Research articles for the 2019-07-07

Density of the set of probability measures with the martingale representation property
Dmitry Kramkov,Sergio Pulido

Let $\psi$ be a multi-dimensional random variable. We show that the set of probability measures $\mathbb{Q}$ such that the $\mathbb{Q}$-martingale $S^{\mathbb{Q}}_t=\mathbb{E}^{\mathbb{Q}}\left[\psi\lvert\mathcal{F}_{t}\right]$ has the Martingale Representation Property (MRP) is either empty or dense in $\mathcal{L}_\infty$-norm. The proof is based on a related result involving analytic fields of terminal conditions $(\psi(x))_{x\in U}$ and probability measures $(\mathbb{Q}(x))_{x\in U}$ over an open set $U$. Namely, we show that the set of points $x\in U$ such that $S_t(x) = \mathbb{E}^{\mathbb{Q}(x)}\left[\psi(x)\lvert\mathcal{F}_{t}\right]$ does not have the MRP, either coincides with $U$ or has Lebesgue measure zero. Our study is motivated by the problem of endogenous completeness in financial economics.

Exchange Rate Reconnect
Lilley, Andrew,Maggiori, Matteo,Neiman, Brent,Schreger, Jesse
The failure to find fundamentals that co-move with exchange rates or forecasting models with even mild predictive power -- facts broadly referred to as "exchange rate disconnect'' -- stands among the most disappointing, but robust, facts in all of international macroeconomics. In this paper, we demonstrate that U.S. purchases of foreign bonds, which did not co-move with exchange rates prior to 2007, have provided significant in-sample, and even some out-of-sample, explanatory power for currencies since then. We show that several proxies for global risk factors also start to co-move strongly with the dollar and with U.S. purchases of foreign bonds around 2007, suggesting that risk plays a key role in this finding. We use security-level data on U.S. portfolios to demonstrate that the reconnect of U.S. foreign bond purchases to exchange rates is largely driven by investment in dollar-denominated assets rather than by foreign currency exposure alone. Our results support the narrative emerging from an active recent literature that the US dollar's role as an international and safe-haven currency has surged since the global financial crisis.

Existence of the Oman Line in the Empty Quarter of Saudi Arabia and Its Continuation in the Red Sea
Derakhshani, Reza,Farhoudi, Godratollah
The broad structural discontinuity known as the Oman Line extends NNE from Oman across the Strait of Hormuz and divides the flysch-rich eugeosynclinal sediments of the Makran Ranges in the east from the miogeosynclinal shelf sediments of the Zagros Mountain Ranges to the west. The Zagros Crush Zone, west of the Oman Line, marks the location of a continent/continent-style active margin where the Arabian Platform has collided with the Eurasian Plate to the north. To the east, the active margin is a continent/ocean-style boundary where the oceanic lithosphere of the Indian Ocean is being subducted beneath the Central Iranian Microcontinent and other more easterly microcontinental blocks. Geological investigations in the Arabian Plate indicate the presence of a NE-SW trending lineament. This lineament is also recognized on geophysical maps by aligned highs and lows, steep contours gradients and linear offset of trends. There are some indications suggesting that this lineament could represent a SW extension of the Oman Line from Oman across the Empty Quarter (Rub al Khali) of Saudi Arabia to eventually form a transform fault in the Red Sea.

Forecasting security's volatility using low-frequency historical data, high-frequency historical data and option-implied volatility
Huiling Yuan,Yong Zhou,Zhiyuan Zhang,Xiangyu Cui

Low-frequency historical data, high-frequency historical data and option data are three major sources, which can be used to forecast the underlying security's volatility. In this paper, we propose two econometric models, which integrate three information sources. In GARCH-It\^{o}-OI model, we assume that the option-implied volatility can influence the security's future volatility, and the option-implied volatility is treated as an observable exogenous variable. In GARCH-It\^{o}-IV model, we assume that the option-implied volatility can not influence the security's volatility directly, and the relationship between the option-implied volatility and the security's volatility is constructed to extract useful information of the underlying security. After providing the quasi-maximum likelihood estimators for the parameters and establishing their asymptotic properties, we also conduct a series of simulation analysis and empirical analysis to compare the proposed models with other popular models in the literature. We find that when the sampling interval of the high-frequency data is 5 minutes, the GARCH-It\^{o}-OI model and GARCH-It\^{o}-IV model has better forecasting performance than other models.

Market Impact and Performance of Arbitrageurs of Financial Bubbles in An Agent-Based Model
Westphal, Rebecca,Sornette, Didier
We analyse the consequences of predicting and exploiting financial bubbles in an agent-based model, with a risky and a risk-free asset and three different trader types: fundamentalists, noise traders and "dragon riders" (DR). The DR exploit their ability to diagnose financial bubbles from the endogenous price history to determine optimal entry and exit trading times. We study the DR market impact as a function of their wealth fraction. With a proportion of up to 10%, DR are found to have a beneficial effect, reducing the volatility, value-at-risk and average bubble peak amplitudes. They thus reduce inefficiencies and stabilise the market by arbitraging the bubbles. At larger proportions, DR tend to destabilise prices, as their diagnostics of bubbles become increasingly self-referencing, leading to volatility amplification by the noise traders, which destroys the bubble characteristics that would have allowed them to predict bubbles at lower fraction of wealth. Concomitantly, bubble-based arbitrage opportunities disappear with large fraction of DR in the population of traders.

Precautionary Student Borrowing: Hometown Unemployment and Student Loans
Schwartz, Andrew,Bleemer, Zachary
We present a novel partial explanation for the sixfold increase in student borrowing since 2003: precautionary borrowing. Using a stylized model, we show that annual federal loan limits can induce students whose families face unemployment risk to borrow more today. We then use a new dataset of individually-identified student financial aid records from a large US public university to test our theory of precautionary borrowing. Individually-identified student records allow us to control for both student fixed effects and exclude students whose families were directly implicated by unemployment shocks. Among students whose parents' employment status did not change, we find that a 1 standard deviation increase in local unemployment rates corresponds to a 10% increase in the amount borrowed. A back-of-the-envelope calculation suggests that precautionary borrowing accounted for $21 billion of new student borrowing per year during the Great Recession.

Reshaping the Financial Network: Externalities and Redistribution Effects in Central Clearing
Briukhova, Olga,D'Errico, Marco,Battiston, Stefano
This paper argues that the post-crisis infrastructural reform mandating central clearing of standardized over-the-counter derivatives impacts the valuation of a derivative contract and leads to unintended value redistribution effects among market participants. In a theoretical model, we show how the exogenously imposed change in the market structure affects counterparty risk and funding costs of different types of market participants. Specifically, we find that netting is beneficial for relatively high-quality counterparties, but counterparties with low creditworthiness are better off from accumulating larger gross positions. Further, even though a CCP interposes itself between a buyer and a seller of a derivative contract, precisely in times of distress the network of expected exposures between CCP members becomes fully connected. Our results highlight that mutualization of risks and resources in a CCP leads to externalities between the members.

The Credit-Risk Relevance of Bank Loan Loss Provisions Under IFRS 9: Early Evidence
Oberson, Romain
Since the first fiscal quarter of 2018, financial institutions have implemented a new expected credit loss (ECL) model under International Financial Reporting Standard (IFRS) 9 that replaces the International Accounting Standard (IAS) 39 incurred-loss model. The major difference in provisioning approaches between the two models is the incorporation of forward-looking information under the IFRS 9 ECL model. This article examines whether IFRS 9 improves the credit-risk relevance of loan loss provisions (LLP) for credit default swap (CDS) market participants. The findings suggests that LLP are marginally more credit-risk relevant under IFRS 9 than IAS 39. Moreover, LLP under IFRS 9 affect to a greater extent the pricing of credit risk for longer CDS maturities compared to the IAS 39 regime. This finding is consistent with the IFRS 9 ECL model, providing a more forward-looking measure of credit risk. Finally, institutional features play a significant role in the relevance of accounting information. Under IAS 39, LLP were more informative for the pricing of credit risk in countries with strong official supervisory power, suggesting fewer opportunities for an improvement in the credit-risk relevance of LLP for those countries. Consistent with this argument, the analysis shows that the credit-risk relevance of LLP is particularly enhanced by the IFRS 9 implementation in countries with weak official supervisory power.