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 Annals of FinanceJournal Prestige (SJR): 0.579 Citation Impact (citeScore): 1Number of Followers: 37      Hybrid journal (It can contain Open Access articles) ISSN (Print) 1614-2454 - ISSN (Online) 1614-2446 Published by Springer-Verlag  [2658 journals]
• Bank business models, negative policy rates, and prudential regulation

Abstract: Using data from Italian banks over the period 2011–2017, we study how negative interest rate policy and prudential regulation impact on bank business models. We report four key findings. First, banks shifted into retail- and market-oriented business models. Second, high- and low-deposit banks reduced loans and increased security/liquid assets; only market-oriented banks expanded lending. Third, interest rate income compression induced by negative rates has been substantial for the Italian banking system as a whole, although retail banks seem to have suffered less. Fourth, non-interest incomes played a compensatory effect. The portfolio reshuffling, as we observed for wholesale and retail banks (less lending and more securities/liquid assets), is related to the goal of reducing risk exposures and, in turn, the connected capital absorption required by prudential regulation.
PubDate: 2021-10-13

• Welfare implications of mitigating investment uncertainty

Abstract: This study explores the welfare implications of mitigating investment uncertainty in the context of Easley and O’Hara (Rev Financ Stud 22:1817–1843, 2009) While one may expect welfare gains by encouraging participation in financial markets by ambiguity-averse investors, we formally show that it hurts other investors and thus is not Pareto-improving without appropriate income transfers. We also examine the welfare effects of income redistribution among heterogeneous investors and government spending on investor education.
PubDate: 2021-09-15
DOI: 10.1007/s10436-021-00395-3

• Performance of advanced stock price models when it becomes exotic: an
empirical study

Abstract: We calibrate several advanced stock price models to a time series of real market data of European options on the DAX. Via a Monte Carlo simulation, we price barrier down-and-out call options for all models and compare the modeled prices to given real market data of the barrier options. The Bates model reproduces barrier option prices very well. The BNS model overvalues and Lévy models with stochastic time-change and leverage undervalue the exotic options. The Heston model and a local volatility model undervalue the barrier option prices by about 5–6%. A heuristic analysis suggests that the different degree of fluctuation of the random paths of the models are responsible of producing different prices for the barrier options. Higher margins or additional risks like liquidity, calibration or model risk might economically explain why many advanced models undervalue barrier options.
PubDate: 2021-08-28
DOI: 10.1007/s10436-021-00396-2

• Deposit insurance and reinsurance

Abstract: We study the consequences and optimal design of bank deposit insurance and reinsurance in a general equilibrium setting. The model involves two production sectors, financed by bonds and bank loans, respectively. Financial intermediation by banks is required in the model as we assume that one of the production sectors is risky and requires monitoring by banks. Households fund banks through deposits and equity. Deposits are explicitly insured and banks pay a premium per unit of deposits. Any remaining shortfall is implicitly guaranteed by the government. Two types of equilibria emerge: One type of equilibria supports the Pareto optimal allocation. In the other type, bank lending and the default risk are excessively large. The intuition is as follows: the combination of financial intermediation by banks, limited liability of bank shareholders, and deposit insurance makes deposits risk-free from the individual households’ perspective, although they involve risk from the societal point of view. This distorts investment choices and the resulting input allocation to production sectors. We show, however, that a judicious combination of deposit insurance and reinsurance eliminates all non-optimal equilibrium allocations. Our paper thus may provide a benchmark result for policy proposals advocating deposit insurance cum reinsurance.
PubDate: 2021-07-29
DOI: 10.1007/s10436-021-00387-3

• On the money creation approach to banking

Abstract: We study today’s two-tier money creation and destruction system: Commercial banks create bank deposits (privately created money) through loans to firms or asset purchases from the private sector. Bank deposits are destroyed when households buy bank equity or when firms repay loans. Central banks create electronic central bank money (publicly created money or reserves) through loans to commercial banks. In a simple general equilibrium setting, we show that symmetric equilibria yield the first-best level of money creation and lending when prices are flexible, regardless of monetary policy and capital regulation. When prices are rigid, we identify the circumstances in which money creation is excessive or breaks down and the ones in which an adequate combination of monetary policy and capital regulation can restore efficiency. Finally, we provide a series of extensions and generalizations of the results.
PubDate: 2021-07-27
DOI: 10.1007/s10436-021-00385-5

• Fractional Barndorff-Nielsen and Shephard model: applications in variance
and volatility swaps, and hedging

Abstract: In this paper, we introduce and analyze the fractional Barndorff-Nielsen and Shephard (BN-S) stochastic volatility model. The proposed model is based upon two desirable properties of the long-term variance process suggested by the empirical data: long-term memory and jumps. The proposed model incorporates the long-term memory and positive autocorrelation properties of fractional Brownian motion with $$H>1/2$$ , and the jump properties of the BN-S model. We find arbitrage-free prices for variance and volatility swaps for this new model. Because fractional Brownian motion is still a Gaussian process, we derive some new expressions for the distributions of integrals of continuous Gaussian processes as we work towards an analytic expression for the prices of these swaps. The model is analyzed in connection to the quadratic hedging problem and some related analytical results are developed. The amount of derivatives required to minimize a quadratic hedging error is obtained. Finally, we provide some numerical analysis based on the VIX data. Numerical results show the efficiency of the proposed model compared to the Heston model and the classical BN-S model.
PubDate: 2021-07-13
DOI: 10.1007/s10436-021-00394-4

• Model uncertainty on commodity portfolios, the role of convenience yield

Abstract: This paper investigates the effect of model uncertainty on the performance of commodity-based portfolios. We consider a constant relative risk aversion (CRRA) utility maximizer investor in a complete market, with independent ambiguity-aversion levels for the three factors explaining the term structure of future prices, namely, spot prices, convenience yield (CY) and interest rates (IRs), as proposed in the seminal work of Schwartz (J Finance 52(3): 923–973, 1997). This generic investor is interested in the speculative component of the investment rather than possessing/consuming the physical commodity. We obtain closed-form solutions for optimal investments, optimal perturbations (alternative model) and value functions in line with the robust portfolio setting of Maenhout (Rev Financial Stud 17(4): 951–983, 2004). Our main focus is on the effect of convenience yield’s uncertainty on the optimal analysis. We estimate the model by applying a combination of maximum likelihood estimation (MLE) and Kalman Filter (KF) techniques, to two commodities: West Texas Intermediate (WTI) and copper future prices. The analysis demonstrates that uncertainty on the CY factor could be the largest contributor to the under-performance of a commodities portfolio, with wealth equivalent losses (WELs) in the ranges of 33% to 88% (WTI), and 7% to 31% (copper). Moreover, small variations, of up 25%, on CY’s covariance parameters could lead to a WEL of up to 40% (WTI, lesser volatility of CY).
PubDate: 2021-07-07
DOI: 10.1007/s10436-021-00393-5

• Systemic risk measurement: bucketing global systemically important banks

Abstract: The general consensus on the need to enhance the resilience of the financial system has led to the imposition of higher capital requirements for certain institutions, supposedly based on their contribution to systemic risk. Global Systemically Important Banks (G-SIBs) are divided into buckets based on their required additional capital buffers ranging from 1% to 3.5%. We measure the marginal contribution to systemic risk of 26 G-SIBs using the Distressed Insurance Premium methodology proposed by Huang et al. (J Bank Financ 33:2036–2049, 2009) and examine ranking consistency with that using the SRISK of Acharya et al. (Am Econ Rev 102:59–64, 2012). We then compare the bucketing using the two academic approaches and supervisory buckets. Because it leads to capital surcharges, bucketing should be consistent, irrespective of methodology. Instead, discrepancies in the allocation between buckets emerge and this suggests the complementary use of other methodologies.
PubDate: 2021-07-07
DOI: 10.1007/s10436-021-00391-7

• Birds of a feather: separating spillovers from shocks in sovereign default

Abstract: In this paper, I propose a tractable model of sovereign default and the inter-state spillovers emanating from default. A coalition of nations may choose to insure against default, and the behavior of the coalition is used to examine the magnitude of the international spillovers. A voting structure for the coalition is proposed to examine idiosyncratic spillovers. The model is calibrated to the recent Greek Debt crisis to understand the spillovers from a default, and the moral hazard effect of the Troika. I find that spillover effects are large. If the rest of the world defaulted, this would create a loss equivalent to a permanent 9% decrease in government spending. Counterfactual experiments reveal that default would be prevalent without the IMF, suggesting that the own-penalty to defaulting has decreased since the IMF’s creation.
PubDate: 2021-06-23
DOI: 10.1007/s10436-021-00392-6

• Economic profitability and (non)additivity of residual income

Abstract: We show that the standard notion of residual income (RI) does not fulfill additive coherence. This gives rise to ambiguities and inconsistencies. The pitfall resides in the capital charge, which blends a non-market value with a market rate. We solve the problem by using a capital charge based on economic return, obtained as the product of a market value and a market rate. The resultant economic RI enjoys additivity. The economic RI is naturally associated to the average Return on Investment (ratio of total income to total invested capital). Subtracting the respective cost of capital (ratio of total economic return to total invested capital) the marginal economic efficiency of the capital is correctly captured. Economic RI guarantees consistency among the various sets of incomes, book values, economic values, accounting rates, and costs of capital, under an investment perspective as well as a financing one, both at a period level and at an aggregate level, either assuming time-invariant or time-varying costs of capital. Therefore, the economic RI offers a coherent tool for the assessment of a project’s or firm’s economic efficiency.
PubDate: 2021-06-18
DOI: 10.1007/s10436-021-00388-2

• A stock market model based on CAPM and market size

Abstract: We introduce a new system of stochastic differential equations which models dependence of market beta and unsystematic risk upon size, measured by market capitalization. We fit our model using size deciles data from Kenneth French’s data library. This model is somewhat similar to generalized volatility-stabilized models. The novelty of our work is twofold. First, we take into account the difference between price and total returns (in other words, between market size and wealth processes). Second, we work with actual market data. We study the long-term properties of this system of equations, and reproduce observed linearity of the capital distribution curve. In the “Appendix”, we analyze size-based real-world index funds.
PubDate: 2021-05-31
DOI: 10.1007/s10436-021-00390-8

• Valuation of R&amp;D compound option using Markov chain approach

Abstract: Incorporation of technical risk in compound real options has been considered in Cassimon et al. (2011) concerning the valuation of multi-stage pharmaceutical R&D. There, the technical success probabilities at each development stage were assumed to be generated independently of each other. This assumption can be unrealistic in many applied problems, pharmaceutical R&D included. We present a valuation procedure dealing with dependent success probabilities and random development stage times. This greater flexibility allows a better description of the sequence of decision stages and results, which in turn, impact the value of the considered project. The theoretical results are illustrated through a numerical example that shows the implementation of the model to a pharmaceutical R&D problem.
PubDate: 2021-05-31
DOI: 10.1007/s10436-021-00389-1

• Blind portfolios’ auctions in two-rounds

Abstract: This paper proposes a two-stage sealed-bid model for the execution of portfolios. An asset manager auctions a portfolio of securities to a set of brokers who are unaware of the specific details about individual securities. We prove that our mechanism may reduce the costs of execution for the asset manager and may mitigate the “winner’s curse” for participating brokers.
PubDate: 2021-04-12
DOI: 10.1007/s10436-021-00386-4

• Equilibrium asset pricing and the cross section of expected returns

Abstract: In a mean-variance framework with a representative agent, any linear model for the cross section of expected returns can be supported as an equilibrium as long as the market portfolio is spanned by the factor mimicking portfolios. Any set of factors is admissible as long as the spanning condition is satisfied. Factors based on size, book-to-market, momentum, investment, profitability, behavioral biases, principal components, or any combination of these can be used as equilibrium factors. An equilibrium model with M risk factors can be reduced to a collection of M models where each model has a single risk factor, which is covariance with the market portfolio.
PubDate: 2021-03-24
DOI: 10.1007/s10436-021-00383-7

• A volatility smile-based uncertainty index

Abstract: We propose a new uncertainty index based on the discrepancy of the smile of FX options. We show that our index spikes near turbulent periods, forecasts economic activity and its innovations hold a significant and negative equity premium. Unlike other uncertainty indexes, our index is supported by equilibrium models, which relate the difference of options prices across moneyness to uncertainty. Moreover, our index is based on investment decisions, can be easily and continuously updated and is comparable across countries.
PubDate: 2021-03-12
DOI: 10.1007/s10436-021-00384-6

• On modifications of the Bachelier model

Abstract: Mathematically, stock prices described by a classical Bachelier model are sums of a Brownian motion and an absolute continuous drift. Hence, stock prices can take negative values, and financially, it is not appropriate. This drawback is overcome by Samuelson who has proposed the exponential transformation and provided the so-called Geometrical Brownian motion. In this paper, we introduce two additional modifications which are based on SDEs with absorption and reflection. We show that the model with reflection may admit arbitrage, but the model with an appropriate absorption leads to a better model. Comparisons regarding option pricing among the standard Bachelier model, the Black–Scholes model and the modified Bachelier model with absorption at zero are executed. Moreover, our main findings are also devoted to the Conditional Value-at-Risk based partial hedging in the framework of these models. Illustrative numerical examples are provided.
PubDate: 2021-01-18
DOI: 10.1007/s10436-020-00381-1

• Revisiting the link between financial development and industrialization:
evidence from low and middle income countries

Abstract: The paper uses a dynamic panel model to analyze the relationship between financial development and industrialization in the context of low and middle income countries between 1970 and 2014. The results indicate that the relationship between the two is non-linear. More precisely, the results indicate that financial development has a negative effect on industrial development up to a point, after which the effect turns positive. This evidence of a “U-shaped” relationship emphasizes the centrality of financial development in the industrialization process in developing economies, but it also points to the complex nature of the relationship.
PubDate: 2020-11-09
DOI: 10.1007/s10436-020-00376-y

• Heterogeneous beliefs, monetary policy, and stock price volatility

Abstract: In this paper, I build a two-agent New Keynesian model in which households with subjective and objective beliefs about capital gains from stock prices exist. The former type of households constructs their beliefs about expected capital gains by Bayesian learning from observed growth rates of stock prices. In a homogenous agent model with only subjective beliefs, the effect of the interest rate on stock prices tends to be unrealistically strong. I show how the presence of heterogeneity improves second moments of stock prices with realistic moments of business cycle properties. This quantitative improvement in stock price behaviors allows me to conduct a realistic analysis of how the stance of monetary policy affects stock price volatilities. Strong inertia of monetary policy provides the stability of stock prices. This is because the near-term real interest rate has dominant effects on stock prices under the presence of subjective beliefs since the presence limits the forward-looking nature in pricing stocks. However, because output depends on the expected path of the real interest rate in the forward-looking manner, strong monetary policy inertia does not necessarily provide stabilities of stock prices and output at the same time.
PubDate: 2020-11-09
DOI: 10.1007/s10436-020-00379-9

• Two price economic equilibria and financial market bid/ask prices

Abstract: Demand and supply uncertainty lead to a model of markets that set prices to acceptable risk levels for excess supplies and net revenues. The result is a two price partial equilibrium economy. The equilibrium solutions are applied to two price financial market data to infer demand and supply elasticities and log normal volatilities from market quotes on bid and ask prices. Demand elasticities are observed to be higher than supply elasticities as are the volatilities. Normalizing observed volatilities to the volatility of the daily traded volume a market implied duration of the economic equilibrium is inferred. The median level of duration is around a minute and half with an interquartile range from 37 s to 2 min. For larger orders, bid and ask prices may be constructed by calibrating the demand and supply volatilities.
PubDate: 2020-11-09
DOI: 10.1007/s10436-020-00377-x

• Panel data modeling of bank deposits

Abstract: Studying the dynamics of deposits is important for three reasons: first, it serves as an important component of liquidity stress testing; second, it is crucial to asset-liability management exercises and the allocation between liquid and illiquid assets; third, it is the support for a Liquidity at Risk methodology. Current models are based on $$\textit{AR}(1)$$ processes that often underestimate liquidity risk. Thus, a bank relying on those models may face failure in an event of crisis. We propose an alternative approach for modeling deposits, using panel data and a momentum term. The model enables the simulation of a variety of deposit trajectories, including episodes of financial distress, showing much higher drawdowns and realistic liquidity at risk estimates, as well as density plots that present a wide range of possible values, corresponding to booms and financial crises. Therefore, this methodology is more suitable for liquidity management at banks, as well as for conducting liquidity stress tests.
PubDate: 2020-10-06
DOI: 10.1007/s10436-020-00373-1

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