The First International Moscow Finance Conference. November 18-19, 2011

Conference program

Public lectures

List of speakers

Arnoud Boot, University of Amsterdam

Banking at the Cross Roads: How to deal with Marketability and Complexity?

The objective of this overview paper is to address some key issues affecting the stability of financial institutions. The emphasis is on the micro-economics of banking: what type of incentives do financial institutions have in the current landscape? And what does this imply for regulation and supervision? The paper is motivated by the proliferation of financial innovations and their impact on the financial services industry. A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability. Building on this, the paper discusses the incentives of individual financial institutions. Issues addressed include: frictions between relationship banking and transaction activities that are more financial market focused, ownership structure issues, the impact of the cost of capital, the effectiveness of market discipline, and what configuration of the industry can be expected. We will argue that market forces might be at odds with financial stability. We will point at institutional and regulatory changes that might be needed to deal with the complexity of financial institutions.

Alexey Boulatov, Higher School of Economics (co-author: Dan Bernhardt) 

Robustness of equilibrium in Kyle model of informed speculation 

We analyze single-period Kyle (1983) model where the risk-neutral informed trader can use arbitrary (linear or non-linear) deterministic strategies, and the market makers can use arbitrary pricing rules. We call a Nash equilibrium robust if the first variations of all agents' expected payoffs with respect to a small variation of any agent's conjecture (including themselves) vanishes at equilibrium. In other words, all market participants are indifferent to small errors of beliefs of the others and themselves. Our notion of robustness is consistent and can be viewed as a particular case of the definition given in Stauber (2006, 2011). We show that the standard linear Nash equilibrium of Kyle (1983) is robust with respect to small "conjecture errors" of the agents in a sense defined above. Moreover, we demonstrate that the only robust Nash equilibrium of Kyle (1983) model is a standard linear one.

Miloš Božović, Center for Investments and Finance, Belgrade and University of Novi Sad

An efficient method for market risk management under multivariate extreme value theory approach

This paper develops an efficient multivariate extreme-value approach for calculating Value at Risk (VaR) and expected shortfall. It is based on the notion that some key results of the univariate extreme value theory can be applied separately to a set of orthogonal random variables, provided they are independent and identically distributed. Such random variables can be constructed from the principal components of ARMA-GARCH conditional residuals of a multivariate return series. The model's forecasting ability is then tested on a portfolio of foreign currencies. The results indicate that the generalized Pareto distribution of peeks over threshold of residuals performs well in capturing extreme events. In particular, model backtesting shows that the proposed multivariate approach yields more precise VaR forecasts than the usual methods based on conditional normality, conditional t-distribution or historical simulation, while maintaining the efficiency of conventional multivariate methods. 

Mikhail Chernov, London School of Economics (co-authors: J. Graveline and I. Zviadadze) 

Sources of Risk in Currency Returns 

We quantify the risks in currency returns, as a first step towards understanding the high returns to carry trades. We develop and estimate an empirical model of exchange rate dynamics that incorporates (i) Gaussian shocks to exchange rates with stochastic variance, (ii) crashes, or large moves, in exchanges rates, and (iii) jumps in the variance of Gaussian shocks to exchange rates. We use a joint dataset of excess currency returns and short-term at-the-money implied variances for four currencies (AUD, CHF, GBP, and JPY). For each currency pair, we find that the probability of a large depreciation (appreciation) in the U.S. dollar is driven by the U.S. (foreign) interest rate. We also find that the variance of currency returns is itself subject to jump risk. Moreover, the probability of a jump in variance depends positively on the current level of variance. We are able to link jumps in currencies to important macro and political announcements, but cannot do the same for jumps in variance. The latter are associated with events broadly interpreted as economic uncertainty. Jumps may account for up to 25% of total currency risk, as measured by entropy. The model we estimate also has realistic implications for option valuation.

Roman Chuhay, ICEF, Dept. of Economics and LFE, Higher School of Economics (co-author: Huber Janos Kiss) 

Social structure and propagation of depositors panic 

Empirical evidence suggest that social network effects are important regarding the decision-making of depositors. Contribution of our paper to the bank-run literature is twofold. First, we explicitly specify who can observe whom by considering underlying network of social contacts. Second, we allow depositors to re-diced upon observing the actions of their neighbors and effectively study multistage game. We identify ultimate proportion of depositors who withdraw money as a function of proportion of impatient depositors in the population. We also study how different network structures affect the probability of bank run.

Dean Fantazzini, Moscow School of Economics at Moscow State University and Higher School of Economics

Optimal Capital Allocation: VaR, C-VaR, Spectral Measures and Beyond in Russian Markets

The problem of selecting the optimal capital allocation with Russian stocks is examined. Alternative risk measures, such as VaR, C-VaR and spectral measures, as well as different returns distributions are examined to find out which method provide the best capital allocation. In this regard, the use of volatility proxy measures plays a key role in any capital allocation strategy. An empirical comparison of several volatility measures is performed to assess their ability to describe and forecast the conditional variance and to provide the best capital allocation. The alternative models are compared out-of-sample using a set of the 24 most liquid Russian stocks.  Loss measures, superior predictive ability tests and portfolio performance measures are then employed for model comparison.

Diego Garcia, Kenan Flagler Business School, University of North Carolina

Sentiment During Recessions 

This paper studies the effect of sentiment on asset prices during the 20th century (1905--2005). As a proxy for sentiment, we use the fraction of positive and negative words in two columns of financial news from the New York Times. The main contribution of the paper is to show that, controlling for other well-known time-series patterns, the predictability of stock returns using news' content is concentrated in recessions. A one standard deviation shock to our news measure during recessions changes the conditional average return on the DJIA by twelve basis points over one day.

Sergey Gelman, ICEF and LFE, Higher School of Economics (co-author: Dmitry Storcheus) 

Continuous time option pricing with scheduled jumps in the underlying asset

This paper introduces a new model of continuous time option pricing, which explicitly accounts for scheduled jumps caused by quarterly earnings announcements in the underlying stock. We present the stock price process as the product of a geometric brownian motion and scheduled jump process with a uniform jump size. This simple specification allows for obtaining a closed-form analytical solution for the European call option price. Empirical tests using a vast number of options with different strikes and maturities on several US stocks during 1999-2008 show significant superiority of our model over Black-Scholes in terms of fitting option prices. Moreover, the suggested model turns out to be no less precise as the Merton (1976) model with unscheduled jumps. Considering the parsimony and computational simplicity of our model compared to Merton (1976), we deem it preferable for application in the pricing of options on individual securities.

Christian Julliard, London School of Economics (co-authors: Kathy Yuan and Edward Dembee)

Interbank Network, Liquidity Provision and Key Players 

This paper studies whether structural properties of inter-bank networks affect individual bank's incentive to provide liquidity. Assuming liquidity provision is a public good, when a neighbouring bank has a lot of liquidity, an individual bank may choose to provide less. Following Ballester, Calvo-Armengol and Zenou (2005), we show that, at the Nash equilibrium, outcome of each individual bank embedded in a network is proportional to its Katz-Bonacich centrality measure. This measure takes into account of the liquidity provision of both direct and indirect neighbours of each bank but puts less weight to banks with distant connections. We then bring the model to the data by using a very detailed dataset of interbank networks and casting our equilibrium model in a spatial error framework. After controlling for observable individual bank characteristics, aggregate risk and unobservable network specific factors, we find evidence for a substantial, and time varying, network risk.

Victor Lapshin, Laboratory of Financial Engineering and Risk Management, Higher School of Economics

An Infinite-Dimensional Interest Rates Term Structure Model: Arbitrage-Free, Realistic and Practical 

We present a new infinite-dimensional model of interest rates term structure within the Heath-Jarrow-Morton framework and its infinite-dimensional extension by Filipovic. Usual term structure models (e.g. Nelson-Siegel) don’t allow for consistent stochastic dynamics: these models will cause arbitrage when modified to include any stochastic dynamics of their parameters. Usual finite-dimensional stochastic models (e.g. Cox-Ingersoll-Ross or Hull-White) cannot offer a flexible enough snapshot yield curve. We “marry” the snapshot fitting possibilities of static models and the temporal variability of dynamic models at the price of going infinite-dimensional. The model is nevertheless fully practicable and applicable on the real data. We present evidence from the Russian bond market before and during the crisis.

Dmitry Makarov, New Economic School (co-author A. Schornick)

Equilibrium Portfolios and Equity Premium with Wealth Heterogeneity and Uncertainty Aversion 

We provide a unified theoretical explanation for the following salient patterns of household investments: (i) a sizeable fraction of households do not  participate in the stock market, with poorer households less likely to participate, and (ii)  among the households that do participate, wealthier ones choose to invest a larger share of their wealth into risky assets than poorer ones. We develop a general equilibrium asset pricing model whose key ingredients are uncertainty aversion, wealth heterogeneity leading to heterogeneity in uncertainty levels across the households, and wealth effect. Solving analytically for equilibrium, we obtain that the equilibrium portfolios are consistent with the above patterns. We also find that a (occurring endogenously) lower participation is associated with a higher equity premium. Finally, we compare our predictions with and without the wealth effect, and find notable differences in equilibrium portfolios, while the link between participation and equity premium is not affected. 

Stanimir Morfov, ICEF and LFE, Higher School of Economics 

Executive Pay and Outside Options 

This paper considers a principal-agent problem where aggregate shocks affect both firm’s technology and agent's outside options. A calibrated version of the model is used to analyze CEO compensation, the provision of incentives, and the dynamics under the optimal contract. We further investigate the impact on pay-performance sensitivity and relative performance evaluation.

Yuliy Sannikov, Princeton University

Macroeconomics with Financial Frictions: Endogenous Risk, Instability and Nonlinearities 

Classical macroeconomic models with financial frictions, including work of Bernanke-Gertler-Gilchrist and Kiyotaki-Moore, have uncovered how macroeconomic shocks can be amplified through price effects.  A shock to intermediaries balance sheets causes them to adjust risk exposures, leading to asset sales, price impact, and further deterioration of balance sheets.  This feedback loop creates excess volatility, which is called endogenous risk.  While classical models study linear approximations of these effects, recent research and experience suggest that equilibrium dynamics can be highly nonlinear.  While normal times may be very stable, a large enough shock may put the financial system in an unstable regime, where amplification and endogenous risk are much greater.

Vladimir Sokolov, ICEF and LFE, Higher School of Economics 

The Impact of maturity Financing Choices made by Primary Bond Dealers on Repo market Rates 

Testing of the expectation hypothesis (EH) for very short interest rates has provided mixed results. My paper seeks to reconcile conflicting evidence on the EH for the US repo market by exploiting the fact that repo rates are affected by the demand/supply of bonds provided as collateral against repo agreements. My empirical investigation is organized around a theoretical model formulated by Duffie (1996) and Krishnamurthy (2002) on the relative "specialness" of bonds. This model demonstrates how variation in bond prices is related to variation in repo rates on collateralized loans against bonds. I hypothesize that this mechanism also works across different maturities of repo contracts and can explain variation in term repo rates relative to overnight rates. Using NY Fed data, I construct a factor measuring primary dealers' net financing in the overnight repo segment relative to their financing in the term repo segment and demonstrate that this variable was a significant forecaster of the repo market excess returns in the 2001-2008 period. The finding is robust to the inclusion of a Cochrane-Piazzesi factor, change in fed funds futures prices and a measure of dealers' overbidding at Fed's repo auctions.

Carsten Sprenger ICEF and LFE, Higher School of Economics (co-author: Branko Urošević) 

Investment and Financing Decisions of an Intrinsically Motivated Entrepreneur 

There is empirical evidence that intrinsic motivation is highly relevant in entrepreneurial decisionmaking. So far its role has been mostly studied in the context of optimal employment contracts. The goal in this project is to investigate the role of intrinsic motivation for investment and financing decisions of entrepreneurs. Data from the Panel Study of Entrepreneurial Dynamics are used to test some of the model predictions. 

 Sergey Stepanov, New Economic School 

Takeovers under Asymmetric Information: Block Trades and Tender Offers in Equilibrium 

I study transfers of control in a firm having atomistic shareholders and one dominant minority blockholder (incumbent). A potential acquirer can try to negotiate a block trade with the incumbent. If the negotiations are successful, the control changes hands via a block trade. If the negotiations fail, the acquirer can launch a public tender o¤er. According to empirical evidence, both types of transactions occur in the market. However, the existing models that allow for both types of control transfer ultimately obtain that the incumbent and the acquirer always negotiate a block trade in equilibrium. By introducing asymmetry of information about the acquirer's ability to generate value, I bring imperfections into the bargaining between the acquirer and the incumbent, which allows me to generate either a block trade or a tender o¤er as the game outcome. In equilibrium, high ability acquirers take over the firm by means of a tender offer, intermediate ability acquirers negotiate a block trade, and low ability acquirers do not attempt any transaction. This result provides an immediate explanation for a generally higher target's stock price reaction to tender offers as compared to block trade announcements. The model also explains why takeover premiums are generally higher in countries with stronger legal protection of shareholders and predicts that better shareholder protection should result in a higher stock price reaction to block trade announcements as well. Finally, the model predicts how, for a given incumbent's share, the choice between a tender offer and a block trade is affected by the legal shareholder protection. 

Dimitrios Tsomocos, Said School of Business, Oxford University (co-author Juan Francisco Martinez) 

Liquidity effects on asset prices, financial stability and economic resilience 

This paper analyzes the different channels of shock transmission in an economy affected by financial frictions. We distinguish between the liquidity and default effects on asset prices.Furthermore, we develop a framework in which we can assess financial stability policy under financial frictions. We introduce a simplified model of trade and financial intermediation that captures the effects of shocks on financial and real variables of the economy. Our results suggest that financial stability and economic resilience to adverse shocks should take into account default in the credit market as well as the liquidity of goods traded in the commodity market. 

Branko Urošević, National Bank of Serbia and Faculty of Economics, University of Belgrade (co-authors Mikica Drenovac and Ranko Jelic) 

European bond ETFs - tracking errors and sovereign debt crisis 

We examine effects of the new risk and return paradigm in the Euro sovereign bond market on the tracking performance of 31 Euro zone sovereign debt exchange traded index funds (ETFs), during 2007-2010. The tracking performance was examined using traditional, OLS, and cointegration tracking error models. Overall, ETFs underperform their respective benchmarks. There are, however, some important differences across families of sample ETFs. In particular, ETFs with the highest tracking errors estimated using short term correlations tend to have lowest tracking errors based on cointegration metric. The results of our panel data analysis document significant changes in the sample ETFs’ tracking performance during sovereign debt crisis. Our results also confirm that, as a result of the crisis, credit risk considerations have become an important determinant of the ETFs’ tracking performance. We also find evidence for the importance of ETFs’ replication methods and volatility of underlying indices for the tracking performance, irrespective of the error metric. In an environment of widening sovereign credit default swap (CDS) spreads and divergent yield trends, understanding the credit quality of various issuers together with the selection rules of benchmark indices is, therefore, crucial for understanding ETFs’ performance.