Quiet bubbles

Motivated by the recent subprime mortgage crisis, we explore whether speculative bubble models of equity based on investor disagreement and short-sales constraints can also provide an explanation for the overvaluation of debt contracts. We find that this is unlikely. Equity bubbles are loud: price and volume go together as investors speculate on capital gains from reselling to more optimistic investors. But this resale option is limited for debt since its upside payoff is bounded. Debt bubbles then require an optimism bias among investors. But greater optimism leads to less speculative trading as investors view the debt as safe and having limited upside. Debt bubbles are hence quiet—high price comes with low volume. We find the predicted price–volume relationship of credits over the 2003–2007 credit boom.     

Short-sale constraints and price bubbles

Miller (1977) demonstrated that if investors have heterogeneous beliefs and short sales are restricted, trade of a security will disproportionately reflect positive information, generating a price bubble. As this intuition applies most relevantly to short intervals of trade, a question arises as to the longevity of such a bubble. In this paper, I argue that a bubble effected by short-sale constraints persists only if agents cannot distinguish between order flow caused by positive information or order flow caused by the constraints. If the constraint is common knowledge, it should have no effect on the long-term pricing of the stock. If, however, the constraint is random and unknown, a price bubble may form.     

Real option analysis of a technology portfolio

This article contributes to methodology of real options analysis of investments in capital intensive process industries, where relatively homogenous outputs are produced using commonly known production technologies. In addition to capacity expansion, the method can be used for analysis of mergers and acquisitions. Valuation of the real option is based on bid price; i.e., the maximum price the firm is willing to pay. To find such a price, stochastic optimization with an expected utility criterion is used to determine investments in product specific technologies as well as in publicly traded financial instruments (the competing investments). To operationalize the valuation principle, we develop a double binary tree employing Kalman filter for scenario generation. For exponential utility, valuation is carried out by dynamic programming. We extend known methods to allow interdependence of the mill cash flow and return on competing financial investments. For forest industries, we provide an illustration, where the underlying price process in our Kalman filter application is a vector error correction model.     

Credit spreads: An empirical analysis on the informational content of stocks,bonds, and CDS

This paper explores the dynamic relationship between stock market implied credit spreads, CDS spreads, and bond spreads. A general VECM representation is proposed for changes in the three credit spread measures which accounts for zero, one, or two independent cointegration equations, depending on the evidence provided by any particular company. Empirical analysis on price discovery, based on a proprietary sample of North American and European firms, and tailored to the specific VECM at hand, indicates that stocks lead CDS and bonds more frequently than the other way round. It likewise confirms the leading role of CDS with respect to bonds.     

Inexperienced investors and bubbles

We use mutual fund manager data from the technology bubble to examine the hypothesis that inexperienced investors play a role in the formation of asset price bubbles. Using age as a proxy for managers’ investment experience, we find that around the peak of the technology bubble, mutual funds run by younger managers are more heavily invested in technology stocks, relative to their style benchmarks, than their older colleagues. Furthermore, young managers, but not old managers, exhibit trend-chasing behavior in their technology stock investments. As a result, young managers increase their technology holdings during the run-up, and decrease them during the downturn. Both results are in line with the behavior of inexperienced investors in experimental asset markets. The economic significance of young managers’ actions is amplified by large inflows into their funds prior to the peak in technology stock prices.     

Stock market bubbles, inflation and investment risk

This paper proposes an autoregressive regime-switching model of stock price dynamics in which the process creates pricing bubbles in one regime while error-correction prevails in the other. In the bubble regime the stock price depends negatively on inflation. In the error-correction regime it depends on the price-dividend ratio. We find that the probability of regime-switch depends on exogenous inflation and lagged price. The model is consistent with Shleifer and Vishny's theoretical noise trader and arbitrageur model and Modigliani's inflation illusion phenomenon. The results emphasize the importance of inflation and the price-dividend ratio when assessing investment risk.     

Liquidity and Optimal Market Transparency

In this paper I explore some of the consequences of greater market transparency for market performance in the presence of a strategic specialist. Although numerous studies have dealt with this issue, previous work has only considered either fully transparent or fully opaque markets. My model allows for different levels of transparency, and therefore sheds light on how transparency affects market performance. I show that an intermediate level of transparency can improve market performance relative to the more extreme cases of full transparency or no transparency at all.     

Identification of speculative bubbles using state-space models with Markov-switching

In this paper we use a state-space model with Markov-switching to detect speculative bubbles in stock-price data. To this end we express a present-value stock-price model in state-space form which we estimate using the Kalman filter. This procedure enables us to estimate a two-regime Markov-switching specification of the unobservable bubble process. The respective Markov-regimes represent two distinct phases in the bubble process, namely one in which the bubble survives and one in which it collapses. We ultimately identify bursting stock-price bubbles by statistically separating both Markov-regimes from each other. In an empirical analysis we apply our methodology to a plethora of artificial and real-world data sets. Our study has two major findings. First, we find significant Markov-switching structures in real-world stock-price bubbles. Second, in the stock markets considered our identification procedure correctly detects most speculative periods which have been classified as such by economic historians.     

Insider trading in credit derivatives

Insider trading in the credit derivatives market has become a significant concern for regulators and participants. This paper attempts to quantify the problem. Using news reflected in the stock market as a benchmark for public information, we find significant incremental information revelation in the credit default swap market under circumstances consistent with the use of non-public information by informed banks. The information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks, and increases with the number of a firm's relationship banks. We find no evidence, however, that the degree of asymmetric information adversely affects prices or liquidity in either the equity or credit markets.     

Optimal smooth consumption and annuity design

We propose an optimization criterion that yields extraordinary consumption smoothing compared to the well known results of the life-cycle model. Under this criterion we solve the related consumption and investment optimization problem faced by individuals with preferences for intertemporal stability in consumption. We find that the consumption and investment patterns demanded under the optimization criterion is in general offered as annuity benefits from products in the class of ‘Formula Based Smoothed Investment-Linked Annuities’.     

Beyond Sharpe ratio: Optimal asset allocation using different performance ratios

As the assumption of normality in return distributions is relaxed, classic Sharpe ratio and its descendants become questionable tools for constructing optimal portfolios. In order to overcome the problem, asymmetrical parameter-dependent performance ratios have been recently proposed in the literature. The aim of this note is to develop an integrated decision aid system for asset allocation based on a toolkit of eleven performance ratios. A multi-period portfolio optimization up covering a fixed horizon is set up: at first, bootstrapping of asset return distributions is assessed to recover all ratios calculations; at second, optimal rebalanced-weights are achieved; at third, optimal final wealth is simulated for each ratios. Eventually, we make a robustness test on the best performance ratios. Empirical simulations confirm the weakness in forecasting of Sharpe ratio, whereas asymmetrical parameter-dependent ratios, such as the Generalized Rachev, Sortino–Satchell and Farinelli–Tibiletti ratios show satisfactorily robustness.     

Do stock price bubbles influence corporate investment?

Dispersion in investor beliefs and short-selling constraints can lead to stock market bubbles. This paper argues that firms, unlike investors, can exploit such bubbles by issuing new shares at inflated prices. This lowers the cost of capital and increases real investment. Perhaps surprisingly, large bubbles are not eliminated in equilibrium nor do large bubbles necessarily imply large distortions. Using the variance of analysts’ earnings forecasts to proxy for the dispersion of investor beliefs, we find that increases in dispersion cause increases in new equity issuance, Tobin's Q, and real investment, as predicted by the model.     

Optimal VWAP trading under noisy conditions

This article proposes an empirically tractable way to incorporate intra-day noise into a VWAP trading rule. In volatile markets, news arrives unexpectedly and rapidly. This should influence a trader’s trading decisions. However, the literature has not incorporated such information into an algorithmic trading framework. Subsequently, this paper presents a Dynamic VWAP (DVWAP) framework that allows informed traders to utilize random news; and thus, improve trade-execution.     

Speculations in option markets enhance allocation efficiency with heterogeneous beliefs and learning

Many studies investigate the impact of heterogeneous beliefs in the first moment, while very few in the second moment. This is partially due to continuous-time setup which makes it difficult to incorporate heterogeneous beliefs in the second moment. In a two-period exponential–normal model with Bayesian learning, I demonstrate that heterogeneous prior variances give rise to the economic value of option markets. Investors speculate in option market and public information improves allocation efficiency of markets only when there is heterogeneity in prior variances. Heterogeneity in mean is neither a necessary nor a sufficient condition for generating speculations in option markets. With heterogeneous beliefs, options are non-redundant assets which can facilitate side-betting and enable investors to take advantage of the disagreements and the differences in confidence. This fact leads to a higher growth rate in the investors’ certainty equivalents and, thus, a higher equilibrium interest rate. Furthermore, option exhibits a unique feature of enabling signal precision to affect the ex ante risk premium of underlying asset, which quadratic derivative and stock do not have.     

Securitization bubbles: Structured finance with disagreement about default risk

An additional reason for the structured finance boom of the 2000s may have been disagreement about default risk of collateral assets. When risk-neutral investors disagree about average default probabilities, structuring collateral cash flow raises prices by concentrating optimists’ demand on risky tranches. With disagreement about default correlation, low-correlation investors believe in diversification and pay high prices for senior tranches they deem riskless. High-correlation investors value junior tranches they expect to pay whenever aggregate conditions are good. Risk aversion and short selling through credit default swaps reduce the prices of both pass-through and structured securitizations but may increase the return to tranching.     

Options, short-sale constraints and market efficiency: A new perspective

This paper undertakes a new investigation of the potential for options to mitigate short-sale constraints. I find that option introduction alleviates 79% of the price adjustment efficiency disparity between short-sale constrained and unconstrained stocks in relation to negative news. No significant improvement in adjustment efficiency is found in response to positive information. These results are robust to controls for endogeneity biases associated with the option introduction selection process. Further, I find evidence that post-option improvement in efficiency is similar in relation to private and public information. This suggests that short-sale constraint effects stem, at least in part, from an irrational, optimism bias or another behavioral source as suggested theoretically by Miller (1977). Collectively, these results suggest that options act as an effective substitute to short-sales, significantly contributing to the informational efficiency of the market.     

Retail payments: New contributions,empirical results,and unanswered questions

We offer a selected survey of retail payments and suggest areas where additional research would prove useful. After summarizing eight papers presented at a recent Norges Bank (Central Bank of Norway) payment conference and published in this volume, we show how they, and many of the other papers presented there, have contributed to the payments literature. We also illustrate how institutional and other differences across countries led to different payment arrangements historically which now, due to technological innovation affecting bank costs, have made payment arrangements across countries more homogeneous.     

Prospect theory and trading patterns

Reference dependence, loss aversion, and risk seeking for losses together comprise the preference-based component of prospect theory that sets its value function apart from the standard risk-aversion model. Using an elasticity analysis, we show that this distinctive preference component serves to underpin negative-feedback trading propensities, but cannot manifest itself in behavior directly or holistically at the individual-choice level. We then propose and demonstrate that the market interaction between prospect-theory investors and regular CRRA investors allows this preference component to dominate in equilibrium behavior and hence helps to reestablish the intuitive link between prospect-theory preferences and negative-feedback trading patterns. In the model, the interaction also reconciles the contrarian behavior of prospect-theory investors with asymmetric volatility and short-term return reversal. The results suggest that prospect-theory preferences can lead investors to behave endogenously as contrarian noise traders in the market interaction process.     

Noise, equity prices, and hedging: A new approach

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of January 1998 to May 2003.     

The strategic specialist and imperfect competition in a limit order market

The empirical literature suggests that the limit order book contains information that might be used by the specialist to his own advantage. I develop a model where there is a strategic specialist who competes against a limit order book and has information about supply. The presence of a strategic specialist in an imperfectly competitive limit order book market induces non-monotonicity of market indicators with respect to the variance of liquidation value. Moreover, the existence of private information about supply significantly affects market performance as it induces, among other effects, lower market liquidity. Finally, this model suggests another link between Kyle’s (1985, 1989) [Kyle, A., 1985. Continuous auctions and insider trading. Econometrica 53, 1315–1336, Kyle, A., 1989. Informed speculators with imperfect competition. Review of Economic Studies 56, 317–356] and Glosten and Milgrom’s (1985) [Glosten, L., Milgrom, P., 1985. Bid, ask and transaction prices in a specialist market with heterogeneously informed markets. Journal of Financial Economics 14, 71–100] models by allowing for strategic behaviour of the specialist.