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2008, 50
This paper addresses and resolves the issue of microstructure noise when measuring the relative importance of home and U.S. market in the price discovery process of Canadian interlisted stocks. In order to avoid large bounds for information shares, previous studies applying the Cholesky decomposition within the Hasbrouck (1995) framework had to rely on high frequency data. However, due to the considerable amount of microstructure noise inherent in return data at very high frequencies, these estimators are distorted. We offer a modified approach that identifies unique information shares based on distributional assumptions and thereby enables us to control for microstructure noise. Our results indicate that the role of the U.S. market in the price discovery process of Canadian interlisted stocks has been underestimated so far. Moreover, we suggest that rather than stock specific factors, market characteristics determine information shares.
2008, 49
Innovative automated execution strategies like Algorithmic Trading gain significant market share on electronic market venues worldwide, although their impact on market outcome has not been investigated in depth yet. In order to assess the impact of such concepts, e.g. effects on the price formation or the volatility of prices, a simulation environment is presented that provides stylized implementations of algorithmic trading behavior and allows for modeling latency. As simulations allow for reproducing exactly the same basic situation, an assessment of the impact of algorithmic trading models can be conducted by comparing different simulation runs including and excluding a trader constituting an algorithmic trading model in its trading behavior. By this means the impact of Algorithmic Trading on different characteristics of market outcome can be assessed. The results indicate that large volumes to execute by the algorithmic trader have an increasing impact on market prices. On the other hand, lower latency appears to lower market volatility.
2008, 47
Macro announcements change the equilibrium riskfree rate. We find that treasury prices reflect part of the impact instantaneously, but intermediaries rely on their customer order flow in the 15 minutes after the announcement to discover the full impact. We show that this customer flow informativeness is strongest at times when analyst forecasts of macro variables are highly dispersed. We study 30 year treasury futures to identify the customer flow. We further show that intermediaries appear to benefit from privately recognizing informed customer flow, as, in the cross-section, their own-account trade profitability correlates with access to customer orders, controlling for volatility, competition, and the announcement surprise. These results suggest that intermediaries learn about equilibrium riskfree rates through customer orders.
2008, 48
We report evidence that the presence of hidden liquidity is associated with greater liquidity in the order books, greater trading volume, and smaller price impact. Limit and market order submission behavior changes when hidden liquidity is present consistent with at least some traders being able to detect hidden liquidity. We estimate a model of liquidity provision that allows us to measure variations in the marginal and total payoffs from liquidity provision in states with and without hidden liquidity. Our estimates of the expected surplus to providers of visible and hidden liquidity are positive and typically of the order of one-half to one basis points per trade. The positive liquidity provider surpluses combined with the increased trading volume when hidden liquidity is present are both consistent with liquidity externalities.
2008, 33
The single most important policy-induced innovation in the international financial system since the collapse of the Bretton-Woods regime is the institution of the European Monetary Union. This paper provides an account of how the process of financial integration has promoted financial development in the euro area. It starts by defining financial integration and how to measure it, analyzes the barriers that can prevent it and the effects of their removal on financial markets, and assesses whether the euro area has actually become more integrated. It then explores to which extent these changes in financial markets have influenced the performance of the euro-area economy, that is, its growth and investment, as well as its ability to adjust to shocks and to allow risk-sharing. The paper concludes analyzing further steps that are required to consolidate financial integration and enhance the future stability of financial markets.
2008, 35
We study the relation between cognitive abilities and stockholding using the recent Survey of Health, Ageing and Retirement in Europe (SHARE), which has detailed data on wealth and portfolio composition of individuals aged 50+ in 11 European countries and three indicators of cognitive abilities: mathematical, verbal fluency, and recall skills. We find that the propensity to invest in stocks is strongly associated with cognitive abilities, for both direct stock market participation and indirect participation through mutual funds and retirement accounts. Since the decision to invest in less information-intensive assets (such as bonds) is less strongly related to cognitive abilities, we conclude that the association between cognitive abilities and stockholding is driven by information constraints, rather than by features of preferences or psychological traits.
2008, 34
We investigate whether information sharing among banks has affected credit market performance in the transition countries of Eastern Europe and the former Soviet Union, using a large sample of firm-level data. Our estimates show that information sharing is associated with improved availability and lower cost of credit to firms. This correlation is stronger for opaque firms than transparent ones and stronger in countries with weak legal environments than in those with strong legal environments. In cross-sectional estimates, we control for variation in country-level aggregate variables that may affect credit, by examining the differential impact of information sharing across firm types. In panel estimates, we also control for the presence of unobserved heterogeneity at the firm level, as well as for changes in macroeconomic variables and the legal environment.
2008, 38
We examine insurance markets with two types of customers: those who regret suboptimal decisions and those who don.t. In this setting, we characterize the equilibria under hidden information about the type of customers and hidden action. We show that both pooling and separating equilibria can exist. Furthermore, there exist separating equilibria that predict a positive correlation between the amount of insurance coverage and risk type, as in the standard economic models of adverse selection, but there also exist separating equilibria that predict a negative correlation between the amount of insurance coverage and risk type, i.e. advantageous selection. Since optimal choice of regretful customers depends on foregone alternatives, any equilibrium includes a contract which is o¤ered but not purchased.
2008, 37
When a spot market monopolist participates in a derivatives market, she has an incentive to deviate from the spot market monopoly optimum to make her derivatives market position more profitable. When contracts can only be written contingent on the spot price, a risk-averse monopolist chooses to participate in the derivatives market to hedge her risk, and she reduces expected profits by doing so. However, eliminating all risk is impossible. These results are independent of the shape of the demand function, the distribution of demand shocks, the nature of preferences or the set of derivatives contracts.
2008, 21
Motivated by the prominent role of electronic limit order book (LOB) markets in today’s stock market environment, this paper provides the basis for understanding, reconstructing and adopting Hollifield, Miller, Sandas, and Slive’s (2006) (henceforth HMSS) methodology for estimating the gains from trade to the Xetra LOB market at the Frankfurt Stock Exchange (FSE) in order to evaluate its performance in this respect. Therefore this paper looks deeply into HMSS’s base model and provides a structured recipe for the planned implementation with Xetra LOB data. The contribution of this paper lies in the modification of HMSS’s methodology with respect to the particularities of the Xetra trading system that are not yet considered in HMSS’s base model. The necessary modifications, as expressed in terms of empirical caveats, are substantial to derive unbiased market efficiency measures for Xetra in the end.
2008, 22
How do fiscal and technology shocks affect real exchange rates? : New evidence for the United States
(2008)
Using vector autoregressions on U.S. time series relative to an aggregate of industrialized countries, this paper provides new evidence on the dynamic effects of government spending and technology shocks on the real exchange rate and the terms of trade. To achieve identification, we derive robust restrictions on the sign of several impulse responses from a two-country general equilibrium model. We find that both the real exchange rate and the terms of trade – whose responses are left unrestricted – depreciate in response to expansionary government spending shocks and appreciate in response to positive technology shocks.
2008, 17
This paper introduces adaptive learning and endogenous indexation in the New-Keynesian Phillips curve and studies disinflation under inflation targeting policies. The analysis is motivated by the disinflation performance of many inflation-targeting countries, in particular the gradual Chilean disinflation with temporary annual targets. At the start of the disinflation episode price-setting firms’ expect inflation to be highly persistent and opt for backward-looking indexation. As the central bank acts to bring inflation under control, price-setting firms revise their estimates of the degree of persistence. Such adaptive learning lowers the cost of disinflation. This reduction can be exploited by a gradual approach to disinflation. Firms that choose the rate for indexation also re-assess the likelihood that announced inflation targets determine steady-state inflation and adjust indexation of contracts accordingly. A strategy of announcing and pursuing short-term targets for inflation is found to influence the likelihood that firms switch from backward-looking indexation to the central bank’s targets. As firms abandon backward-looking indexation the costs of disinflation decline further. We show that an inflation targeting strategy that employs temporary targets can benefit from lower disinflation costs due to the reduction in backward-looking indexation.
2008, 15
Risk transfer with CDOs
(2008)
Modern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisite for solid risk management. This paper aims to resolve a part of the opaqueness surrounding credit-risk allocation to tranches that represent claims of different seniority on a reference portfolio. In particular, this paper analyzes the allocation of credit risk to different tranches of a CDO transaction when the underlying asset returns are driven by a common macro factor and an idiosyncratic component. Junior and senior tranches are found to be nearly orthogonal, motivating a search for the whereabout of systematic risk in CDO transactions. We propose a metric for capturing the allocation of systematic risk to tranches. First, in contrast to a widely-held claim, we show that (extreme) tail risk in standard CDO transactions is held by all tranches. While junior tranches take on all types of systematic risk, senior tranches take on almost no non-tail risk. This is in stark contrast to an untranched bond portfolio of the same rating quality, which on average suffers substantial losses for all realizations of the macro factor. Second, given tranching, a shock to the risk of the underlying asset portfolio (e.g. a rise in asset correlation or in mean portfolio loss) has the strongest impact, in relative terms, on the exposure of senior tranche CDO-investors. Our findings can be used to explain major stylized facts observed in credit markets.
2008, 20
We explore the pattern of elderly homeownership using microeconomic surveys of 15 OECD countries, merging 60 national household surveys on about 300,000 individuals. In all countries the survey is repeated over time, permitting construction of an international dataset of repeated cross-sectional data. We find that ownership rates decline considerably after age 60 in all countries. However, a large part of the decline depends on cohort effects. Adjusting for them, we find that ownership rates start falling after age 70 and reach a percentage point per year decline after age 75. We find that differences across country ownership trajectories are correlated with indicators measuring the degree of market regulations.
2008, 23
Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.
2008, 16
Monetary policy analysts often rely on rules-of-thumb, such as the Taylor rule, to describe historical monetary policy decisions and to compare current policy to historical norms. Analysis along these lines also permits evaluation of episodes where policy may have deviated from a simple rule and examination of the reasons behind such deviations. One interesting question is whether such rules-of-thumb should draw on policymakers "forecasts of key variables such as inflation and unemployment or on observed outcomes. Importantly, deviations of the policy from the prescriptions of a Taylor rule that relies on outcomes may be due to systematic responses to information captured in policymakers" own projections. We investigate this proposition in the context of FOMC policy decisions over the past 20 years using publicly available FOMC projections from the biannual monetary policy reports to the Congress (Humphrey-Hawkins reports). Our results indicate that FOMC decisions can indeed be predominantly explained in terms of the FOMC´s own projections rather than observed outcomes. Thus, a forecast-based rule-of-thumb better characterizes FOMC decision-making. We also confirm that many of the apparent deviations of the federal funds rate from an outcome-based Taylor-style rule may be considered systematic responses to information contained in FOMC projections.
2008, 24
Modern macroeconomics empirically addresses economy-wide incentives behind economic actions by using insights from the way a single representative household would behave. This analytical approach requires that incentives of the poor and the rich are strictly aligned. In empirical analysis a challenging complication is that consumer and income data are typically available at the household level, and individuals living in multimember households have the potential to share goods within the household. The analytical approach of modern macroeconomics would require that intra-household sharing is also strictly aligned across the rich and the poor. Here we have designed a survey method that allows the testing of this stringent property of intra-household sharing and find that it holds: once expenditures for basic needs are subtracted from disposable household income, household-size economies implied by the remainder household incomes are the same for the rich and the poor.
2008, 31
The future of securitization
(2008)
Securitization is a financial innovation that experiences a boom-bust cycle, as many other innovations before. This paper analyzes possible reasons for the breakdown of primary and secondary securitization markets, and argues that misaligned incentives along the value chain are the primary cause of the problems. The illiquidity of asset and interbank markets, in this view, is a market failure derived from ill-designed mechanisms of coordinating financial intermediaries and investors. Thus, illiquidity is closely related to the design of the financial chains. Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements.