Previously on MoreLiver's weekend:
Sat - Weekender: ECB bond swap special
Fri - Weekly Support
Fri - Press Digest
Fri - Best of The Week
WolframAlpha Pro launches in an effort to democratize data science – FlowingData
Taking the next step in the Wolfram|Alpha experiment, Wolfram launches a Pro version that lets you plug in your own data and get information out of it.
Datastream Professional launched – Thomson Reuters
Integrates economic research and strategy with cross asset analysis
Collections
Week in Review 160212 – mathfinance
Week in Review 090212 – mathfinance
Alpha Research Digest – Turnkey Analyst
Free Courses
ECON 159: Game Theory – Open Yale
ECON 252: Financial Markets (2008, with Robert Shiller) – Open Yale
ECON 251: Financial Theory – Open Yale
ECB
Monthly Bulletin, February 2012 – ECB (pdf)
Statistics Pocket Book Statistics Pocket Book, February 2012 – ECB (pdf)
Research Bulletin No 15, Spring 2012 – ECB (pdf)
ARTICLES
The Financial System Five Years from Now – IMF
The financial crisis has made clear that almost everyone – academics, policymakers and practitioners alike – had a limited understanding of the true complexity and risks in modern financial systems. Financial policy was far behind the curve, with large regulatory and supervisory deficiencies.
Both the Norwegian Government Pension Fund Global and Yale University's endowment -- run by the popular David Swensen -- have emerged as industry pillars in asset management, and a new paper compares and scrutinizes their reputations.
A slice of S&P 500 kurtosis history – Portfolio Probe
How fat tailed are returns, and how does it change over time?
RESEARCH PAPERS
Stochastic Herding in Financial Markets Evidence from Institutional Investor Equity Portfolios – BIS
We estimate a structural model of herding behavior in which feedback arises due to mutual concerns of traders over the unobservable "true" level of market liquidity.
Relative Strength and Portfolio Management – SSRN
This paper presents the results of several relative strength (momentum) strategies tested in a real world portfolio management setting. Monte Carlo simulations are used to determine the possible range of outcomes if a portfolio manager selects a subset of high relative strength (momentum) securities over time. A testing protocol that rebalances the portfolio on a continuous basis is also used to simulate real world portfolio management practices.
Capital Controls Lead to Bubbles In Neighboring Countries – HistorySquared
We find that increases in Brazil’s capital controls cause investors to decrease their portfolio allocations to Brazil. Investors simultaneously decrease portfolio allocations to other countries believed to be more likely to use controls, and increase allocations to other countries in Latin America, that constitute a large share of the benchmark index, and that have substantial exposure to China.
Predictability and Underreaction in Industry-Level Returns: Evidence from Commodity Markets – SSRN
This paper finds significant evidence that commodity prices can predict industry level returns for horizons between one trading day and up to six trading weeks (30 days). We find that for 1985-2010 period, 40 out of 49 U.S. industries can be predicted by at least one commodity. Our findings are, in part, consistent with Hong and Stein’s (1999) “underreaction hypothesis”. Unlike other papers in the literature, a) we pinpoint the length of underreaction by using daily data; b) we document the existence of short-term predictability; c) we provide a comprehensive examination of twenty five commodities and forty nine industries. This enables us to present a more detailed investigation of predictability, underreaction, and investor inattention hypotheses. Finally, we implement data-mining robust methods to assess the statistical significance of industry returns reactions to commodity price changes.
This paper finds significant evidence that commodity prices can predict industry level returns for horizons between one trading day and up to six trading weeks (30 days). We find that for 1985-2010 period, 40 out of 49 U.S. industries can be predicted by at least one commodity. Our findings are, in part, consistent with Hong and Stein’s (1999) “underreaction hypothesis”. Unlike other papers in the literature, a) we pinpoint the length of underreaction by using daily data; b) we document the existence of short-term predictability; c) we provide a comprehensive examination of twenty five commodities and forty nine industries. This enables us to present a more detailed investigation of predictability, underreaction, and investor inattention hypotheses. Finally, we implement data-mining robust methods to assess the statistical significance of industry returns reactions to commodity price changes.
The Information Content of Option Demand – SSRN
This paper presents a model that relates the presence of option traders possessing private information on the underlying stock with imbalances in option market demand. From the model we derive a measure that captures the asymmetric information using excess demand in options and empirically verify its predictive power for stock returns. We find economically significant returns for option market strategies that trade on the excess demand in options (e.g., 27% or 42% for out-of-the-money long calls or puts with 1-month time to maturity). Additionally, excess option demand is associated with an increase in option bid-ask spreads implying that informed trading reduces liquidity in the option market.
This paper presents a model that relates the presence of option traders possessing private information on the underlying stock with imbalances in option market demand. From the model we derive a measure that captures the asymmetric information using excess demand in options and empirically verify its predictive power for stock returns. We find economically significant returns for option market strategies that trade on the excess demand in options (e.g., 27% or 42% for out-of-the-money long calls or puts with 1-month time to maturity). Additionally, excess option demand is associated with an increase in option bid-ask spreads implying that informed trading reduces liquidity in the option market.
The Sharpe Ratio Indifference Curve – SSRN
The problem of capital allocation to a set of strategies could be partially avoided or at least greatly simplified with an appropriate procedure for strategy approvals. This paper proposes such procedure. We begin by splitting the capital allocation problem into two tasks: Strategy approval and portfolio optimization. Then we argue that the goal of the second task is to beat a naïve benchmark, and the goal of the first task is to identify which strategies improve the performance of such naïve benchmark. This is a very appealing result, because it doesn’t leave all the work to the optimizer, which should add robustness to the final outcome.
The problem of capital allocation to a set of strategies could be partially avoided or at least greatly simplified with an appropriate procedure for strategy approvals. This paper proposes such procedure. We begin by splitting the capital allocation problem into two tasks: Strategy approval and portfolio optimization. Then we argue that the goal of the second task is to beat a naïve benchmark, and the goal of the first task is to identify which strategies improve the performance of such naïve benchmark. This is a very appealing result, because it doesn’t leave all the work to the optimizer, which should add robustness to the final outcome.
What Investors Want: Evidence from Investors’ Use of the EDGAR Database – SSRN
The most requested filings include the 10-K, 10-Q, and 8-K, along with insider trading disclosures filed on Form 4. However, many of the filings that are required by the SEC are rarely used by investors. Examining the timing of investor requests, we find that investors commonly request historical disclosures filed in prior periods and that abnormal demand for historical filings is higher when lagged and current abnormal stock returns are lower. Examining firm characteristics associated with the demand for filings, we find that abnormal EDGAR requests are negatively associated with lagged abnormal returns, and positively associated with lagged return volatility, media attention, and the presence of earnings announcements. Thus, we find that investors turn to mandatory financial filings during periods of time when news is released, but more specifically when the news is negative and when there is increased uncertainty about the firm.
The most requested filings include the 10-K, 10-Q, and 8-K, along with insider trading disclosures filed on Form 4. However, many of the filings that are required by the SEC are rarely used by investors. Examining the timing of investor requests, we find that investors commonly request historical disclosures filed in prior periods and that abnormal demand for historical filings is higher when lagged and current abnormal stock returns are lower. Examining firm characteristics associated with the demand for filings, we find that abnormal EDGAR requests are negatively associated with lagged abnormal returns, and positively associated with lagged return volatility, media attention, and the presence of earnings announcements. Thus, we find that investors turn to mandatory financial filings during periods of time when news is released, but more specifically when the news is negative and when there is increased uncertainty about the firm.
Equity Anomalies Around the World – SSRN
This study investigates a number of anomaly variables in capital markets research around the world, including asset growth, book-to-market, investment-to-assets, momentum, net stock issues, size, and total accruals. We use zero-cost trading strategies, the Fama-French factor model, and the newly developed alternative investment-based three-factor model (Chen, Novy-Marx, and Zhang 2010) to show that these anomalies produce significant abnormal returns across countries. We show that abnormal returns vary dramatically among countries and between developed and emerging economies. We provide strong evidence to support the limits of arbitrage theory in international equity markets by documenting a positive correlation between idiosyncratic risk and abnormal returns for all of the anomalies. We also show that idiosyncratic risk has less impact on abnormal return for developed countries than emerging countries. Our results support the mispricing explanation of the existence of various anomalies around the world.
This study investigates a number of anomaly variables in capital markets research around the world, including asset growth, book-to-market, investment-to-assets, momentum, net stock issues, size, and total accruals. We use zero-cost trading strategies, the Fama-French factor model, and the newly developed alternative investment-based three-factor model (Chen, Novy-Marx, and Zhang 2010) to show that these anomalies produce significant abnormal returns across countries. We show that abnormal returns vary dramatically among countries and between developed and emerging economies. We provide strong evidence to support the limits of arbitrage theory in international equity markets by documenting a positive correlation between idiosyncratic risk and abnormal returns for all of the anomalies. We also show that idiosyncratic risk has less impact on abnormal return for developed countries than emerging countries. Our results support the mispricing explanation of the existence of various anomalies around the world.
International Market Links and Volatility Transmission – SSRN
This paper proposes a framework to gauge the degree of volatility transmission among international stock markets by deriving tests for conditional independence among daily volatility measures… We find significant volatility spillovers across all markets, especially if we control for jumps and/or market microstructure effects. Apart from the expected bidirectional link between the UK and the US, we uncover signficant Japan and China effects on the US stock market volatility. Their impact is particularly apparent if we further conditioning on the realized measure of the FTSE 100 index to control for the presence of global shocks.
Safe Haven Assets and Investor Behaviour Under Uncertainty – SSRN
We study two different safe haven assets, US government bonds and gold, and examine how the price changes of these assets can be used to infer investor behaviour under uncertainty. We find that investors are ambiguity-averse, that is they buy gold when faced with extreme uncertainty about the state of the economy or the financial system and when they receive ambiguous signals. In contrast, investors buy US government bonds when faced with extreme but unambiguous signals. We also show that there is overreaction to ambiguous signals.
We study two different safe haven assets, US government bonds and gold, and examine how the price changes of these assets can be used to infer investor behaviour under uncertainty. We find that investors are ambiguity-averse, that is they buy gold when faced with extreme uncertainty about the state of the economy or the financial system and when they receive ambiguous signals. In contrast, investors buy US government bonds when faced with extreme but unambiguous signals. We also show that there is overreaction to ambiguous signals.
Global Stock Market Linkages Reduce Potential for Diversification – Dallas FED
Recent European government debt difficulties demonstrate how linked stock markets have become. Problems in countries such as Greece and Italy have depressed stock markets not only on the continent but also in the United States. Such comovement across international financial markets highlights U.S. equity markets’ exposure to foreign markets.
U.S. International Equity Investment – NBER
The single most important determinant of the amount of U.S. investment a foreign firm receives is whether the firm cross-lists on a U.S. exchange. Correcting for selection biases, cross-listing leads to a doubling (or more) in U.S. investment, an impact greater than all other factors combined. We also show that our firm-level analysis has implications for country-level studies, suggesting that research investigating equity investment patterns at the country-level should include cross-listing as an endogenous control variable.
The single most important determinant of the amount of U.S. investment a foreign firm receives is whether the firm cross-lists on a U.S. exchange. Correcting for selection biases, cross-listing leads to a doubling (or more) in U.S. investment, an impact greater than all other factors combined. We also show that our firm-level analysis has implications for country-level studies, suggesting that research investigating equity investment patterns at the country-level should include cross-listing as an endogenous control variable.
Markov-Switching Dynamic Factor Models in Real Time – SSRN
We extend the Markov-switching dynamic factor model to account for some of the specificities of the day-to-day monitoring of economic developments from macroeconomic indicators, such as ragged edges and mixed frequencies. We examine the theoretical benefits of this extension and corroborate the results through several Monte Carlo simulations. Finally, we assess its empirical reliability to compute real-time inferences of the US business cycle.
We extend the Markov-switching dynamic factor model to account for some of the specificities of the day-to-day monitoring of economic developments from macroeconomic indicators, such as ragged edges and mixed frequencies. We examine the theoretical benefits of this extension and corroborate the results through several Monte Carlo simulations. Finally, we assess its empirical reliability to compute real-time inferences of the US business cycle.
Individual and collective stock dynamics: intra-day seasonalities – arXiv
The average correlation between stocks increases throughout the day, leading to a smaller relative dispersion between stocks. Somewhat paradoxically, the kurtosis (a measure of volatility surprises) reaches a minimum at the open of the market, when the volatility is at its peak. We confirm that the dispersion kurtosis is a markedly decreasing function of the index return. This means that during large market swings, the idiosyncratic component of the stock dynamics becomes sub-dominant. In a nutshell, early hours of trading are dominated by idiosyncratic or sector specific effects with little surprises, whereas the influence of the market factor increases throughout the day, and surprises become more frequent.
Identifying States of a Financial Market – arXiv
We find that a wide variety of characteristic correlation structure patterns exist in the observation time window, and that these characteristic correlation structure patterns can be classified into several typical "market states". Using this classification we recognize transitions between different market states. A similarity measure we develop thus affords means of understanding changes in states and of recognizing developments not previously seen.
Modeling the non-Markovian, non-stationary scaling dynamics of financial markets – arXiv
A central problem of Quantitative Finance is that of formulating a probabilistic model of the time evolution of asset prices allowing reliable predictions on their future volatility. As in several natural phenomena, the predictions of such a model must be compared with the data of a single process realization in our records. In order to give statistical significance to such a comparison, assumptions of stationarity for some quantities extracted from the single historical time series, like the distribution of the returns over a given time interval, cannot be avoided. Such assumptions entail the risk of masking or misrepresenting non-stationarities of the underlying process, and of giving an incorrect account of its correlations. Here we overcome this difficulty by showing that five years of daily Euro/US-Dollar trading records in the about three hours following the New York market opening, provide a rich enough ensemble of histories. The statistics of this ensemble allows to propose and test an adequate model of the stochastic process driving the exchange rate. This turns out to be a non-Markovian, self-similar process with non-stationary returns. The empirical ensemble correlators are in agreement with the predictions of this model, which is constructed on the basis of the time-inhomogeneous, anomalous scaling obeyed by the return distribution.
Value Premium Across Countries – SSRN
Value premium varies substantially across countries. We explore whether the inter-country cross-sectional variation in value premium can be predicted by those variables known to predict the intra-country time-variation in value premium. After examining data from 23 developed markets and 13 emerging markets between 2000 and 2010, we found that the earnings-yield spread and the return dispersion have predictive power in emerging markets, but not in developed markets. The earnings-growth spread was found not to have significant predictive power.
Value premium varies substantially across countries. We explore whether the inter-country cross-sectional variation in value premium can be predicted by those variables known to predict the intra-country time-variation in value premium. After examining data from 23 developed markets and 13 emerging markets between 2000 and 2010, we found that the earnings-yield spread and the return dispersion have predictive power in emerging markets, but not in developed markets. The earnings-growth spread was found not to have significant predictive power.
Engineering an Orderly Greek Debt Restructuring – SSRN
In this essay, we describe and compare three alternative approaches that would achieve an orderly restructuring but avoid an outright default: (1) “retrofitting” and using a collective action clause (CAC) that would allow the vast majority of outstanding Greek government bonds to be restructured with the consent of a supermajority of creditors; (2) combining the use of a CAC with an exit exchange, in which consenting bondholders would receive a new English-law bond with standard creditor protections and lower face value; (3) an exit exchange in which a CAC would only be used if participation falls below a specified threshold. All three exchanges are involuntary in the sense that creditors that dissent or hold out are not repaid in full. (hat tip marginal revolution)
In this essay, we describe and compare three alternative approaches that would achieve an orderly restructuring but avoid an outright default: (1) “retrofitting” and using a collective action clause (CAC) that would allow the vast majority of outstanding Greek government bonds to be restructured with the consent of a supermajority of creditors; (2) combining the use of a CAC with an exit exchange, in which consenting bondholders would receive a new English-law bond with standard creditor protections and lower face value; (3) an exit exchange in which a CAC would only be used if participation falls below a specified threshold. All three exchanges are involuntary in the sense that creditors that dissent or hold out are not repaid in full. (hat tip marginal revolution)
Follow the money: what does the literature on banking tell prudential supervisors on bank business models? – De Nederlandsche Bank
Overview of the recent literature on bank business models, structured along what we deem to be the three central questions when analysing business models.
The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements – BIS (pdf)
International spillovers associated with a global increase in capital requirements are relatively modest, especially if monetary policies have scope to ease in response to a widening of interest rate spreads by banks.
The Global Macroeconomic Costs of Raising Bank Capital Adequacy Requirements – IMF (pdf)
This paper examines the transitional macroeconomic costs of a synchronized global increase in bank capital adequacy requirements under Basel III, as well as a capital increase covering globally systemically important banks. The analysis, using an estimated multi-country model, contributed to the work of the Macroeconomic Assessment Group analysis, especially in estimating the potential international spillovers associated with a global increase in capital requirements. The magnitude of the effects found in this analysis is relatively modest, especially if monetary policies have scope to ease in response to a widening of interest rate spreads by banks.
Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge – NY FED
Under rational expectations, monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure: Anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets.
Optimal Interest Rate Rules and Inflation Stabilization versus Price-Level Stabilization – NY FED
This paper compares the properties of interest rate rules such as simple Taylor rules and rules that respond to price-level fluctuations—called Wicksellian rules—in a basic forward-looking model. By introducing appropriate history dependence in policy, Wicksellian rules perform better than optimal Taylor rules in terms of welfare and robustness to alternative shock processes, and they are less prone to equilibrium indeterminacy.