Practitioners' Corner

The first 150 words of the full text of this article appear below. The transition from some preliminary qualitative assessmentsto quantitative assertions is a hallmark of scientific progress.One dollar today is more valuable than one dollar availabletomorrow, but the scientific issue is by how much and why thisamount? Similarly a random gain with unit expectation and significantrisk is less valuable than one dollar available with certainty.Financial theories of the discount rate and the mean-variancetrade-off have afforded helpful quantitative answers to thesecrucial issues in asset pricing, investment, and risk management.Meanwhile, modern financial econometrics has characterized thedynamic features of interest rates as well as of risk and returnthrough state variables models with volatility clustering, mean-volatilityfeedback, and dynamic correlations. From this perspective, a striking common feature of all thearticles in the current issue of the Journal of Financial Econometricsis the reintroduction of qualitative variables previously treatedusing purely quantitative approaches. The first . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. The analysis of volatility remains a preoccupation. In our veryfirst issue, "Practitioners' Corner" offered a brief retrospectiveon volatility modeling, surveying several strategies in thehistory of volatility modeling and locating the contributionsof the first issue within these broad themes. Of course, notall the highlights of this voluminous literature could be visitedor all noteworthy references cited. Nonetheless, we should havereferred to the venerable literature on mixture models introducedby the polymath Simon Newcomb in the late 19th century and subsequentlystudied by Karl Pearson. A neglected reminder was certainlysupplied by Lanne and Saikkonen (2003), who in this same firstissue of JFEC offered the wry understatement that the conditionalheteroskedasticity inherent in mixture autoregressive modelsmay not adequately capture the time-series properties of financialdata. The point is made again in the contribution to this issueby Markus Haas, Stefan Mittnik, and Marc . . . [Full Text of this Article]     

Practitioners' Corner: Introduction to the Special Issue

The first 150 words of the full text of this article appear below. The material in this volume is the result of a call for papersto the participants of the "Conference on Analysis of High-FrequencyFinancial Data and Market Microstructure" held in December 2003in Taipei, Taiwan. Jeffrey Russell and Ruey Tsay have actedas guest editors for this special issue, together with the editorsRené Garcia and Eric Renault. The availability of high-frequency data has spawned considerableliterature on volatility measurement and forecasting. The materialis mathematically delicate and perhaps "Practitioners’Corner" would be well advised to let the dust settle a bit tosee what emerges at the end of the day. On the other hand, thepractically minded may well be served by a good road map ofthe issues. So with only mild apology do we take up the cartographyof some difficult terrain. To fix ideas, let S(t) denote the price process of a . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. In our discussion in the last issue of Journal of FinancialEconometrics (JFEC) of the nonparametric methods developed byBarndorff-Nielsen and Shephard (2006) to detect jumps in thelocal behavior of the continuous time path of a price process,we observed these tests were not designed to detect major pricediscontinuity events such as the 1987 crash, since the testingmethodology precludes jumps in adjacent time intervals. Indeed,a major event such as Black Monday is characterized by a sequenceof jumps in consecutive time intervals throughout the day. Inthe interest of thematic continuity, let’s pursue thematter of jumps further. The first article in the current issue by Hossein Asgharianand Chistoffer Bengtsson addresses directly the detection ofbig events in stock prices. More particularly, the authors analyzethe spillover of jumps across international stock markets. Tomeasure jumps, the authors formulate a parametric model in . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. This issue of the Journal of Financial Econometrics containspapers that were presented at the (EC)² conference Econometricsof Financial and Insurance Risks held in Istanbul on December15–17, 2005. Launched in 1990, (EC)² is an annual seriesof international conferences on research in quantitative economicsand econometrics. The acronym stands for European Conferencesof the Econom[etr]ics Community. Its primary aim is to providea vibrant forum where both senior and junior European researchersin quantitative economics and econometrics can discuss the resultsand progress of their research. (EC)² conferences are of relativelysmall scale (less than 200 participants) and quite intensive.Each year a different topic is selected as the major theme ofthe conference. A few leading quantitative economists or econometriciansare invited as keynote speakers, such as Eric Ghysels, who alsoacts as co-Guest editor of this issue; the other speakers areselected . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. The year 1982 was not a particularly good period for the worldeconomy. At year's end, the Organization for Economic Cooperationand Development (OECD) revised its growth figures for membernations from slightly over 1% to –0.5%, with some 32 millionunemployed in its 24 member states. In the United States thejobless rate was 11% and 30% of plant capacity stood idle. OttoEckstein found the economy in its worst shape in nearly halfa century. Truly the year belonged to Scrooge. Yet 1982 was a very good year indeed for financial econometrics,the debut of an explosion of activity in the area that continuesvigorously 20 years later, as the emergence of the Journal ofFinancial Econometrics attests. In fact, it can convincinglybe argued that 1982 heralded the beginning of our subject, andperhaps with the recent awarding of the Nobel Prize in Economicsto Robert Engle . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. The article by Christian Gourieroux and Razvan Sufana providesa complete characterization of two-factor affine diffusion termstructure models. The presentation of the article may seem forbiddingto the practitioner audience, so it is perhaps useful that thisinstallment of the column provide some context for the resultsof this article. Prominent among affine diffusion models in the term structureliterature are the Gaussian and square-root diffusion modelsof Vacisek (1977) and Cox, Ingersoll, and Ross (1985). The seminalcontribution of Duffie and Kan (1996) had been to provide anecessary and sufficient condition on the stochastic model toobtain the desirable property of "affine yields," whereby theyield of any zero-coupon bond is seen as a maturity-dependentaffine combination of a selected "basis" set of yields. SubsequentlyDuffie, Pan, and Singleton (2000) proved that the aforementionedcharacterization is even more general, both for the stochasticmodel that may . . . [Full Text of this Article]     

Practitioners' Corner

The first 150 words of the full text of this article appear below. During the 1980s, the early stages of modeling financial timeseries focused on the striking stylized fact that while returnswere themselves not serially correlated, squared returns were.This history has been nicely documented in the influential bookby Taylor (1986) and, indeed, the opening chapters of contemporaryfinancial econometrics open with Engle (1982) and Bollerslev(1986) who provided a specific ARMA structure of squared returnsvia the celebrated [G]ARCH models. This general orientationin effect acknowledged that there was some room for predictingrisk, as measured by squared values or absolute values of returns,while at the same time maintaining the hypothesis that returnsthemselves were hardly predictable in keeping with some versionof market efficiency. However, this paradigmatic view has beenchallenged over the subsequent 20 years in at least three regards. First, with Nelson (1991), it has been widely acknowledged thatalthough GARCH modeling is about . . . [Full Text of this Article]     

LARCH, Leverage, and Long Memory

We consider the long-memory and leverage properties of a modelfor the conditional variance of an observable stationary sequence X_t, where is the square of an inhomogeneous linear combination of X_s, s < t, withsquare summable weights b_j. This model, which we call linearautoregressive conditionally heteroskedastic (LARCH), specializes,when depends only on X_t–1, to theasymmetric ARCH model of Engle (1990, Review of Financial Studies3, 103–106), and, when depends only on finitely many X_s, to a version of the quadratic ARCH modelof Sentana (1995, Review of Economic Studies 62, 639–661),these authors having discussed leverage potential in such models.The model that we consider was suggested by Robinson (1991,Journal of Econometrics 47, 67–84), for use as a possiblylong-memory conditionally heteroskedastic alternative to i.i.d.behavior, and further studied by Giraitis, Robinson and Surgailis(2000, Annals of Applied Probability 10, 1002–1004), whoshowed that integer powers , =" BORDER="0">2 can have long-memory autocorrelations. We establish conditionsunder which the cross-autocovariance function between volatilityand levels, , decays in the manner of moving average weights of long-memory processes on suitable choiceof the b_j. We also establish the leverage property that h_t <0 for 0 < t k, where the value of k (which may be infinite)again depends on the b_j. Conditions for finiteness of thirdand higher moments of X_t are also established.     

Nondisclosure and adverse disclosure as signals of firm value

We present a model in which some of the firm's information ('news')can be disclosed verifiably and some information ('type') cannot,to show that some firms may voluntarily withhold good news anddisclose bad news. We describe an equilibrium in which high-typefirms withhold good news and disclose bad news, whereas low-typefirms disclose good news and withhold bad news. Under some parametervalues, this equilibrium exists when other more traditionalequilibria are ruled out by standard equilibrium refinements.The model explains some otherwise anomalous empirical evidenceconcerning stock price reactions to disclosure, provides somenew empirical predictions, and suggests that mandatory disclosurerequirements may have the undesirable consequence of makingit more difficult for firms to reveal information that cannotbe disclosed credibly.     

Service Sector Protection: Considerations for Developing Countries

The inclusion of services in the Uruguay Round of multilateraltrade negotiations has focused attention on the protection ofdomestic service suppliers against competition from foreignsuppliers. Issues arising from these negotiations, however,may obscure another and more important issue: the case for unilateralliberalization. This article first surveys methods of protectionin the service sector, and then examines the likely cost ofprotection. Particular attention is given to developing countries.What evidence there is suggests that the costs of protectionmay be high. The article also discusses economic principlesthat could guide a review of policy toward international transactionsin the service sector. Quantitative restrictions or bans onforeign service suppliers—whether they wish to supplythrough trade or establishment—cannot easily be defendedin economic terms, and provide an obvious first target.     

THE INFLUENCE OF PREDICTABILITY ON DIFFERENCES IN THE MARKET REACTION TO DEBT AND EQUITY ISSUE ANNOUNCEMENTS

Existing empirical evidence suggests that the announcement-day reaction to equity issuance is about 2.88 percent more negative than the reaction to debt. However, announcement-day returns do not accurately reflect investor reaction if issue announcements are anticipated. I re-examine the announcement-day reaction to equity and debt issues after controlling for the predictability of security type and for firms' previous issue experience. Results indicate that the reaction to a first-time seasoned equity issue is more than 4.15 percent more negative than the reaction to debt. This increase over the conventional estimate suggests that the reaction to equity may be more negative, relative to debt, than previously believed. The evidence supports the assertion that giving preference to debt over equity could reduce issue costs when asymmetric information is a problem. Timing and certification strategies for lowering issue costs appear to be relatively unimportant for debt issues.     

Transactions Accounts and Loan Monitoring

We show that transactions accounts, by providing ongoing dataon borrowers’ activities, help financial intermediariesmonitor borrowers. This information is most readily availableto commercial banks, which offer these accounts and lendingtogether. We find that (1) monthly changes in accounts receivableare reflected in transactions accounts; (2) borrowings in excessof collateral predict credit downgrades and loan write-downs;and (3) the lender intensifies monitoring in response. Thisis evidence on a key issue in financial intermediation—thereis an advantage to providing deposit-taking and lending jointly.But this advantage may have fallen as the cost of communicationhas declined. (JEL G10, G20, G21)     

Financial Safety Nets: Lessons from Chile

Should governments ever override bank regulators who are attemptingto close down insolvent financial institutions? An analysisof Chile's history shows that time after time from the 1850sto the 1980s, prudential banking regulations were abandonedduring economic crises when attempts to impose tight solvencystandards proved impossible to enforce. Chile's current stringentbanking regulations may prove more durable, but mounting financialdistress is equally likely to lead the government to adopt policiesthat prevent bank failure but undermine the authority of regulators. Bank regulators, including the central bank, are responsiblefor creating a financial safety net to protect depositors againstloss and for enforcing the rules of prudent behavior that arerequired for a stable financial system. Because safety netsoften additionally cover losses to bank owners and borrowers,the support they offer encourages risk-taking by the privatesector an action that may promote financial deepening, but ata high budgetary cost to the government. Poorly designed safetynets may have to be suspended during crises to prevent lossesfrom mounting and to limit the government's liability.      

Warrants on the London Stock Exchange: Pricing Biases and Investor Confusion

This study of warrants on the London Stock Exchange examineswhether they display particular pricing biases and whether investorsunderstand how to value them at the time of issue. In a sampleof 72 warrants on closed-end funds (investment trusts) overthe 1985–94 period, more than one third of the 12,673prices are anomalously low. The other two thirds behave likestock options, with lower volatility when they are in-the-moneyor have a long time until maturity. Despite their frequent undervaluation,it is rational to add warrants to a new equity issue: an examinationof 127 new equity issues (95 with warrants) reveals that attachingwarrants significantly increases market value. The reason forthis appears to be investor confusion: they do not seem to understandthat the more the warrants are worth, the less the value ofthe ordinary shares.     

The Pooling and Tranching of Securities: A Model of Informed Intermediation

I show that when an issuer has superior information about thevalue of its assets, it is better off selling assets separatelyrather than as a pool due to the information destruction effectof pooling. If, however, the issuer can create a derivativesecurity that is collateralized by the assets, pooling and "tranching"may be optimal. If the residual risk of each asset is not highlycorrelated, tranching allows the issuer to exploit the riskdiversification effect of pooling to create a low-risk and highlyliquid security. In contrast, for an uninformed seller, purepooling reduces underpricing and is preferred to separate assetsales. These results lead to a dynamic model of financial intermediation:originators sell pools of assets, some of which are purchasedby informed intermediaries who then further pool and tranchethem. Pooling and tranching allow intermediaries to leveragetheir capital more efficiently, enhancing the returns to theirprivate information.     

The BDS Test as a Test for the Adequacy of a GARCH(1,1) Specification: A Monte Carlo Study

In this study we examine the widely used Brock, Dechert, andScheinkman (BDS) test when applied to the logarithm of the squaredstandardized residuals of an estimated GARCH(1,1) model as atest for the adequacy of this specification. We review the conditionsderived by De Lima (1996; Econometric Reviews 15, 237–259)for the nuisance-parameter-free property to hold and addressthe issue of their necessity, using the flexible framework offeredby the GARCH(1,1) model in terms of moment, memory, and timeheterogeneity properties. By means of Monte Carlo simulations,we show that the BDS test statistic still approximates the standardnull distribution even for mildly explosive processes that violatethe majority of the conditions. Thus the test performs reasonablywell, its empirical size being rather close to the nominal one.As a by-product of this study, we also shed light on the relatedissue of the consistency of the QML estimators of the conditionalvariance parameters under various parameter configurations andalternative distributional assumptions on the innovation process.     

Assessing corporate social performance: Strategies of legitimation and conflicting ideologies

Our study started with an action research project carried out within an organization specialized in the assessment of corporate social performance (CSP), in a French context: we were asked to achieve a critical analysis of the rating grid used by this organization for the domain of corporate governance. Assessing CSP has become in France an issue around which an organizational field has emerged in the mid 90s. The quest for legitimacy appears as a powerful driver for all the organizations in this field, but the strategies that social analysis and rating organizations deploy to achieve this aim differ significantly. Using a Weberian methodology, we have identified two ideal types of strategy: conservative (perpetuating the societal status quo) and activist (trying to impel change). We argue that these differences in strategies reflect ideological oppositions. Here also we have typified two opposite ideologies: utilitarian and non-utilitarian. Conservative strategies appear to be embedded in a utilitarian ideology; in the short term, they may seem more successful than activist strategies, but in the long term, their future appears more uncertain.     

Spin-offs, Divestitures, and Conglomerate Investment

We examine whether spin-offs or divestitures cause improvementsin conglomerate investment efficiency. At issue are endogeneityof these restructuring decisions and correct measurement ofinvestment efficiency. Endogeneity is a problem because thefactors that induce firms to spin off or divest divisions mayalso improve investment efficiency; measurement error is a problembecause efficiency measures employ Tobin’s q as a noisyproxy for investment opportunities. We find important differencesbetween firms that divest or spin off and a control sample.After accounting for these differences and for measurement errorin q, we find no evidence of improvements in investment efficiency.(JEL G31, G34)     

Inequality Constraints in the Fractionally Integrated GARCH Model

In this article we derive necessary and sufficient conditionsfor the nonnegativity of the conditional variance in the fractionallyintegrated generalized autoregressive conditional heteroskedastic(p, d, q) (FIGARCH) model of the order p 2 and sufficient conditionsfor the general model. These conditions can be seen as beinganalogous to those derived by Nelson and Cao (1992, Journalof Business & Economic Statistics 10, 229–235) forthe GARCH(p, q) model. However, the inequality constraints whichwe derive for the FIGARCH model illustrate two remarkable propertiesof the FIGARCH model which are in contrast to the GARCH model:(i) even if all parameters are nonnegative, the conditionalvariance can become negative and (ii) even if all parametersare negative (apart from d), the conditional variance can benonnegative almost surely. In particular, the conditions forthe (1, d, 1) model substantially enlarge the sufficient parameterset provided by Bollerslev and Mikkelsen (1996, Journal of Econometrics73, 151–184). The importance of the result is illustratedin an empirical application of the FIGARCH(1, d, 1) model toJapanese yen versus U.S. dollar exchange rate data.