edgeworth expansions. This family encompasses many of the univariate semi-non-parametric densities proposed in financial econometrics as marginal of its different formulations. Within this family, we focus on the analysis of the specifications that guarantee positivity to obtain well-defined multivariate semi-non-parametric densities. We compare two different multivariate distributions of the family with the multivariate Edgeworth–Sargan, Normal, Student's t and skewed Student's t in an in- and out-of-sample framework for financial returns data. Our results show that the proposed specifications provide a reasonably good performance, and would therefore be of interest for applications involving the modelling and forecasting of heavy-tailed distributions.     

A comprehensive and quantitative internal control index: construction,validation, and impact

We use a new method to better measure internal control quality. Specifically, we construct an internal control index for all public firms in China, because the lack of internal control regulations during our sample period presents an interesting setting, in which the diversity of internal control quality is preserved. Two distinctive features set our index apart from the information currently available under SOX 404 in the U.S. First, it comprehensively evaluates a firm’s internal control, based on the COSO framework. Second, it quantitatively measures a firm’s internal control, using the analytic hierarchy process designed for analyzing complex decisions. We proceed to validate our index by confirming the known relation between internal control quality and earnings management. Further, we theorize that our internal control index has a positive impact on the earnings response coefficient, and find that better internal control indeed makes financial reporting more credible to investors.     

Alternative Defaultable Term Structure Models

The objective of this paper is to consider defaultable term structure models in a general setting beyond standard risk-neutral models. Using as numeraire the growth optimal portfolio, defaultable interest rate derivatives are priced under the real-world probability measure. Therefore, the existence of an equivalent risk-neutral probability measure is not required. In particular, the real-world dynamics of the instantaneous defaultable forward rates under a jump-diffusion extension of a HJM type framework are derived. Thus, by establishing a modelling framework fully under the real-world probability measure, the challenge of reconciling real-world and risk-neutral probabilities of default is deliberately avoided, which provides significant extra modelling freedom. In addition, for certain volatility specifications, finite dimensional Markovian defaultable term structure models are derived. The paper also demonstrates an alternative defaultable term structure model. It provides tractable expressions for the prices of defaultable derivatives under the assumption of independence between the discounted growth optimal portfolio and the default-adjusted short rate. These expressions are then used in a more general model as control variates for Monte Carlo simulations of credit derivatives. Nicola Bruti-Liberati: In memory of our beloved friend and colleague.     

Performance and Merton-type default risk of listed banks in the EU: A panel VAR approach

This paper provides empirical evidence that sheds new light into the dynamic interactions between risk and efficiency, a highly debated issue. First, we estimate three alternative measures of bank performance, by employing a directional distance function framework, along with a cost frontier and a profit function. As a second step, we calculate a Merton-type bank default risk. Then, we employ a panel VAR analysis, which allows the examination of the underlying relationships between efficiency and risk without applying any a priori restrictions. Most evidence shows that the effect of a one standard deviation shock of the distance to default on inefficiency is negative and substantial. There is some evidence of a reverse causation. As part of a sensitivity analysis, we extent our study to investigate the relationship between efficiency and default risk for banks with different types of ownership structures and across financial systems with different levels of development.