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Corporate Governance, Market Valuation and Dividend Policy in Brazil

André Carvalhal-da-Silva, Ricardo Leal

This study investigates the effects of the corporate governance structure on market valuation and dividend payout of Brazilian companies. The empirical results indicate a high degree of ownership and control concentration. We can also note a significant difference between the voting and total capital owned by the largest shareholders, mainly through the existence of non-voting shares, pyramidal structures, and shareholding agreements. These mechanisms seem to be used by controlling shareholders to keep the firm’s control without having to own 50% of the total capital. The evidence also reveals that there is a relationship between governance structure, market valuation, and dividend policy in Brazil.

JEL Classification: G30, G32

Keywords: Ownership structure; corporate control; agency costs; Brazil

The Effects of Decision Flexibility In the Hierarchical Investment Decision Process

Winfried Hallerbach, Haikun Ning, Jaap Spronk

Large institutional investors allocate their funds over a number of classes (e.g. equity, fixed income, real estate and cash), various geographical regions and different industries.

In practice, these allocation decisions are usually made in a hierarchical (top-down), consecutive way. At the higher decision level, the allocation is made on the basis of benchmark portfolios (indexes). Such indexes are then set as targets for the lower levels. For example, at the top level the allocation decision is made on the basis of asset class benchmark indexes, on the second level the decisions are made on the basis of sector benchmark indexes, etc. Obviously, the lower levels have considerable flexibility to deviate from these targets. That is the reason why targets often come with limits on the maximally allowed deviation (or ‘tracking error’) from these targets. The potential consequences of deviations from the benchmark portfolios have received very little attention in the literature.

In this paper, we discuss and illustrate this influence. The lower level tracking errors with respect to the benchmark indexes propagate to the top level. As a result the risk-return characteristics of the actual aggregate portfolio will be different from those of the initial benchmark-based portfolio. We illustrate this effect for a two level process to allocate funds over individual US stocks and sectors. We show that the benchmark allocation approaches used in practice yield inferior solutions when compared to a non-hierarchical approach where full information about individual lower level investment opportunities is available. Our results reveal that even small deviations from the benchmark portfolios can cause large shifts in the top-level risk-return space. This implies that the incorporation of lower level information in the initial top-level decision process will lead to a different (possibly better) allocation.

JEL Classification : C61, G2, G11

Keywords : multi-level decision process, decisison flexibility , tracking error analysis, portfolio management


Random Walk As A Universal Test Of Weak-Form Foreign Exchange Market Efficiency: A Proof

Edward E. Ghartey

The paper proves that the domestic or national value of foreign exchange earnings from holding foreign assets (bonds and bank deposits accounts) follows a martingale process. It then employs the martingale process and the definition of rational expectation to prove that the pure random walk spot exchange rate is an adequate means to universally test weak-form foreign exchange market efficiency. This makes it possible for countries without forward markets to test for weak-form efficiency of their foreign exchange markets.

JEL Classification : F3 and C1.

Keywords: Martingale, rational expectation, random walk, and weak-form foreign exchange market efficiency.

Credit Exposure & Sovereign Risk Analysis:The Case of South America

Elena Kalotychou, Sotiris K. Staikouras

This study makes use of a panel data framework to identify the economic signals that shape the debt repayment behaviour of the South American region. The paper employs a logit estimator with the endogenous variable based on country specific thresholds of default. A stepwise general to specific methodology is applied to identify the set of economic variables employed. The results indicate the stronger influence of domestic, rather than international, financial factors in determining default. The forecasting ability of the proposed estimator is evaluated through a cumulative three-year rolling prediction. Although the performance of the model seems satisfactory, the empirical findings indicate an upward bias signalling a possible type II error.

JEL Classification: F34, G15, G21

Keywords: Financial crises, Sovereign default, Logit modelling, Forecasting credit risk.

Strategic Conduct And Access Discrimination, In The Semi-Liberalized Electricity Sector In Mexico

Alejandro Ibarra-Yunez

Regulatory reform in the energy, and specifically the electricity sector, has ranged from full unbundling, liberalization, and privatization, to partial deregulation and liberalization, with little or no unbundling and non-privatization. The Mexican case originated from a need for full restructuring but recently has adjusted downwards to lukewarm deregulation in the generation segment, where the parastatal incumbent arguably will stay integrated and private generation will be promoted. A model of duopoly, with an integrated parastatal incumbent and residual private firms sheds light on potential access discrimination to residual private firms under the “Mexican model.”

JEL Classification : L12, L13, L94

Keywords: Duopoly, incumbent parastatals, electricity generation.

Canadian Mutual Fund Flows and Capital Market Movements

Roger B. Atindéhou, Jean-Pierre Gueyié

The causality relationship between Canadian capital market returns and mutual fund financial flows is analyzed over the period 1991-1999, using Granger causality tests. Our results indicate that in Canada, capital market returns cause mutual fund financial flows. Conversely, mutual fund flows have an impact on bond market returns, but not on stock market returns. These results generally confirm those found in US studies (i.e., a causality from returns to mutual fund flows, and a lack of causality from flows to returns), with the exception that in Canada, mutual fund flows cause bond returns. They suggest that while there are some institutional differences between Canadian and US capital markets, they generally behave in the same way.

Keywords : Granger causality, mutual funds flows, capital markets returns, Canada, United States.

Parametric and Non-Parametric Analysis of Performance Persistence in Spanish Investment funds

Luis Ferruz,  José L. Sarto,  María Vargas

This paper describes a financial study of performance persistence in Spanish short-term fixed-interest funds. It is a completely new study and the database is free of survivorship bias.Performance is analysed using a novel index based on Sharpe’s original that provides consistent rankings for the whole sample.The performance persistence phenomenon is analysed using two methodologies. The first of these is a non-parametric methodology (contingency tables) in which the statistical tests of Malkiel (1995), Brown and Goetzmann (1995), and Kahn and Rudd (1995) are applied to establish the robustness of the phenomenon studied, while the second is parametric (regression analysis).We can confirm that the phenomenon of persistence is present to a significant degree in the database used in the study. Our research also shows that the availability of a greater volume of historical information does not necessarily imply any increase in the level of persistence.

Keywords : Persistence, contingency tables, regressions, investment funds.

JEL Classification : G11

An Empirical Analysis of Kenyan Daily Returns Using EGARCH Models

Georges Ogum, Francisca M. Beer, Genevieve Nouyrigat

This paper offers a comprehensive view of four time properties that emerge from the empirical time series literature on asset returns. It examines: (1) the predictability of returns from past observations; (2) the auto-regressive behavior of conditional volatility; (3) the asymmetric response of conditional volatility to innovations; (4) and the conditional variance risk premium. One emerging market previously under-researched in this respect is considered: Kenya (NSE index). The paper employs exponential GARCH (EGARCH) framework for the analyses. The results indicate that asymmetric volatility found in the U.S. and other developed markets does not appear to be a universal phenomenon. In Kenya, the asymmetric volatility coefficient is significant positive, suggesting that positive shocks increase volatility more than negative shocks of an equal magnitude. NSE (Kenya) returns series report negative but insignificant risk-premium parameters. The results also show that expected returns are predictable, the auto-regressive return parameter (Ø1) is significant. Finally, the GARCH parameter (b) is statistically significant indicating that volatility persistence is present in Kenya

Keywords : Emerging market, ARCH, Conditional volatility, hedictability of returns

JEL Classification : G15, G14, C14

Real Options, Uncertainty and Firm Value

Gema Pastor Agustín, Manuel Espitia Escuer

Real options capture the value of managerial flexibility to adapt previous strategies in response to unexpected market developments. This flexibility enables managers to leverage uncertainty and limit downside risk. From this perspective, uncertainty would positively affect the valuation of a particular asset if there were real options on it. In this paper we analyse this view and we propose a model in which the possession of real options by a firm affects its market value in a twofold manner. On the one hand, the real options may constitute a valuable asset by themselves. On the other, they may alter the view that agents have about the uncertainty. To test this we carried out an empirical analysis on a sample of monthly time series of Spanish firms listed on the continuous market between 1993 and 1999 and for which there were call options on their shares. Through this analysis we conclude that real options generates value for the firm. Moreover, we also observe that the agents modify their perception of the industrial uncertainty that a firm supports if it possesses real options.

JEL Classification : C12, C23, D81, G12

Keywords : Real options, uncertainty, firm value, panel data


Parametric and Non-Parametric Measures of Volatility: Risk Estimation via the Gini Decomposition and Comparison with the Value-at-Risk

Stéphane Mussard, Virginie Terraza

In this paper we make an analogy between inequality ratios and financial risk measures. Value-at-Risk is one of the most popular risk index. It gauges the potential losses included in the tail of the distribution. Its parametric estimation yields a risk decomposition using the additive property of separability. This property permits one to transform portfolio’s VaRs into component VaRs and to define VaR metrics. However, it is based on the restrictive normality hypothesis. Then, we define a non-parametric risk measure from the Gini ratio that is assimilated to a volatility index under conditions. Using the property of decomposability, the Gini risk index can be decomposed to define new risk measures. An application on the French stock market yields comparisons between the methods.

Keywords: Component Value-at-Risk, Decomposition, Gini, Marginal Value-at-Risk, Volatility.

JEL Classification: C3, D31, D63, G11.

Frontiers of Financially Constrained and Unconstrained Firms: a New Development in Finance

Monica H. Maestro,  Alberto de Miguel,  Julio Pindado

This paper presents a new development in Finance that could be used to know whether a firm suffers from financial constrains. Our method consists of, first, developing a financial constraints model that objectively separates over 50% of all firms. The results of this first stage are then used to classify the remaining firms by using logit analysis. Our methodology yields classification results in agreement with the financial development of the economic areas studied (the US, Japan and the EU). Furthermore, the suggested methodology substantially improves the classification of firms, since whatever the correct classification percentage yielded by logit analysis, previous application of our Financial Constraints Model allows the researcher to obtain a good final classification.

Keywords: Firms’ investment, Financial constraints, Logit analysis,  JEL classification: G31


Attitudes with Regard to Risk : Risk Aversion, Prudence and Temperance

Octave Jokung N.

Understanding the behavior of economic agents dealing with risk is reached by the way of three concepts: Risk Aversion, Prudence and Temperance. The first one has proved to be sufficient in motivating hedging within the scope of one-risk insurance. The second concept, linked to the first one, allows to follow the evolution of this demand with respect to income. Taking these three feelings into consideration simultaneously allows to justify the more chilly attitude of economic agents within the scope of several risks, and allows to guarantee the increase in the demand for hedging in relation to the one-risk situation as well as the decrease in the demand for risky assets. We give justification for this attitude of investors, more cautious than chilly, and above all, more temperate than prudent. With the concept of prudence, the mean-variance approximation of expected utility is no longer valid.

Key-words: precautionary saving, risk aversion, utility, background risk, mean-variance paradigm

Additional Panel Data Evidence on the Savings-Investment Relationship and Foreign Aid in LDCs

Risa Kumazawa, James E. Payne

Using several panel data estimation procedures, this study examines the impact of savings, foreign aid, the degree of capital mobility over time, and openness to international trade upon investment rates for a sample of 74 less developed countries over the time period 1980 to 2001. The results find that the estimates of capital mobility are similar to those reported in previous studies of developing economies.  Capital mobility has increased over time while foreign aid and openness both have positive and significant impacts on investment rates.

Keywords: Capital mobility, Foreign Aid, Panel Data, JEL classification : F32, F35, O16

The Kraus and Litzenberger Quadratic Characteristic Line and Event Studies

Arun J. Prakash, Suchismita Mishra, Dipasri Ghosh

Research into the efficiency of capital market has been an ongoing process, and it has given rise to two very widely-used techniques in corporate finance. They are the event study and performance evaluation techniques. Some scholars have incorporated the preference for positive skewness in the performance evaluation technique, and using the quadratic characteristic line model à la Kraus and Litzenberger they have accounted for skewness preference. However, the preference for skewness has not been explored so far in the context of evaluation of abnormal performance of securities following an event. It appears to be of interest to examine if the abnormal returns, obtained using the quadratic characteristic line (QCL),  result in an outcome different from the one obtained using the market model in event studies. The purpose of this paper is to explore a priori the theoretical conditions under which the results of an event study will be different for using the QCL in place of the market model.

Keywords: Skewness, Event Studies, Three-moment CAPM , JEL classification: G11, G14


The Product Life Cycle and The Real Option of Waiting

Óscar Gutiérrez

Standard models of real options miscalculate the option-to-invest value of projects whose returns follow the pattern of a Product Life Cycle. This paper analyzes the option of waiting to invest when profits derived from sales in the market obey a stochastic Product Life Cycle, providing analytical solutions for the optimal entry rule and for the investment opportunity value. The model helps to explain the initial size of markets that follow a Product Life Cycle. The main difference between our model and standard models of real options is the existence of a random moment in time where the evolution of market sales changes.

Keywords: Product Life Cycle, Gamma process, Optimal entry rule, Investment lag, JEL classification: D92, G31, M31.

The Evolution of European and US Aerospace and Defence Markets

Vasilis Zervos

The aim of this paper is to consider the evolution of the US and European Aerospace and Defence (A&D) markets. The present industrial structure is analysed in terms of the performance of US and European major contractors in commercial and government controlled markets (defense) within an industrial economics framework. This is then compared to possible future industrial structures, where procurement policies open up the markets to overseas firms. The comparison supports the hypothesis that efficiency can be improved and points to the need for co-ordination of procurement and industrial policies within a joint US/European military industrial complex to reduce collusion between transatlantic A&D integrators.

Keywords: Aerospace, Defense, Procurement, Industry, JEL Classification: L13, F13, H53


Manufacturing Labour Demand, Technological Progress and Military Expenditure

J Paul Dunne, Duncan Watson

During the Cold a major justification of high levels of military spending was the spin off of innovations to the civil sector, such as computers, which could then be exploited profitably and to the benefit of the economy and society. There is evidence that this has changed in more recent times, with the speed of consumer industry led technological change leading to ‘spin in’ to advanced weapons systems. If this is the case it has removed a major benefit of military spending. There is, however, little systematic evidence and little recent empirical work. This paper makes a contribution to the debate, analysing the impact of military spending on technological progress, and hence labour productivity and economic growth, for a number of major weapons producers. It uses data on the manufacturing sector,   for the period 1966-2002 and estimates a CES production function in which military spending is assumed to effect growth through its impact on trend technological change.

Keywords: Military spending; spin off; employment; productivity; panel, JEL Classification:H56; O30; J20


Military Spending and Economic Growth in Greece, Portugal and Spain

Paul Dunne,  Eftychia Nikolaidou

Analysing the relationship between military spending and growth has been an important area of empirical research. Early studies focussed on large cross sections of countries, but criticisms of these led to a focus on case studies of individual countries and studies of groups of relatively homogeneous countries. Granger causality methods have also become common techniques for such analyses, both as single equation analyses and more recently, within a cointegrating VAR framework. This paper does two things. First it provides an empirical analysis the relation between military spending and growth of three of the EU’s poorest, peripheral economies, namely Greece, Portugal and Spain. Second, it considers the range of available techniques and compares their results. It finds that the results differ across the methods used, indicating the problems with earlier studies, and across the countries, indicating the problems of drawing inferences across even relatively homogeneous economies.

Keywords : Military expenditure;  growth; causality, JEL classification : O40; H56

Revolution in the Defence Electronics Markets?An Economic Analysis of Sectoral Change

Paul Dowdall, Derek Braddon

Within the defence sector there have been marked changes in the nature of the composite industries. This is particularly true of the electronics industry which continues to grow in importance, with electronic components built into nearly every weapons system and piece of equipment. Given the “Revolution in Military Affairs” (RMA) it seems certain that this growth will continue, impacting on both product and process. The result, however, may not be the contestable open market many expect (and hope for) as Network Enabled Warfare may result in new entrants, such as IT specialist and increased competition.  Alternatively the nature of the market may continue to benefit the incumbents. This paper presents an analysis of the changes taking place in the industry using firm-level, primary, survey-based, qualitative data on corporate conduct. The results suggest that in practice the incumbents do seem to be in a strong position. The new demands of the customer require much more than mere technical capability. Specialists who do not have established industry relationships, who do not understand industry “protocols” and who cannot communicate effectively with the customer are unlikely to survive. This suggests that rather than new entrants, there may in fact be exits from the industry and further consolidation.

Keywords: Defence, Electronics, Industry structure, Conduct, Contestability, JEL Classification: D2, D4, L1, L2, L63, O3


What Lies Beneath? Who Owns British Defence Contractors And Does It Matter?

Derek Braddon, Jonathan Bradley

This paper presents the findings of research into the distribution of the rewards from capital used in defence production. Much existing research has examined the supply chain in the production of defence goods, but there have been few attempts to look at the ownership of suppliers. First, the paper examines two theoretical issues: why the identity of shareholders in defence contractors should have any economic or political significance, and whether the use of capital in defence industries should in principle be expected to be the same as that in any other industry. It then investigates the identity and ownership of the contractors concerned in 2003-4, using several case studies.  It finds that many of the largest suppliers to the UK government are foreign-owned or controlled, and it finds evidence of a surprising degree of American equity participation in major British contractors.

Keywords :Defence, corporate ownership, supply base; industry structure and conduct, JEL classification : D2, D4, L1, L2, L64.


Option Pricing with Long-Short Spreads

Pengguo Wang

This paper addresses no-arbitrage pricing of options in a market with long-short spreads. First, it characterizes the term structure of no-arbitrage valuation in a frictional capital market. It shows that no arbitrage opportunities imply, and are implied by, the existence of an equivalent probability measure, under which the discounted long prices of traded securities are supermartingales, and the discounted short prices are submartingales. Second, the classic option-pricing model is generalized to a more realistic and imperfect capital market. It is shown that, in the absence of arbitrage opportunities, the equilibrium price of a call or put option must lie within an arbitrage-band. Two general partial differential equations (PDEs), which long and short prices of a contingent claim must satisfy, are identified. Third, it shows that the long-short spreads in option-pricing have important implications for portfolio hedging.

Keywords: option pricing, no-arbitrage, long-short spreads, martingale measure, hedging

Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach

William A. Barnet, Chang Ho Kwag

We incorporate aggregation and index number theory into monetary models of exchange rate determination in a manner that is internally consistent with money market equilibrium. Divisia monetary aggregates and user-cost concepts are used for money supply and opportunity-cost variables in the monetary models. We estimate a flexible price monetary model, a sticky price monetary model, and the Hooper and Morton (1982) model for the US dollar/UK pound exchange rate. We compare forecast results using mean square error, direction of change, and Diebold-Mariano statistics.  We find that models with Divisia indexes are better than the random walk assumption in explaining the exchange rate fluctuations.  Our results are consistent with the relevant theory and the “Barnett critique.”

Keywords: Exchange rate, forecasts, vector error correction, aggregation theory, index number theory, Divisia index number, JEL Classification: C43, F31, F37

International Portfolio Formation, Skewness & the Role of Gold

Brian M Lucey, Valerio Poti, Edel Tully

This paper examines the optimal allocation of assets in well diversified equity based portfolio where the investor is concerned not only with mean and variance but also with the skewness of the returns. Beginning with an analysis of the rationale for concerning with skewness, the paper then discusses previous attempts to model multi-objective portfolio problems. The second part of the paper outlines the attractive nature of the gold asset in equity portfolios. The paper then integrates the two elements, showing the changes in portfolio composition that arise when not only skewness but gold are concerned.

Keywords: Portfolio Allocation, Skewness, Gold, JEL Classification: C61, G11

Interdependence of Asean Business Cycles

Hway-Boon Ong, Chin-Hong Puah, Muzafar Shah Habibullah

This paper examines the interdependent relationship of five ASEAN business cycles, namely, Indonesia, Malaysia, Philippines, Singapore and Thailand. We conducted an augmented VAR of Granger non-causality test and discovered that there is strong interdependence among the ASEAN countries under study.  Our empirical findings revealed the existence of bi-directional causality among ASEAN countries, especially Malaysia and Singapore. That is to say, economic shocks or policy implementation by any neighbouring countries may be easily transmitted to another.

Keywords: Granger non-causality, augmented-VAR, MWald test, business cycles, ASEAN.

Crisis Anticipation at a Micro-Level: Mexico 1995-1996

Karen Watkins

The following study is concerned with the anticipation of the 1995-1996 Mexican crisis.  It uses data from the balance sheets of 73 private, non-financial companies.  The results indicate that firms were not able to foresee the coming crisis. This conclusion is robust to using one year, three, two, and one quarters lags as the anticipation period. In addition, there is no significant difference in the outcome when considering the industry and size of firms.

Keywords: crisis anticipation, firm-level data, event study, JEL Classification: G3, G14

Zelig and the Art of Measuring Excess Profit

Carlo Alberto Magni

This paper tells the story of a student of economics and finance who meets a couple of alleged psychopaths, suffering from the ‘syndrome of Zelig’, so that they think of themselves to be experts of economic and financial issues. While speaking, they come across the concept of excess profit. The student tells them that the formal way to translate excess profit is to apply Stewart’s (1991) EVA model and shows that this model is equivalent to Peccati’s (1987, 1991, 1992) decomposition model of a project’s Net Present (Final) Value. The ‘Zeligs’ listen to him carefully, then try to apply themselves the EVA model: Unfortunately, both She-Zelig and He-Zelig seem to feel uneasy with basic mathematics, so they make some mistakes. Consequently, each of them miscalculates the excess profit. Strangely enough, they make different mistakes but both get to the (correct) Net Final Value of the project and, in addition, their excess profits do coincide. Further, the (biased) models presented by the Zeligs, though different from the EVA model, seem to bear strong relations to the latter. The student is rather surprised.I give my version of this event, arguing that the Zeligs are offering us a rational way of measuring excess profit, alternative to EVA but equally valuable. As I see it, they are only adopting a different cognitive interpretation of the concept of excess profit, which is based on a counterfactual conditional that differs from Stewart’s and Peccati’s.

Keywords: Excess profit, Economic Value Added, Net Final Value, Systemic Value Added, Counterfactual, JEL Classification: G00, G30, G31.

Stock Market Reaction to Unexpected Changes in Interest Rates

Gitit G. Gershgoren, Shmuel Hauser

Most studies on monetary policy of central banks in many countries have focused primarily on price stability in the long-run. In this study, we investigate the short-term (within days) effect of that policy on the stock market. We employ the Vector Error Correction Models to estimate the relationship between interest rates, share prices and other macroeconomic variables to estimate the expected and unexpected interest rates announced by the Central Bank, and the GARCH model to characterize stock prices volatility. Based on these estimates, we use an event study methodology to investigate the immediate effects of unexpected announcement of interest rates by the Central Bank on share prices and their volatility. Using a unique data set obtained from the Bank of Israel we find that despite of its success in achieving the goal of price stability in the long-run, the impact on the stock market in the short-run was unwarranted, as it often generated superfluous share prices fluctuations.

Keywords: stock market, interest rates

JEL classification: E44, G14

The long-run performance of UK rights issuers

Abdullah Iqbal, Susanne Espenlaub, Norman Strong

The long-run performance of 424 UK rights issues during 1991–95 shows that issuers outperform the market and non-issuing peers in the pre-issue period and underperform in the post-issue period.  To explain these results, we examine the timing and earnings management hypotheses and show that our results support the latter.  Specifically, we find that issuing firms use discretionary current accruals to manipulate earnings, with operating performance improving significantly before the issue but deteriorating thereafter and that discretionary current accruals in the pre-issue year predict the return underperformance in the two years post-issue.  That we find these results for rights issues where new equity is offered pro rata to existing shareholders suggests the incentives of managers or informed shareholders drive earnings management.

Keywords: earnings management, rights issues, SEOs, return performance, operating performance

JEL classification: G14; G15; G24; G32; M41


Has the stock market integration between the Asian and OECD countries improved after the Asian crisis?

Girijasankar Mallik

In recent years the world economy has become closely integrated due to increasing trade and financial capital flows across countries. In this study we investigate the cointegrating relationships between the stock price indices of 7 emerging Asian economies (Malaysia, South Korea, Singapore, Thailand, Taiwan, Hong Kong and the Philippines) with each of 4 OECD countries (Australia, Japan, USA and UK). We have used monthly stock price indices from September 1990 to June 2004 – subdivided into two groups (before and after the Asian crisis) – to determine the effect of the crisis. Using the Johansen ML approach, we have found that the seven Asian markets are integrated with the Australian, Japanese, US and UK markets separately. We have also found that the integration has increased after the Asian crisis.

Keywords: Asian crisis, cointegration, unit root.

JEL Classification: G15, C22, C51, C52


Are Stock Markets Integrated? Evidence from a Partially Segmented ICAPM with Asymmetric Effects

Mohamed El Hedi Arouri

In this paper, I test a partially segmented ICAPM for two developed markets, two emerging markets and world market, using an asymmetric extension of the multivariate GARCH process of De Santis and Gerard (1997,1998). I find that this asymmetric process provides a significantly better fit of the data than a standard symmetric process. The evidence obtained from the whole period and sub-periods analysis supports the financial integration hypothesis and suggests that domestic risk is not a priced factor.

Keywords: International Asset Pricing, Financial Integration, Emerging Markets, Multivariate GARCH.

JEL Classification : F36; C32; G15


Portfolio Theory and Portfolio Management:A Synthetic View

Dipasri Ghosh, Dilip K. Ghosh 

This work revisits the analysis of portfolio theory, originally brought out by Harry Markowitz and A. D. Roy, and then it takes the analytical structures beyond the Markowitz and Roy paradigms of mean-variance efficiency frontier. Selection- and revision-theoretic analysis against the backdrop of utility maximization is then presented, and comparative static exercises are performed to examine the effects of expected changes in asset prices on the optimal configuration of resultant portfolio structure. In this examination, effects of price changes are decomposed into Hicksian income effects and substitution effects. The final section shows that theoretical constructs and practitioners’ works are not really divorced from each other. In fact, it is pointed out that the practical management of portfolios is deeply rooted in the theoretical work.

Keywords: mean-variance efficiency frontier, risk aversion,  safety-first, capital market line, security market line.

JEL Classification: G11


Hedging of Exchange Rate Risk: A Note

Udo Broll, Stefan Schubert

Using a risk management framework, a model is presented in which currency futures markets for a less common currency, in which exports are invoiced, does not exist. However, the exporting firm can cross-hedge by using future contracts of other countries’ currencies correlated to the spot exchange rate in question. The main purpose of the study is to show the effectiveness of an optimal cross-hedge strategy of an international firm.

Keywords: exchange rate risk, currency futures markets, cross-hedge.

JEL Classification : F21, F31

Marginal Conditional Stochastic Dominance between Value and Growth

  1. Victor Chow, Bih-Shuang Huang, Ou Hu

Marginal Conditional Stochastic Dominance (MCSD) is an extension of the second order stochastic dominance that considers the joint nature of return distributions. It is a useful tool for examining marginal dominance of one asset to another conditionally to a given market return distribution for all risk-averse investors.  MCSD is superior to conventional market models in that it requires no modeling specification and is distributional free.  Although the size and value effect of equity portfolio performance has been well documented, most of analysis relies on statistical regression description and/or linear factor models.  This manuscript applies MCSD to re-exanimate the size/value effects for international equity markets.  The empirical MCSD test reveals that U.S. value stocks outperformed the market and dominated growth stocks for the post 1975 period.  However, the phenomenon of value over growth is generally insignificant in markets around the world, and it varies with different valuation criteria.

Keywords:  Value, Size, Stochastic Dominance, and Portfolio Selection.

JEL Classification:  G11, G14

Call and Put Implied Volatilities and the Derivation of Option Implied Trees

  1. Moriggia S. Muzzioli C. Torricelli

Resting on the stylized fact that call and put prices imply different volatilities, the present paper proposes a methodology for the derivation of  an arbitrage free implied tree that takes into account the information in both option classes. Specifically, we derive an implied tree that is characterised by interval values for the stock prices and we endogenously imply the corresponding artificial probabilities based on the risk neutral valuation argument. The implied tree obtained is then calibrated to market option prices by means of a non-linear optimisation routine. The methodology proposed is tested both in and out of sample using DAX index options data. Numerical results are benchmarked to the Derman and Kani’s approach. The comparison suggests that the methodology proposed in this paper, by taking into account the informational content of both call and put prices, highly improves both the in sample fitting and the out of sample performance.

Keywords: Implied Binomial Tree, Smile Effect, Interval Tree.

JEL classification: G13, G14.

Multicriteria Framework for the Prediction of Corporate Failure in the UK

Constantin Zopounidis Michael Doumpos,Fotios Pasiouras

This study investigates the efficiency of two multicriteria decision aid methods, namely UTADIS and MHDIS in the development of business failure prediction models in the UK, as opposed to models developed with discriminant analysis and logistic regression. The dataset consists of 200 manufacturing UK firms out of which 100 failed during the period 2001-2003. The models are developed and validated using 10-fold cross validation. The results show that UTADIS and MHDIS achieve satisfactory classification accuracies, while both outperform logistic regression and discriminant analysis. Thus, the developed MCDA models could be of particular interest to creditors, investors, auditors and regulators in the UK

Keywords: Bankruptcy, Failure, Multicriteria decision aid, Prediction, UK. 

JEL codes: G33, C63

The Information Content of Cross-sectional Volatility for Future Market Volatility: Evidence from Australian Equity Returns

Md. Arifur Rahman

This paper presents research into the information content of firm-level and industry-level cross-sectional volatility (CSV) of daily equity returns for future market-level volatility in Australia. Using a conditional volatility framework that allows for commonly observed excess kurtosis in asset returns, we find that CSV does contain information beyond what is already contained in the lagged market-level return shocks and has a significant positive relationship with the conditional market volatility. Our analysis gives new empirical evidence that the effect of CSV is stronger in relatively stable market conditions than in more volatile market conditions. We also examine how the information content of stock turnover and aggregate company announcements compares with that of CSV, and take a novel data-driven approach to verify whether CSV captures any information about multiple common factor shocks in asset returns. The explanatory power of CSV for future market volatility remains robust even after controlling for the effects of stock turnover, company announcements and omitted factor shocks in returns.

Keywords: Incremental information, Conditional market volatility, Cross-sectional volatility, Stock turnover, Multiple common factor shocks

JEL Classification: G12, G14

The Effect of Price Limits on Unconditional Volatility:The Case of CASE

Medhat Hassanein  Eskandar A. Tooma

This nonparametric policy-shift event study examines the relationship between symmetric price limit mechanisms and stock market volatility. We investigate price dynamics on the Cairo and Alexandria Stock Exchange (CASE), where three different limit regimes were in place between 1994 and 2004. We find when price limits are made tighter (looser) by regulators stock market volatility is usually not lower (higher).    These results contradict the widely held view among regulators that restrictive price limits can moderate volatility.  We attribute the source of higher volatility that the CASE experienced, during the tightest limit regime, to volatility on subsequent trading days increasing as limits prevent large one-day price changes. Previous research has referred to this phenomenon as the “volatility spillover” of daily price limits.

Keywords: Price Limits, Circuit Breakers, Stock Market Volatility, Egyptian Stock Exchange.

JEL Classifications: G14, G15, G18

Introduction to the European Internal Market :An abstract of the present development of the European Internal Market

Dr. Wolfgang Berger – DDr. Marian Wakounig – Mag. Caroline Kindl

Since 1 January 1993, when the Internal Market was created, a supposedly “transitional” VAT arrangement has been applicable to trade in the Community. Initially the system was intended to remain in force for four years, but it is still with us and there is no sign of any changes in the pipeline.

The first chapter of this paper deals with the historical development of the European Internal Market in concerns with VAT regulations. It explains the ongoing from the initially planned origin principle to the now applicable transitional VAT system realising the destination principle. Furthermore material-substantive and legal procedural problems as well as practical difficulties of the current VAT system are discussed. The last chapter presents an overview of the planned simplification and modernisation measures set forth by the European Commission. Over all it is clear that the Commission will focus its efforts on adapting the “transitional” VAT arrangements instead of designing a new system based on the origin principle.

Keywords: Valued added tax (VAT), Internal Market, intra-Community trade

JEL Classification: K 34

The Impact of Value Added Tax on Financial Services and Insurances – the Law of Unintended Consequences ?

Arthur Kerrigan

The EU’s common value added tax system exempts most main stream financial services including insurances and investment fund management. The precise reasons for the exemption have never been set out but whilst it has been variously attributed to economic or social policy considerations, the main one seems to be the technical complexity inherent in taxing financial services. To some extent the Directive reflects an uncertain approach in that it also allows Member States to grant taxable persons the option of taxing these services. Nevertheless, the general practice of the last thirty years has been exemption. This article looks at some aspects of the way in which the exemption is handled in practice by Member States, focusing on the methodologies used for calculating the recoverable portion of input tax. Although the VAT Directive seems to envisage harmonisation of the deductible proportion, it is questionable as to whether this is actually the case in practice. The reality is that exemption produces growing tax revenue for national treasuries because of the inability of financial institutions to recover the bulk of their input tax. In so far as this is effectively a tax on business as opposed to a tax on final consumption, the existence of a uniform basis of assessment is difficult to establish.

JEL Classification: H20, H30, and H50

Keywords: indirect taxation, value added tax, financial services, European Union.

Economic Growth and Indirect Financial Taxes. Empirical Evidence from Greece, Spain and Portugal.

Athena  K. Kaliva – Radu Tunaru

In this paper we examine the effects of consumption and financial taxes on economic growth in Greece, Spain and Portugal, testing some theoretical predictions and assumptions derived from the neo-classical and endogenous growth mechanisms. Theoretically, a permanent increase in tax revenues (as a percentage of gdp) will permanently reduce the growth rate of real gdp, according to the endogenous growth theory, but not in the neo-classical model, where the rate of growth will be affected only temporarily, the only permanent effect being a decrease in the level of the real gdp. Using data for Greece, Spain and Portugal in a cointegrating VAR framework we obtain results that are closer to the theoretical prediction of the neo-classical model rather than to that of the endogenous growth theory. The results for Portugal were slightly contradictory (only for the consumption taxes).

JEL Classification: H20, H30

Keywords: indirect taxation, financial taxation, and growth.

The Causal Relationship between Indirect Taxes and Expenditures: A Comparative Investigation of Greece, Spain and Portugal

Athena  K. Kaliva – Radu Tunaru

In this paper the causal relationship between indirect tax revenues and expenditures is examined for Greece, Spain and Portugal using cointegration and error correction methodology. Our aim is to investigate the impact on expenditures of two different categories of indirect taxes: taxes that fall only on final consumption and taxes that may fall on intermediate and investment goods. The empirical results support a bi-directional causality between indirect financial taxes and expenditures in Spain and Portugal. This implies that the decision to apply indirect taxes on financial services and the decisions to spend, in the two countries, are jointly made. However, for Greece the decision to spend Granger causes consumption taxes.

Keywords: indirect taxation, expenditures, financial taxation, cointegration, Granger causality

JEL Classification: H20, H30, and H50

Corporate Taxation and Futures-Hedging

Udo Broll – Jack E. Wahl

This paper analyzes hedging behavior of a risk averse management in the presence of corporate taxation. We demonstrate that risk-taking may increase when corporate tax rates increase and, therefore, the incentive for financial hedging decreases. Furthermore we show that speculative and pure hedging is differently affected by corporate taxation. A higher risk may reduce the tax-induced incentive to revise a hedge. In this context tax policy of the European Union is discussed.

JEL classification: F21, F31, H20

Keywords: Hedging, risk-taking, corporate taxation, differential taxation, tax harmonization.

Comparing Effective Corporate Tax Rates

Gaëtan Nicodème


This paper investigates various methodologies for computing effective corporate tax rates. All methodologies present strengths and shortcomings. In addition, they also provide different rankings of countries as they measure different concepts. This paper also uses an unexploited database on financial statements of companies to compute effective corporate tax rates for eleven European countries, the US, and Japan. It reveals that there are large differences between statutory and effective taxation, as well as between countries for different sectors and sizes of companies. Finally, it suggests that effective corporate tax rates are sensitive to the business cycle.

Keywords: Corporate taxation, effective taxation.

JEL classification: H25.

The Impact of EU Law on National Dividend Tax Systems

Evgenia Chatziioakeimidou


This paper examines the impact of EU law on national dividend tax systems. The aim is to bring to light incompatibilities of national legislations that restrict the free movement of capital. The different stages of control of EU law application are presented in detail, supported by well-established case law. Along these lines, it is possible to track the problematic areas of existing dividend tax systems which dissuade shareholders from investing their capital in different Member States and which discourage companies from raising capital across Europe.

The analysis shows that Member States tend to comply with EU law requirements following infringement procedures or preliminary rulings of the Court of Justice (ECJ). Although great progress has been achieved this way, it is preferable for investors that conditions of legal certainty be created either by adopting legislation at community level or by co-ordinating the national dividend tax systems.

Jel Classification: Κ34, Η24, Η25

Keywords :Internal Market, Tax Law, ECJ Case Law, Dividends taxation, Personal Income Taxation, Company Taxation

Fundamental Capital Valuation for IT Companies:A Real Options Approach

Chung Baek, Brice Dupoyet, Arun Prakash


This study attempts to estimate the fundamental capital value of a growing firm by combining two separate capital valuation techniques, namely the corporate debt valuation of Merton (1974) and the rational pricing technique of internet companies of Schwartz and Moon (2000). For simplicity, the Black and Scholes (1973) approach is used to infer an estimate of the value of the debt of the firm, while the valuation technique  of Schwartz and Moon (2000) has been used to estimate the total value of the firm. Making use of the fact that firm value is a function of the value of debt and equity, we first derive a closed-form solution for the value of the debt and then estimate the implied fundamental equity values for sample firms in the information technology sector, and show how the share prices are either undervalued or overvalued. Inferences on the risk premium on the debt are also provided.

Keywords : Fundamental valuation, Real options, Monte Carlo simulation

JEL Classification : G3, G12, G31, M13, M41

Statistical Inference for Risk-Adjusted Performance Measure

Miranda Lam


This paper examines the statistical properties of and significance tests for a popular risk-adjusted performance measure, the M-squared measure.  Test statistics along with asymptotic moments and probability distributions developed by prior studies are reviewed and their applications to the M-squared measure are discussed.  This paper demonstrates through an example that calculation of the analytic test statistic and the corresponding p-value can be performed easily using a spreadsheet or mathematical software.  Results of significance tests using bootstrapping are similar to those based on the analytic solutions, suggesting that the analytic solution approach is a useful method for conducting statistical inference.  The results appear relatively robust even in small samples.

Keywords: Performance Evaluation, Hypothesis Testing, Mutual Funds

JEL Classification: C12, G12

Intra-Day Stock Returns and Close-End Price Manipulation in the Istanbul Stock Exchange

Güray Küçükkocaoğlu


In this paper, we examine the behavior of the intra-daily stock returns and close-end stock price manipulation in the Istanbul Stock Exchange (ISE). Understanding the price behavior in a given trading day could help investors when they are making their buy and sell decisions. Studies of intra-daily returns have found that stock prices systematically rise near the closing minute and the last trade is more often initiated by a buyer. It is likely that a trader in the ISE with a big net position in a given day will want to enhance his performance by manipulating the closing price, this trader will try to improve his position by placing the last buy order. The possibility to artificially influence stock prices in the ISE is an important issue to everybody who is involved in stock trading securities exchanges, investors, brokers, the largest share holders etc. In order to test for the closing price manipulation by the traders in the ISE, we used a standard OLS regression model, which looks for the effects of the size of the daily traders net position in twenty-three stocks selected from the ISE National-30 index companies. If a trader acquires a large net position in one of these stocks during the trading day, it is possible that he tries to influence the closing price of the stock.  We find that, close-end price manipulation through big buyers and big sellers is possible in the ISE.

Keywords: Stock market returns; Closing Price; Manipulation; Istanbul Stock Exchange

JEL classification: C22, G1, G14, G15, G24

Relationship between Implied and Realized Volatility of S&P CNX Nifty Index in India

Siba Prasada Panda, Niranjan Swain, D.K. Malhotra


Measures of volatility implied in option prices are widely believed to be the best available volatility forecasts. According to the efficient market hypothesis, since implied volatilities are calculated based upon today’s pricing information, they contain the best information about the market. Therefore, implied volatilities are considered as the best representation of market expectations. Recently, Christensen and Prabhala (1998) found that implied volatility in “at-the-money” one month OEX call options on S&P 100 index is an unbiased and efficient forecast of ex-post realized index volatility after the 1987 stock market crash. In this paper, we examine the information content of call and put options on the S&P CNX Nifty index. We examine one month at-the-money call option from 4-June-2001 to 28-oct-2004. We find that implied volatility contains more information than past realized volatility. In other words the predictability of implied volatility is more than that of past realized volatility. In fact, implied volatility remains significant even in the multiple regressions where historical volatility is included. Thus, we find that it is an efficient albeit slightly biased estimator of realized return volatility.

Keywords: Implied Volatility, Realized Volatility, Two Stage Least Square

JEL Classification: C22, C53, G10

The Determinants of Commercial Bank Interest Margin and Profitability: Evidence from Tunisia

Samy Bennaceur, Mohammed Goaied


This paper investigates the impact of banks’ characteristics, financial structure and macroeconomic indicators on banks’ net interest margins and profitability in the Tunisian banking industry for the 1980-2000 period. Individual bank characteristics explain a substantial part of the within-country variation in bank interest margins and net profitability. High net interest margin and profitability tend to be associated with banks that hold a relatively high amount of capital, and with large overheads. Size is found to impact negatively on profitability which implies that Tunisian banks are operating above their optimum level. On the other hand, we found that macroeconomic variables have no impact on Tunisian bank’s profitability. Turning to financial structure and its impact on banks’ interest margin and profitability, we find that stock market development has a positive effect on bank profitability. This reflects the complementarities between bank and stock market growth. We have found that the disintermediation of the Tunisian financial system is favourable to the banking sector profitability. On the ownership side, we reach the conclusion that private banks tend to perform better than state owned ones. Finally, interest rate liberalization has contrasting effect on net interest margins. In fact, partial liberalization has a negative impact on the interest margin whereas complete liberalization strengthens the ability of Tunisian banks to generate profit margins.

Keywords: bank interest margin, bank profitability, panel data, Tunisia.

JEL Classification : G18, G21; O16

First Passage and Excursion Time Models for Valuing Defaultable Bonds: a Review with Some Insights

Martina Nardon


In structural models of defaultable bond pricing default occurs at the first time a relevant  process either reaches the default boundary or has spent continuously (or cumulatively) a fixed time period below that threshold. Unlike first-passage time approaches, excursion time models allow for a non-absorbing state of default. In this contribution, we provide a  generalization of both first-passage and excursion time approaches by defining the default time as the first instant at which the firm value process (or another signaling process) either remains a certain time below the default threshold or hits a lower barrier. This corresponds, for instance, to a situation in which a firm is temporarily allowed to be short of funds, but enters default immediately when the financial distress becomes severe. We also examine the effects of different default time specifications on bond prices and credit spreads.

Keywords: Credit risk, structural models, default boundary, first-passage time, excursion time.

JEL Classification: C15, C63, G12, G13.

Using Weekly Empirical Probabilities in Currency Analysis and Forecasting

Andrew C Pollock, Alex Macaulay, Mary E Thomson, Dilek Önkal


The Empirical Probability (EP) technique is proposed as an effective support tool to assist agents operating in a global fusion of financial markets. This technique facilitates the identification and prediction of primary, secondary and tertiary trends in addition to the recognition of trend reversals and the detection of changes in trend momentum. The suggested procedure is illustrated by deriving weekly (five-day) non-overlapping estimated probabilities from daily Euro/USD exchange rate data from 04/01/1999 to 31/12/2004 and applying these probabilities to the analysis and forecasting of exchange rate movements. In addition, trend characteristics of the data are used to develop a trading system that not only provides buy and sell indicators but also supplies directional probabilities associated with the signalled actions.

Key Words: Foreign Exchange, Forecasting, Investment Decisions

JEL Classification: F31, F47, G11 and G15

Financing and Valuation of a Marginal Project by a Firm Facing Various Tax Rates

Axel Pierru


A multinational firm operating under various tax regimes can minimize the total after-tax cost of its debt by allocating it optimally between its projects. To value a marginal project in this context, we build a multi-period model for the selection of projects, assuming that the firm maintains a target debt ratio on a firm-wide basis. To define a project’s adjusted present value, we successively adopt the Miles-Ezzell analysis and the Harris-Pringle analysis. We show that a project’s net present value results from the addition of two sums of cash flows discounted at the firm’s (marginal) after-tax WACC: the sum of the discounted expected after-tax operating cash flows and a sum of discounted differences in expected interest tax shields (multiplied by a simple adjustment factor in the Miles-Ezzell case). This valuation formula extends the field of application of the standard WACC method, since it can be applied to a project whose debt ratio differs from the firm’s target debt ratio.

Keywords: interest tax shields, adjusted present value, WACC, debt allocation, debt ratio

JEL Classification: G31, G32, C61

Dynamic Copula Modelling for Value at Risk

Dean Fantazzini


This paper proposes dynamic copula and marginals functions to model the joint distribution of risk factor returns affecting portfolios profit and loss distribution over a specified holding period. By using copulas, we can separate the marginal distributions from the dependence structure and estimate portfolio Value-at-Risk, assuming for the risk factors a multivariate distribution that can be different from the conditional normal one. Moreover, we consider marginal functions able to model higher moments than the second, as in the normal. This enables us to better understand why VaR estimates are too aggressive or too conservative. We apply this methodology to estimate the 95%, 99% VaR by using Monte-Carlo simulation, for portfolios made of the SP500 stock index, the Dax Index and the Nikkei225 Index. We use the initial part of the sample to estimate the models, and the the remaining part to compare the out-of-sample performances of the different approaches, using various back-testing techniques.

Keywords: Copulae, Value at Risk, Dynamic Modelling

JEL classification: G11, G12, G32

Computational Efficiency and Accuracy in the Valuation of Basket Options

Pengguo Wang


The complexity involved in the pricing of American style basket options requires careful consideration of both computational efficiency and accuracy. The conventional assumption of lognormal distribution for the value of a basket is the key for the trade-off. This paper examines the mispricing errors of Bermudan basket options based on the assumption. The mispricing error is measured by the price differences between the price resulting from the assumption of lognormal distribution and the “true” option price. The “true” option prices are obtained from simulation based on procedure described in Longstaff and Schwartz (2001). The effects on the maturities, the volatilities, the correlations, the dividend payments for the underlying assets, number of underlying assets in the basket and the “moneyness” on mispricing are addressed.

Key words: Basket option, Bermudan option, mispricing, lognormal, simulation

JEL classification: G12, G13

Forecasting VaR and Expected Shortfall using Dynamical Systems: A Risk Management Strategy

Cyril Caillault, Dominique Guégan


Using non-parametric and parametric models, we show that the bivariate distribution of an Asian portfolio is not stable along all the period under study. We suggest several dynamic models to compute two market risk measures, the Value at Risk and the Expected Shortfall: the RiskMetrics methodology, the Multivariate GARCH models, the Multivariate Markov-Switching models, the empirical histogram and the dynamic copulas. We discuss the choice of the best method with respect to the policy management of bank supervisors. The copula approach seems to be a good compromise between all these models. It permits taking financial crises into account and obtaining a low capital requirement during the most important crises.

Keywords: Value at Risk, Expected Shortfall, Copulas, Risk management,

GARCH models, Markov switching models.

JEL classification: C15, C32, C52, G28.

A Note on Stakeholder Theory and Risk: Implications for Corporate Cash Holdings and Dividend Policy

Gerhard Speckbacher, Paul Wentges


According to Zingales (1999), corporate governance is defined as the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by a firm. This paper argues that corporate cash holdings and dividend policy can be used as soft constraints in this regard in order to mitigate the holdup situation of corporate stakeholders and to enhance incentives for firm-specific investments in the face of high total firm risk. Hence stakeholder theory contributes to answering the question why firms choose conservative financial policies.

Key Words: Corporate Cash Holdings, Dividend Policy, Holdup, Risk, Stakeholder Theory.

JEL classification: G30.

The Mid 1990s Peso Crisis in Mexico: An Application of the Girton-Roper Model

Edward E. Ghartey


The Peso crisis is examined by using the exchange market pressure model (EMP) over the period 1971:1 – 1995:4. Different estimators are used to obtain robust results. Empirical findings indicate that an increase in domestic credit, crisis dummy and inflation rates leads to outflows of foreign reserves and/or depreciation of the peso, while an increase in foreign inflation and domestic income results in inflow of foreign reserves and appreciation of the peso. Sensitivity tests of the EMP to its composition between changes in exchange rate and foreign reserves, confirms that the Mexican economy absorbs the EMP through the loss of foreign reserves instead of the depreciation of the peso. This suggests that a fixed exchange rate regime is optimal for Mexico, and that timely external loans assistance from international institutions could have avoided the crisis. The later explains why Mexico recovered swiftly from the peso crisis after receiving external assistance.

Keywords: Mexico, exchange market pressure and peso crisis.

JEL Classification: C22, C32, E44, E65 and F31.

Cash Management Routines: Evidence From Spain

Txomin Iturralde, Amaia Maseda, Leire San-Jose


The purpose of this article is to provide an overview of corporate treasury management, understood as the application of cash management. The decision-making actions of treasury department heads are analysed and have been confirmed by empirical evidence. This article seeks to contribute to the ongoing debate in financial literature by analysing the extent to which the size of companies, the sectors in which they operate and the training of financial decision-makers influence treasury management. In this way, companies seek maximise results obtained by the treasury department and, therefore, maximise the value of the firm. The results confirm the idea that there is a culture of cash management and that whether or not new treasury management techniques are used depends more on the initiative of the treasury manager than on the size of the corporation, the sector to which it belongs or the training of the decision-maker.

Key Words: corporate finance, cash management, firm size, discriminant analysis, cluster analysis.

JEL Classification: G31, G32

Opportunity Cost, Excess Profit, and Counterfactual Conditionals

Carlo Alberto Magni


Counterfactual conditionals are cognitive tools that we incessantly use during our lives for judgments, evaluations, decisions. Counterfactuals are used for defining concepts as well; an instance of this is attested by the notions of opportunity cost and excess profit (residual income), two all-pervasive notions of economics: They are defined by undoing a given scenario and constructing a suitable counterfactual milieu. Focussing on the standard paradigm and Magni’s (2000, 2005, 2009a,b) proposal this paper shows that the formal translation of the counterfactual state is not univocal and that Magni’s model retains formal properties of symmetry, additive coherence, homeomorphism, which correspond to properties of frame-independence, time invariance, completeness. Two introductory studies are also presented to illustrate how people cope with these counterfactuals and ascertain whether either model is seen as more “natural”. A brief discussion of the results obtained is also provided.

Keywords: Opportunity cost, excess profit, residual income, counterfactual, modelling

JEL classification: A12, B41, D40, G11, G12, G31, M41

Why Do Monetary Policymakers Lean With the Wind During Asset Price Booms?

Wolfram Berger, Friedrich Kißmer


In this paper we explore the optimal policy reaction to an asset price boom. Empirical evidence shows that the monetary policy stance is typically loose during asset price booms. Employing a modified New Keynesian sticky price model we show that this policy of leaning with the wind can be attributed to the forward-looking nature of the private sector’s expectations. Agents incorporate the macroeconomic consequences of a looming asset price bust in their expectations. The expectation-induced deviations of output and inflation from their targets enforce a monetary loosening before the bust occurs. Furthermore, we argue that a policy of benign neglect towards asset price movements, as often advanced by monetary practitioners, is (generally) not optimal in welfare terms.

Keywords: monetary policy, asset prices, credit crunch, boom bust cycles, forward-looking behavior

JEL classification: E52, E58, E44


Further Evidence on the Impact of Economic News on Interest Rates

Dominique Guégan, Florian Ielpo


We investigate the shape of the term structure reaction of the US swap rates to announcements using several linear and non-linear time series models. We document the non-linearity of the market reaction to macroeconomic news. First, we find that the introduction of non linear models leads to the finding of a significant number of macroeconomic figures that actually produce an effect over the yield curve. Second, we noticed at least four types of patterns in the term structure reaction of interest rates across maturities, including the humpshaped one that is generally considered. Third, we propose a first interpretation and classification of these different shapes. Fourth we find that the existence of outliers in interest rates leads to an underestimation of the reaction of interest rates to announcements, explaining the different results obtained between high-frequency and daily datasets.

Keywords: Macroeconomic Announcements, Interest Rates Dynamic, Outliers, Reaction Function, Principal Component Analysis.

JEL classification: G14


Private Equity Firms’ Behaviours in Western Europe: Does Country Matter?

Abdesselam Rafik, Bastié Françoise, Cieply Sylvie


Using a unique dataset of private equity firms (PEFs), this paper analyses the investment behaviour of private equity fund managers. This paper uses a multi-country sample of PEFs to compare the approaches to investee valuation, contractual agreements and financial tools in Europe. Univariate analyses describe practices of PEFs and multivariate analyses identify groups of homogeneous countries i.e. countries where PEFs’ behaviours are similar. The comparison of these groups with traditional classifications based on legal regimes does not perform very well. This result can illustrate either the limits of the classification of countries based on legal regimes or the increasing integration of the most developed European countries that makes practices of financial actors converge across European countries.


Keywords: Private Equity, Legal Regimes, Investment Appraisal, Contractual Agreements, Financial Tools

JEL classification: G24, G30, D81, D82, G32, M13, M40


Money Supply in a Simple Economic Growth Model and Multiple Steady States Equilibria

Laurent Augier, Jalloul Sghari


We intend to examine a monetary economic growth model à la Sidrauski-Brock where money is introduced both in the utility function and the production function. We assume that utility is derived from the flow of services derived from real money holdings and that money is held by firms to facilitate production. We show that the level of equilibrium depends on the rate of discount. We give conditions to guarantee uniqueness of the equilibrium. We demonstrate that the unique equilibrium is either a classical « saddle point » or a « source point »; that the introduction of money in the utility and production function is sufficient to produce multiple stationary equilibria; and that the initial stock of money appears as an important economic control variable. Therefore, the initial amount of the monetary emission issued by the central bank becomes essential for the long run economic equilibrium properties.

Keywords: economic growth, money, multiple equilibria.

JEL classification : E13, E41, D90.


Consumer Welfare in the Deregulated Swedish Electricity Market

Jens Lundgren


The deregulation of the Swedish electricity market in 1996 affected both the market design and the pricing of electricity. Since 1996, the electricity price faced by consumers has increased dramatically. Due to the high electricity price and large company profits, a debate about the success of the deregulation has emerged. As such, the aim of this paper is to investigate whether or not the deregulation of the Swedish electricity market has improved consumers’ welfare. The theoretical framework is an equivalent variation method and the analysis is performed using monthly data for the period January 1996 to January 2007. The results indicate that deregulation has kept the power price (excluding taxes) down and increased consumer welfare in Sweden.

Keywords: Equivalent variation, Consumer welfare, Power market.

JEL classification: D60, L13, L43.


Electricity Traffic over the Barriers of Networks: The Case of Germany and The Netherlands

Hans Andeweg, André Dorsman, Kees van Montfort


Since the electricity market was liberalized at the end of the last century, the authorities no longer fix prices, and there is now a variable price determined by the market. Every system has its own price-forming process. However, these systems are not completely isolated. It is possible to have a restricted measure of electricity traffic between the systems. This article describes a value-creating trade strategy on the basis of the prices of electricity in The Netherlands and Germany, making use of the restricted electricity traffic between the two countries, providing empirical evidence on exploitable pricing inefficiencies in the electricity markets and potential trading strategies based thereupon. This research has not been conducted before and will provide a better understanding of the interaction between separate electricity markets.

Key words: Efficient markets, Electricity markets, Electricity traffic, Trade strategy

JEC classification: G14


Restructuring the European Energy Market through M&As – An Application of the Model of Economic Dominance

Wassim Benhassine


In 1998, the European Commission decided to deregulate the national electricity sector with the objective of creating a single energy market. This deregulation involved an important increase in M&As (Mergers & Acquisitions), leading to a large reorganization of the European electricity industry. Using the theory of economic dominance developed by R. Lantner in 1974 – a theory inspired by the graph theory – this article aims at gaining an insight into the M&A strategies of electricity firms in Europe between 1998 and 2003, and the way in which these strategies affected the industry at the European level. We found that European electricity firms increasingly used strategies of M&A to strengthen their economic dominance.

Key Words: Electricity industry, mergers, graph theory

JEL classification: F14, R15


The Two-Parameter Long-Horizon Value-at-Risk

Guy Kaplanski, Haim Levy


Value-at-Risk (VaR) has become a standard measure for risk management and regulation. In the case of a two-parameter distribution, a common method among practitioners is first to calculate the daily VaR and then to apply it to a longer investment horizon by using the Square Root Rule (SRR). We show that the SRR is theoretically incorrect and propose a correct measure. The error from employing the SRR is positive for short horizons, inducing an overestimation of the true VaR, and negative for longer horizons, inducing underestimation of the true VaR. This error is relatively small for conservative portfolios and for short horizons. However, for risky portfolios and for long horizons – where accurate VaR is most important – the underestimation error is both substantial and systematic.

Keywords: Risk analysis, Risk management, Value-at-Risk, Basel regulations, Square Root Rule.

JEL Classification: C10, C13, C46


Mitigation of Foreign Direct Investment Risk and Hedging

Jack E. Wahl, Udo Broll


Instruments of risk mitigation play an important role in managing country risk within the foreign direct investment (FDI) decision. Our study assesses country risk by state-dependent preferences and introduces futures contracts as a tool of risk mitigation. We show that foreign direct investment related country risk assessments do not matter if the multinational firm enters currency futures markets. Besides currency risk multinationals cross-hedge country risk via the derivatives market. This may explain the empirical result, why host country risk is not a significant determinant of FDI (Bevan/Estrin 2004) together with the fact that almost all (92 %) of the world’s top 500 companies enter derivatives markets for hedging purposes (ISDA 2008).

JEL Classification: F21, F23, G32

Keywords: state-dependency, country risk, foreign direct investment, hedging.


Evaluation and Comparison of Market and Rating Based Country Default Risk Assessment

Alexander Karmann, Dominik Maltritz


We compare two different approaches to assess country default risk by evaluating their forecast accuracy. In particular we analyze whether market based or rating based risk assessment is superior. To evaluate the forecast accuracy we analyze the differences between several default risk measures and realizations of defaults/non defaults in the forecast period. The considered risk measures are, on the one hand, default probabilities and binary crisis forecasts (default/non default), on the other. Within a sample of 19 emerging market countries in 1998 to 2007 we find that risk measures derived by reduced form credit risk models from market data outperform ratings of S&P.

Keywords: sovereign risk, ratings, yield spreads, forecast accuracy, country default

JEL classification: F34


To Outsource or Not To Outsource in North-South Trade

  1. Kwan Choi, Jai-Young Choi


This paper investigates outsourcing and foreign direct investment (FDI) decisions based on factor price differentials in North-South trade when the production is fragmented into two independent processes. It is shown that (a) when the Southern firm does not have the Northern firm-specific technology for a fragmentable process and capital is imperfectly (perfectly) mobile between countries, the Northern firm produces the final product by outsourcing the other fragmentable process from the South via FDI (either FDI or outsourcing to a Southern outsourcee); (b) when the Southern firm acquires the Northern firm-specific technology for the fragmentable process and capital is imperfectly (perfectly) mobile, only the Northern firm produces the final product by outsourcing the other process via FDI and drives out the Southern firm from the world market (both the Northern and Southern firms produce the final product); (c) in all the cases, outsourcing is unidirectional from the North to the South.

Keywords: outsourcing, north-south trade, foreign direct investment, fragmentable process

JEL Classification : F1, F2


Financial Deregulation, Private Foreign Borrowing and the Risk of Sovereign Default: A Political-Economic Analysis

Oya Celasun, Philipp Harms


It is often1argued that financial liberalization and large external borrowing by the private sector bode ill for sovereign creditworthiness. In this paper, we highlight a channel through which financial liberalization reduces the risk that a developing country’s government defaults on its foreign debt. We present a simple model in which a deregulation-induced surge in private borrowing raises the political costs of default and reduces a government’s incentive to deny repayment

Keywords: International Investment, Sovereign Risk.

JEL Classification: F34, O16


Should Minimum Portfolio Sizes Be Prescribed for Achieving Sufficiently Well-Diversified Equity Portfolios?

Lawrence Kryzanowski, Shishir Singh


This paper uses various (un)conditional metrics to measure the benefits of diversification to determine if a minimum portfolio size should be prescribed to achieve a naively but sufficiently well-diversified portfolio for various investment opportunity sets (un)differentiated by cross-listing status and market capitalization. Based on the population of stocks listed on the Toronto Stock Exchange (TSX) for 1975-2003, the study finds that the minimum portfolio size depends upon the chosen investment opportunity set, the metric(s) used to measure the benefits of diversification, and the criterion chosen to determine when the portfolio is sufficiently well diversified.

Keywords: diversification benefits, portfolio size, dispersion, Sharpe and Sortino ratios.

JEL Classification: G11, G23, C15, D81.


Are All Individual Investors Equally Prone to the Disposition Effect All the Time? New Evidence from a Small Market

Cristiana Cerqueira Leal, Manuel J. Rocha Armada, João L. C. Duque


This paper investigates the disposition effect on the Portuguese stock market, on the basis of a unique database that consists of trading records of 1496 individual investors. We found strong evidence of the disposition effect, studied on the basis of trades, volume and value traded. This preference for realizing gains to losses was observed every month of the year and globally for all individual investors. Even at the end of the fiscal year, the disposition effect still holds, as opposed to the evidence found in other markets. We also studied the disposition effect related to market tendency. By dividing the data period into a bull and a bear period, we found evidence of disposition effect for both periods, but with differences in terms of its intensity. In the bull market period, the disposition effect is even more evident than in the bear market. We believe these results can be explained with behavioral reasons. We also investigated the disposition effect related to proxies of investors’ sophistication. We divided investors on the basis of the trading frequency, volume of transactions and portfolio value and found evidence that investors in the higher percentiles are less prone to the disposition effect than the ones in the lower percentiles, even though both exhibit evidence of this effect.

Keywords: Disposition Effect; Investor Behavior; Individual Investors; Market Trends, Small Markets.

JEL Classification: G11; G12; G14.


Would You Follow MM or a Profitable Trading Strategy?

Brian Baturevich, Gulnur Muradoglu


We investigate the ability of company capital structures to be used as a predictor for abnormal returns. We carry out robustness tests to determine the predictive ability of debt ratios, controlling for size of company, price-toearnings (PE) ratio, market-to-book value ratio (MTBV) and beta. We show that companies in the lowest leverage decile, exhibit the highest abnormal returns – 17% over a three-year period. A strategy of choosing the smallest companies with the lowest leverage yields cumulative abnormal returns (CARs) in excess of 80% over three years.

Keywords: Capital Structure, leverage, abnormal returns, trading strategy

JEL Classification: G11, G12, G17


Size, Book-to-Market, Volatility and Stock Returns: Evidence from Amman Stock Exchange (ASE)

Walid Saleh


Fama and French (1998) investigated the superiority of value-glamour strategy in 13 developed markets as well as in 16 emerging markets. They confirmed the value premium in 12 out of 13 developed markets. However, they hesitated to give a reliable conclusion concerning the emerging market returns for two reasons. First, they used a short time period sample, nine years. Second, they argued that such emerging market returns suffer from high volatility. This paper aims to investigate the value premium using data from Amman Stock Exchange during the period 1980-2000. In particular, this study seeks to examine the validity of value-glamour strategy using book-to-market equity and explore the effect of stock volatility on portfolio returns. This contribution to the extant literature is significant since it introduces stock volatility as a potential explanation of value premium. The study provides evidence suggesting that the value-glamour strategy does not work in Amman Stock Exchange. Consistent with Fama and French’s (1998) prediction, stock volatility has an impact in explaining the difference in returns between value and glamour stocks. In addition, the study shall provide evidence showing that the underperformance of value-glamour strategy in Amman Stock Exchange is mainly related to stock volatility.

Keywords: Contrarian strategies, book-to-market, behavioral finance, stock volatility, emerging market returns.

JEL classification: G15


An Examination of Life Insurers’ Risk Attitudes

Yaffa Machnes


This paper presents evidence of a significant positive relationship between the ratios of life insurance premiums quoted to smokers relative to the premiums quoted to non-smokers, and the financial strength of the insurance company. This suggests that life insurers reveal increasing relative risk aversion. Key words: risk aversion, life insurance, premium quotes.

JE classification: D81, D92, G2


Can Market Actors Help Monitor European Banks?

Anissa Naouar


This paper focuses on the use of equity market information for the monitoring of European banks. To this end, we conduct two event studies: 1) whether equity market variables can in a timely manner  anticipate changes with a constructed rating- proxy of the supervisory rating- named ‘Financial Situation Evaluation’ (FSEvaluation), for audited banks, 2) whether Rating Agencies (RAs) can help monitor European banks during the period 1990-2006. Results show that equity market returns help to anticipate, several quarters in advance, a balance-sheet-based evaluation. However, they issue a counterintuitive signal when European banks are facing a negative evaluation of their risk and/or capital position. RAs have an additional role especially effective in summarising positive information. However, RAs are shown to take time to downgrade banks. Finally, results find evidence that investors’ behaviour is, at least in part, encouraged by a “too big to fail” policy from which large European banks benefit.

Key words: Equity market information, rating agencies, event study, Bank monitoring

JEL classification: G14, G18, G21


Quantitative vs. Qualitative Criteria for Credit Risk Assessment (forthcoming paper)

João O. Soares, Joaquim P. Pina, Manuel S. Ribeiro, Margarida Catalão-Lopes


The existing vast literature on credit risk assessment and default prediction provides models building mostly in quantitative indicators. We present the results of a survey carried out of experts from the main banks in Portugal, conveying evidence on the dominant procedures undertaken by the Portuguese banking system. Our analysis concludes on the relevance of qualitative criteria, particularly management’s experience and reliability, and on their significant negative correlation with banks’ default records. Within this context the paper reflects on the role of multi-criteria decision analysis (MCDA) models as a way to process credit risk assessment integrating qualitative and quantitative aspects.

Keywords: banking; credit risk; qualitative criteria; multi-criteria decision analysis.

JEL Classification: C12; C22; C44; G21; G32


Models for Moody’s Bank Ratings (forthcoming paper)

Anatoly Peresetsky, Alexander Karminsky


The paper presents an econometric study of the two bank ratings assigned by Moody’s Investors Service. According to Moody’s methodology, foreign-currency long-term deposit ratings are assigned on the basis of Bank Finan-cial Strength Ratings (BFSR), taking into account ―external bank support factors‖ (joint-default analysis, JDA). Models for the (unobserved) external support are presented, and we find that models based solely on public infor-mation can approximate the ratings reasonably well. It appears that the ob-served rating degradation can be explained by the growth of the banking sys-tem as a whole. Moody’s has a special approach for banks in developing countries in general and for Russia in particular. The models help reveal the factors that are important for external bank support.

Keywords: Banks, Ratings, Rating model, Risk evaluation, Early Warning System

JEL Classification: G21, G32


Real Interest Rate and Growth Rate: Theory and Empirical Evidence (forthcoming paper)

Jean-Marie Le Page*


This study presents an assessment of the links between the real interest rate and the growth rate. In the first part of the paper we recall the theoretical foundations of these links. In the second part, we compare empirical data with the predictions of the theory. The real interest rate should exceed the growth rate in the long run. This hierarchy has important consequences on the public finances. The Solow-Ramsey-Cass model fits better to the data than the endogenous growth theory. Furthermore, the Sixties and Seventies have been a time of transitory dynamics with real interest rates lower than the growth rates.

Keywords: real interest rate, growth rate, time preference rate, productivity of capital, debt burden

JEL classification: E22, E43, E44, O41


M1, M2, and the U.S. Equity Exchanges (forthcoming paper)

Ali M. Parhizgari

Duong Nguyen


We study the relative positions of M1 and M2 in light of their relationships with four U. S. equity exchanges: S&P500, Dow Jones Industrial, Nasdaq, and Wilshire 5000 composite. It is demonstrated that a long-term equilibrium relationship does indeed exist. Short-run dynamics are also considered and are found to be temporary departures from the long-run equilibrium. Based on a model, which yields robust estimated results and is thus considered well behaved, the direction of causality is established. The model is then put further to test to check the predictive power of the M1 and M2 money aggregates. Based on a set of in- and out-of-sample forecast experiments, the results overwhelmingly indicate that M2 is a better predictive measure and hence a superior indicator than M1. The policy implications of these findings in light of the post financial crisis and the November 2010 US Fed “quantitative easing” policies are discussed.

Keywords: Money supply, M1, M2, Stock return, Granger causality, Error Correction Model, Forecasting.

JEL Classification: E50, E51, E52.


Dynamic Copulas and Long Range Dependence (forthcoming paper)

Beatriz Vaz de Melo Mendes

Silvia Regina Costa Lopes


This paper extends the evolution equation of Patton (2006) for the time variation of the copula parameters by specifying an autoregressive fractionally integrated term. For any copula parameter there is a suitable one-to-one transformation so that the maximum likelihood estimation method may be employed. It is suggested an exploratory tool based on the copula data cross-products for detecting the presence of long range dependence on the copula level of real data. We simulate from copula models possessing long range dependence and work out two examples using real data. Modeling long range dependence on the level of dynamic copulas has the potential for providing improved forecasts and are useful for financial and economic applications.

Keywords: Long Memory, Conditional Copulas, Time Series, Financial Applications.

JEL classification: C22, C51, G10.


Real Interest Rate and Growth Rate: Theory and Empirical Evidence (forthcoming paper)

Jean-Marie Le Page*


This study presents an assessment of the links between the real interest rate and the growth rate. In the first part of the paper we recall the theoretical foundations of these links. In the second part, we compare empirical data with the predictions of the theory. The real interest rate should exceed the growth rate in the long run. This hierarchy has important consequences on the public finances. The Solow-Ramsey-Cass model fits better to the data than the endogenous growth theory. Furthermore, the Sixties and Seventies have been a time of transitory dynamics with real interest rates lower than the growth rates.

Keywords: real interest rate, growth rate, time preference rate, productivity of capital, debt burden

JEL classification: E22, E43, E44, O41


Can Credit Risk Be Rated Through-the-Cycle?

Karlo Kauko


Since the introduction of Basel II, it has been argued that the use of internal credit risk models in banks may strengthen the procyclicality of the financial system. This problem could be alleviated by using through-the-cycle (TTC) ratings. A TTC rating ignores cyclical fluctuations of credit risk. The existence of transitory cyclical fluctuations in corporate credit risk at the company level in Moody’s KMV data on Finnish publicly listed companies is tested. The evidence is mostly negative. The distance-to-default of a typical company seems to follow a unit root process. In most cases company level credit risk does not follow cycles with a predictable regularity, and companies that suffered most from the previous downturn may not benefit particularly strongly from the following upturn. Due to continuous entry and exit of firms, average credit risk can be stationary even if the distance-to-default of each individual company is a unit root process.

Keywords: Through-the-cycle rating, Credit risk, Distance to default, Procyclicality

JEL classification: E44, G21, G33


A Probit Model for Insolvency Risk among Insurance Companies

Leo de Haan, Jan Kakes


We estimate a probit model of insolvency risk, using a dataset of about 400 Dutch insurance companies during the period 1995-2005. The results suggest that surplus capital, company size, profitability, long-tailed business and being a mutual insurer reduce the risk of insolvency. The model can be used to identify insurers with high insolvency risk one year ahead. It is shown that the choice of the threshold above which an insurer is classified as having high insolvency risk, is an important determinant of the relative occurrence of type I and type II prediction errors. We use a loss function to find the optimal threshold given the supervisor’s relative preference with respect to missing insolvencies and false alarms.

Keywords: Probit model, Insolvency risk, Insurance

JEL Classification: G22, G32


Derivatives Use and Analysts’ Earnings Forecast Accuracy

Salma Mefteh-Wali, Sabri Boubaker, Florence Labégorre


This paper examines whether the use of derivatives improves firms’ information environment, which is a relatively under-investigated research area in risk management literature. Using a sample of French non-financial listed firms, we show that firms which use derivatives enjoy high levels of forecast accuracy relative to firms that do not. This result is in accord with the arguments developed by DeMarzo and Duffie (1995) and Breeden and Vishwanathan (1998) suggesting that hedging is an important means of reducing information asymmetry.

Keywords: Hedging, Derivatives use, Analysts’ forecasts; France

JEL Classification: F31, G32


In Search of the “Lost Capital”. A Theory for Valuation, Investment Decisions, Performance Measurement

Carlo Alberto Magni


This paper presents a theoretical framework for valuation, investment decisions, and performance measurement based on a nonstandard theory of residual income. It is derived from the notion of “unrecovered” capital, which is here named “lost” capital because it represents the capital foregone by the investors. Its theoretical strength and meaningfulness is shown by deriving it from four main perspectives: financial, microeconomic, axiomatic, accounting. Implications for asset valuation, capital budgeting and performance measurement are investigated. In particular: an aggregation property is shown, which makes the simple average residual income play a major role in valuation; a dual relation between the standard theory and the lost-capital theory is proved, clarifying the way periodic performance is computed in the two paradigms and the rationale for measuring performance with either paradigm; the average accounting rate of return is shown to be more reliable than the internal rate of return as a capital budgeting criterion, and maximization of the average residual income is shown to be equivalent to maximization of Net Present Value (NPV). Two metrics are also presented: one enjoys the nice property of robust goal congruence irrespective of the sign of the cash flows; the other one enjoys periodic consistency in the sense of Egginton (1995). The results obtained suggest that this theory might prove useful for real-life applications in firm valuation, capital budgeting decisions, ex post performance measurement, incentive compensation.

Keywords: Residual income, valuation, capital budgeting, performance measurement, lost capital, accounting rate, average, Economic Value Added.

JEL classification : M41, G11, G12, G31, M21, M52, D46.


When is Inter-trade Time Informative? A Structural Approach

Tao Chen


This paper reinvestigates the role of inter-trade time in price discovery. The GH model (Glosten & Harris, 1988), the VAR model (Hasbrouck, 1991a), the MRR model (Madhavan et al., 1997), and the HS model (Huang & Stoll, 1997) are extended by the parameterization (Dufour & Engle, 2000) to analyze a cross-sectional sample of 472 composite stocks of the NIKKEI 500 on the Tokyo Stock Exchange (TSE). My results indicate that the price impact is negatively related to inter-trade time without model selection bias. Additionally, I find that the inter-trade time effect reveals an inverse U-shaped intraday pattern.

Keywords: Information Content, Inter-Trade Time, Trading Intensity, Tokyo Stock Exchange

JEL Classification: C32, G12, G14


Exploiting Intraday and Overnight Price Variation for Daily VaR Prediction

Ana Marı´a Fuertes, Jose Olmo


This study investigates the practical importance of several VaR modeling and forecasting issues in the context of intraday stock returns. Value-at-Risk (VaR) pre- dictions obtained from daily GARCH models extended with additional information such as the realized volatility and squared overnight returns, are confronted with those from ARFIMA realized volatility models. The out-of-sample evaluation is based on a novel difference-in-proportions test that exploits the frequency of individual VaR re- jections and a block-bootstrap unconditional coverage test that is robust to estimation uncertainty and model risk. We find that the overnight surprise does not improve the out-of-sample forecastability of the next-day VaR but there is evidence that intraday jumps have forecasting potential. ARFIMA models produce better backtesting results than GARCH models but the latter fare better in terms of independence of the hits sequence. Encompassing tests further suggest that GARCH and ARFIMA models can be fruitfully combined to produce more competitive VaR measures. The techniques are illustrated for a small portfolio of large-cap stocks.

Keywords: Encompassing;High-frequencydata;Modeluncertainty;Realizedvolatility; RiskManagement

JEL Classification: C52;C53;G15


A Case for Europe: the Relationship between Sovereign CDS and Stock Indexes

María Coronado, Teresa Corzo, Laura Lazcano


In 2010 we witnessed a major European sovereign debt crisis. By examining the links between sovereign Credit Default Swaps and stock indexes for eight European countries during the period 2007-2010, this paper studies the lead-lag relationships of the two markets which represent a country’s credit and market risk. Through the use of a Vector Autoregressive model and a panel data model we find that the stock market plays a leading role during the sample period, but when 2010 is isolated a change in this relationship appears: a key role of sovereign CDS markets – the incorporation of new information – emerges. This phenomenon is most significant in countries with high risk spread.

Keywords: sovereign credit risk, sovereign credit derivatives, stock markets, lead-lag relationships.

JEL classification: G15, G14, G20



Optimal Hedge Ratio Estimation during the Credit Crisis: An Application of Higher Moments

Nicholas Apergis, Alexandros Gabrielsen


This study aims to investigate and provide further insight into the dynamics of higher moments in the estimation of optimal hedge ratios during the recent credit crisis period by applying the Gram-Charlier expansion series. Furthermore, it compares the performance of the proposed model with conventional hedge ratio methodologies such as: OLS, GARCH and univariate and multivariate GARCH models. The empirical application is performed on spot and futures data on the FTSE 100 and FTSE/ATHEX 20 indices by comparing the in- and out-of-sample hedging effectiveness. The selection of the FTSE/ATHEX 20 index was on the premise that the Greek equity market experienced a prolonged period of extreme movements during the credit crisis period. Overall, the results indicate that the application of the proposed model increases the performance of the hedges in terms of in- and out-of-sample variance reduction.

Keywords: Optimal hedge ratios; conditional volatility; skewness and kurtosis; higher moments; equity indices

JELClassification: G13, G10, C32


The Effect of Derivative Instrument Use on Capital Market Risk: Evidence from Banks in Emerging and Recently Developed Countries

Mohamed Rochdi Keffala, Christian de Peretti, Chia-Ying Chan


This study investigates the use of derivative instruments by banks in both emerging and recently developed countries in terms of capital market risk. Overall, the results indicate that the use of options increases total return risk and unsystematic risk, while the use of forwards and futures decreases total return risk. Swaps, in the meantime, negatively affect systematic risk. The main conclusion is that banks in the sample do not appear to be at risk by using derivative instruments.

Keywords: Derivatives, Bank, Capital market risk, Panel econometrics.

JEL classification: G21; G32.


Book Review

Financial Aspects in Energy: A European Perspective. Edited by André Dorsman, Wim Westerman, Mehmet Baha Karan and Özgür Arslan. Berlin Heidelberg: Springer Verlag, 2011. Pp. viii, 231. ISBN 978-3-642-19708-6.

Is energy destiny? Evidently, earlier in history it was. According to Malanima (2006), in Europe in the first half of nineteenth century, access to fossil fuels, and the rise in the consumption and productivity of energy associated with innovations in transforming energy into work, “laid the foundation for a new age of growth.”

What are the prospects for the European Union today, when it (1) imports more than 50 percent of the energy that it consumes, (2) lacks secure sources of energy, and (3) must grapple with the impact of energy consumption on the environment? Despite the uncertainty shrouding any answer, today one may argue that the European Union has some advantages over many countries around the world in that

it has recognized the significance of energy dependence, energy security, and environmental damage associated with energy use and has implemented reforms over the past decade. From a finance perspective, on energy matters where does the EU stand today?



Revisiting Idiosyncratic Volatility and Stock Returns

Fatma Sonmez


This paper’s aim is to revisit the relation between idiosyncratic volatility and future stock returns. There are three key findings: First, we confirm earlier studies which show a negative relation. Further we show that it is the month to month changes in idiosyncratic volatility that produce this observed relation. More specifically, a portfolio of stocks that move from a lower (higher) idiosyncratic volatility quintile to higher (lower) one earns positive (negative) abnormal returns. Eliminating all firm-month observations with idiosyncratic volatility quintile changes, we find a positive relation. Second, we link our findings with corporate related events. Third, we find that after 2000, the idiosyncratic volatility effect disappears.

Keywords: Idiosyncratic volatility; stock abnormal returns; change in idiosyncratic volatility.

JEL Classification: G12, G13.


What’s Wrong with Those Duration Measures? Nothing.

Robin Grievesa, J. Clay Singletonb


In this article, we demonstrate that standard and effective durations for bonds without embedded options are not equal. The two measures are nearly always different. The difference can be large enough to be of consequence in some applications. Additionally, we show that the only consistent measure of duration, one that aggregates correctly when yield curves are not flat, is effective duration.

Keywords: Bonds, interest rate risk, duration

JEL classification: G12


Structural Breaks and Predictive Regressions Models of South African Equity Premium

Goodness C. Ayea, Rangan Guptaa, Mampho P. Modise


In this paper, we test for the structural stability of both bivariate and multivariate predictive regression models for equity premium in South Africa over the period of 1990:01 to 2010:12, based on 23 financial and macroeconomic variables. We employ a wide range of methodologies, namely, the popular Andrews (1993) statistic and the Bai (1997) subsample procedure in conjunction with the Hansen (2000) heteroskedastic fixed-regressor bootstrap. We also used the Elliott and Müller (2003) statistic and Bai and Perron (1998, 2003a, 2004) methodologies. We find strong evidence of at least two structural breaks in 22 of 23 bivariate predictive regression models. We also obtain evidence of structural instability in the multivariate predictive regression models of equity premium. Our results also show that the predictive ability of the 23 variables can vary widely across different regimes.ˆ

Keywords: Predictive regression model, equity premium, structural breaks, South Africa

JEL Classification: C22, C52, C53, G12


A Three-Stage Labour-Managed Cournot Duopoly with Lifetime Employment as a Strategic Commitment

Kazuhiro Ohnishi


This paper studies the effectiveness of lifetime employment as a strategic commitment in a three-stage Cournotmodelwith twoidentical labour-managed income-per-worker-maximizing firms. In the first stage, one labour-managed firm is allowed to offer lifetime employment.In the second stage, the other labour-managed firm is allowed to offer lifetime employment. In the third stage, both firms simultaneously and independently chooseand sell actual outputs.The paper then finds that the introduction of lifetime employment into the analysis of the quantity-setting labour-managed duopoly model is profitable for bothfirms.

Keywords:Labour-managed firm; Three-stage Cournotmodel; Lifetime employment

JEL classification:C72; D21; L20