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FEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
There is overwhelming evidence that the expectations hypothesis (EH) does not describe how long yields are determined in practice. We take this evidence at face value and ask how long yields might be set, if not by the EH. We explore the possibility that the EH fails because short yield expectations are subject to behavioral biases, rather than because the hypothesis that long yields are determined by expected short rates is false. To explore this idea, we draw on the well-established literature on behavioral finance that has been developed to explain the stylized features of short-term momentum and long-term return reversals in equity returns. We focus on two particular classes of behavioral models – those based on the representativeness bias and the conservatism bias – and derive the testable implications of these models for expectations in the bond market. In contrast with the equity market – where the markets’ expectations of earnings are not observable – expectations of the short yield can be imputed from the term structure of interest rates. The bond market therefore offers a valuable opportunity to directly test the implications of behavioral models for expectational errors. We find that the predictions of these models are strongly supported by the data, suggesting that investors in the bond market are indeed subject to these behavioral biases.
To read the paper, click HERE.
Anirut Pisedtasalasai (University of Canterbury, New Zealand)
FEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
In this paper, the authors investigate return and volatility spillover effects between large and small stocks in the UK stock market using the multivariate AR-GJR GARCH-M model. They find that the returns and volatilities of large stocks are important in predicting the future dynamics of smaller stocks, but that the returns and volatilities of smaller stocks have much less impact on the future dynamics of large stocks. Their empirical results suggest that information flow has an influence on the pattern of the transmission mechanisms between large and small stocks. Market-wide information is first incorporated into the prices of large stocks before being impounded into the prices of small stocks.
To read the paper, click HERE.
Paolo Vitale (Università D’Annunzio and CEPR)
FEATURED IN PROFESSIONAL INVESTOR
Abstract
Order flow based models seem to offer a promising route to understanding the dynamics of exchange rates. Certainly, R²s of nearly 70% as we have found here are likely to dazzle even the most estimation-weary exchange rate economist. Nevertheless, disentangling the information and liquidity effects that may underlie the explanatory power of order flow is a challenging task. With respect to previous studies based on the analysis of reduced form models we propose an improvement in that our analysis is based on the estimation of a structural model of exchange rate determination.
While a first look at the correlations between order flow, exchange rate returns and innovations in the interest rate differential can suggest an information-based interpretation of the effect of trade innovations on the exchange rate, our investigation indicates that order flow explains very little in terms of information or fundamentals. The relationship between order flow and exchange rates seems to be almost totally due to liquidity effects and not to any information contained in order flow.
To read the paper, click HERE.
FEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
In this paper the authors propose a definition of financial fragility as a combination of high probability of default (PD) and low bank profitability. This definition is modelbased in the sense that in an economy with maximising agents and banks as described in Goodhart et al (2004, 2005 and 2006 a) when, following a shock to an exogenous variable, aggregate endogenous default increases and banks’ profits decrease, agents’ welfare falls. An economy is, therefore, more financially fragile (or equivalently less financially stable) if agents’ welfare decreases following an exogenous shock that induces distress in the financial system. The authors run comparative statics exercises based on a simplified version of the model. Specifically, they introduce a set of reduced-form equations describing households’ behaviour to be able to calibrate the model against UK data. They use output as a proxy for agents’ welfare and simulate a series of shocks to the economy under two alternative assumptions: (1) banks are constrained by capital adequacy requirements (2) they are not. When banks do not have to comply with CARs, shocks that induce a decline in banks profits and an increase in banks’ default rates also produce a fall in GDP. Under the assumption of capital adequacy constraints, most shocks do not result in a fall in bank profits. The reason for this is that banks need to maintain or top up their capital, and they do this by choosing (riskier) investments that raise their profits. Finally, the authors investigate whether data support our claim that banking sector’s distress induces welfare losses (i.e. a drop in GDP). Shocks to banks’ probability of default and equity values have a impact on output that is significant and has the expected sign.
To read the paper, click HERE.
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Featured Research - Winter 2007
Can Behavioural Finance Explain the Term Structure Puzzles?
George Bulkley, Richard D. F. Harris, Vivekanand NawosahFEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
There is overwhelming evidence that the expectations hypothesis (EH) does not describe how long yields are determined in practice. We take this evidence at face value and ask how long yields might be set, if not by the EH. We explore the possibility that the EH fails because short yield expectations are subject to behavioral biases, rather than because the hypothesis that long yields are determined by expected short rates is false. To explore this idea, we draw on the well-established literature on behavioral finance that has been developed to explain the stylized features of short-term momentum and long-term return reversals in equity returns. We focus on two particular classes of behavioral models – those based on the representativeness bias and the conservatism bias – and derive the testable implications of these models for expectations in the bond market. In contrast with the equity market – where the markets’ expectations of earnings are not observable – expectations of the short yield can be imputed from the term structure of interest rates. The bond market therefore offers a valuable opportunity to directly test the implications of behavioral models for expectational errors. We find that the predictions of these models are strongly supported by the data, suggesting that investors in the bond market are indeed subject to these behavioral biases.
To read the paper, click HERE.
Return and Volatility Spillovers Between Large and Small Stocks in the UK
Richard D. F. HarrisAnirut Pisedtasalasai (University of Canterbury, New Zealand)
FEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
In this paper, the authors investigate return and volatility spillover effects between large and small stocks in the UK stock market using the multivariate AR-GJR GARCH-M model. They find that the returns and volatilities of large stocks are important in predicting the future dynamics of smaller stocks, but that the returns and volatilities of smaller stocks have much less impact on the future dynamics of large stocks. Their empirical results suggest that information flow has an influence on the pattern of the transmission mechanisms between large and small stocks. Market-wide information is first incorporated into the prices of large stocks before being impounded into the prices of small stocks.
To read the paper, click HERE.
An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates
Francis Breedon (Tanaka Business School, Imperial College London)Paolo Vitale (Università D’Annunzio and CEPR)
FEATURED IN PROFESSIONAL INVESTOR
Abstract
Order flow based models seem to offer a promising route to understanding the dynamics of exchange rates. Certainly, R²s of nearly 70% as we have found here are likely to dazzle even the most estimation-weary exchange rate economist. Nevertheless, disentangling the information and liquidity effects that may underlie the explanatory power of order flow is a challenging task. With respect to previous studies based on the analysis of reduced form models we propose an improvement in that our analysis is based on the estimation of a structural model of exchange rate determination.
While a first look at the correlations between order flow, exchange rate returns and innovations in the interest rate differential can suggest an information-based interpretation of the effect of trade innovations on the exchange rate, our investigation indicates that order flow explains very little in terms of information or fundamentals. The relationship between order flow and exchange rates seems to be almost totally due to liquidity effects and not to any information contained in order flow.
To read the paper, click HERE.
Towards a measure of financial fragility
Dimitrios P. Tsomocos (Sa ï d Business School, University of Oxford), Oriol Aspachs (London School of Economics), Charles A.E. Goodhart (London School of Economics), Lea Zicchino (Bank of England)FEATURED IN PROFESSIONAL INVESTOR [WINTER 2007]
Abstract
In this paper the authors propose a definition of financial fragility as a combination of high probability of default (PD) and low bank profitability. This definition is modelbased in the sense that in an economy with maximising agents and banks as described in Goodhart et al (2004, 2005 and 2006 a) when, following a shock to an exogenous variable, aggregate endogenous default increases and banks’ profits decrease, agents’ welfare falls. An economy is, therefore, more financially fragile (or equivalently less financially stable) if agents’ welfare decreases following an exogenous shock that induces distress in the financial system. The authors run comparative statics exercises based on a simplified version of the model. Specifically, they introduce a set of reduced-form equations describing households’ behaviour to be able to calibrate the model against UK data. They use output as a proxy for agents’ welfare and simulate a series of shocks to the economy under two alternative assumptions: (1) banks are constrained by capital adequacy requirements (2) they are not. When banks do not have to comply with CARs, shocks that induce a decline in banks profits and an increase in banks’ default rates also produce a fall in GDP. Under the assumption of capital adequacy constraints, most shocks do not result in a fall in bank profits. The reason for this is that banks need to maintain or top up their capital, and they do this by choosing (riskier) investments that raise their profits. Finally, the authors investigate whether data support our claim that banking sector’s distress induces welfare losses (i.e. a drop in GDP). Shocks to banks’ probability of default and equity values have a impact on output that is significant and has the expected sign.
To read the paper, click HERE.
<< BACK