Market Risk Aversion Research Articles

Market volatilities vs oil shocks: Which dominate the relative performance of green bonds?

The market performance of green bonds determines whether they will make a significant contribution to future financial markets and sustainable investment. It is therefore important to conduct a thorough study of the dominant factors affecting the market performance of green bonds, particularly their performance relative to conventional bonds. Thus, the main objective of this paper is to investigate and compare the impact of market volatilities (mainly VIX, OVX, and MOVE) and oil shocks (including supply shock, demand shock, and speculative demand shock) on the relative performance of green bonds. The main findings indicate that when volatilities coincide with oil shocks, the former consistently exert a more pronounced influence on the relative performance of green bonds. This phenomenon is particularly evident in the post-COVID-19 period. Concerning crude oil shocks, oil supply and demand shocks have opposite effects on the relative performance of green bonds, with the supply shock having a negative impact and the demand shock having a positive impact. Furthermore, our analysis shows that volatilities and oil shocks tend to have significant effects on the relative performance of green bonds during periods of heightened market risk aversion, while their impact remains negligible in a stable market environment. The empirical results may provide novel insights and significant implications for the further development of the green bond market.

COVID-19 pandemic, oil prices and Saudi stock market: empirical evidence from ARDL modeling and Bayer–Hanck cointegration approach

In 2020, the world experienced several significant events, including the coronavirus (COVID-19) pandemic and the collapse of international crude oil prices. The rapid spread of this pandemic has dramatic impacts on financial markets all over the world, thereby increasing market risk aversion in an unprecedented way since the subprime financial crisis. The decline in stock markets implied volatilities of equity and oil prices, thereby heightening turmoil in global financial markets despite comprehensive and substantial financial reforms. To this end, we investigated the likely effects of this pandemic on the Saudi stock market while controlling for oil prices based on daily data for a period from 1/1/2020 to 19/9/2022. To ascertain the existence of a long-run equilibrium relationship between the variables, we applied autoregressive distributed lag (ARDL) modeling and the error correction model, with this ultimately revealing the existence of strong cointegration in the long run. The ARDL bounds test was found to be robust by combined cointegration tests, thus providing further evidence of a strong relationship in the long run. Granger causality tests also yielded evidence of causality between the variables in both directions. The total COVID-19 confirmed cases and oil prices also caused movements in stock returns in the short run. Our findings have some prominent implications for asset managers and policymakers to improve stock market efficiency and boost global economic activity. Saudi authorities can consequently remove the regulatory and legal obstacles to develop their stock market and better improve the risk management, which will allow to make quick decisions in response to any oil price volatilities. Policymakers should also adopt proactive strategies that can comfort stock investors’ anxieties over the increasing oil price volatilities. Finally, the findings should be treated with some cautions because of the limited sample size and the tests’ statistical inference. Nevertheless, they do open opportunities for further studies to look in more detail at how the COVID-19 pandemic affected, over the short and long run, monetary and fiscal policy coordination, financial stability, and various other macroeconomic indicators in Saudi Arabia.

Different demands for almost the same assets? Demographic structure's different effect on direct and indirect equity purchase

AbstractThis study is motivated by the improved empirical framework of the Fourier flexible form estimation to investigate how the demographic structure leads to asymmetric effects on direct and indirect (mutual fund) equity demands. We find that, first, the demographic structure has asymmetric effects between direct and indirect equity purchases. Second, those in early old age create a stronger demand for indirect equity than other age cohorts in the middle of declining demand from young period. Third, we find theoretical and empirical evidence that direct and indirect equity demands respond asymmetrically to market risk aversion. Finally, we find evidence that bonds can substitute for indirect equity.

CBDC uncertainty: Financial market implications

The current state of the art in the central bank digital currency (CBDC) literature views indexes constructed from digital currency news to be fully informed about CBDC uncertainty and its impact on the financial system. We argue that the hedging behavior of participants in the currency futures market could be more informative than CBDC uncertainty news in the presence of limited risk absorption capacity in futures markets. We show that the hedging factor has a statistically significant effect on financial market risk aversion and measures of uncertainty. The hedging behavior of currency futures market participants is informative of agents' reactions to the news and central bank policies around CBDC. Our results also show that CBDC uncertainty is a significant risk transmitter in the financial system. Hence, this characteristic makes the hedging factor even more important because it can directly impact risk aversion via its moderating effects, which later influence CBDC uncertainty.

Market risk aversion under volatility shifts: An experimental study

We propose an experiment to analyze the relationship between volatility regimes and investors’ behavior and explore the mechanism by which aggregated risk aversion is configured. We design a market in which the volatility of the fundamentals is controlled and exogenously manipulated. Then we analyze the participation and trading behavior of participants under different volatility states. We observe a decrease in the market risk aversion during high volatility periods. In these periods, relatively more risk-averse investors do not participate in the risky market while less risk-averse investors trade. The individual risk aversion level of agents does not change during the experiment which leads us to conclude that the changes in market risk aversion during high volatility periods are mainly due to a participation effect.

Break-even inflation rates: the Italian case

PurposeThis work aims to study the break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation. The authors focus on Italian Government bonds, one of the most liquid debt markets in the euro area.Design/methodology/approachThe authors set up an auto-regressive distributed lag model and regress the BEIR on a set of variables that proxy inflation, market risk aversion, protection against deflation, credit as well as liquidity risk to get some insights into the importance of these factors. Subsequently, to disentangle market participants’ inflation expectations from their associated risk premia, the authors estimate a term structure model for the joint pricing of the Italian Government’s nominal and real yield curves, considering also a credit and a liquidity pricing factor.FindingsThe results show that BEIRs could be a misleading measure of the expected inflation due to the importance of the inflation risk premium and the credit risk effect. According to the estimates, the decrease of market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of the tail risk of the long-term inflation distribution, signalling that investors become more concerned with downside risks.Originality/valueThis study complements the existing literature primarily based on the USA and euro area data focusing on the Italian market. To this end, the authors modify and adapt a well-known term structure model developed for nominal and real curves.

Time-varying risk aversion and currency excess returns

This paper documents an economically significant risk premium associated with a currency’s sensitivity to time-varying risk aversion. Consequently, an investment strategy that takes a long (short) position in currencies with high (low) sensitivity to aggregate market risk aversion yields significantly positive excess returns. While advanced market currencies including the Euro, Yen and Swiss Francs dominate the short end of these portfolios with low sensitivity to risk aversion, emerging market currencies including the Brazilian Real, Mexican Peso and Turkish Lira are found to be the most sensitive currencies to risk aversion. The excess returns from the proposed strategy are significant even after controlling for systematic equity market risk factors as well as liquidity risk and cannot be explained by measures of economic conditions or uncertainty. Interestingly, the excess returns generated by the risk aversion-based strategy are found to have significant loadings on global momentum, suggesting possible commonality in the behavioral drivers of anomalies in the global equity and currency markets. The findings highlight the role of behavioral factors as predictor of currency excess returns with significant investment implications.

Time-varying risk aversion and currency excess returns

This paper documents an economically significant risk premium associated with a currency’s sensitivity to time-varying risk aversion. Consequently, an investment strategy that takes a long (short) position in currencies with high (low) sensitivity to the aggregate market risk aversion yields significantly positive excess returns. While advanced market currencies including the Euro, Yen and Swiss Francs dominate the short end of these portfolios with low sensitivity to risk aversion, emerging market currencies including the Brazilian Real, Mexican Peso and Turkish Lira are found to be the most sensitive currencies to risk aversion. The excess returns from the proposed strategy are significant even after controlling for systematic equity market risk factors as well as liquidity risk and cannot be explained by measures of economic conditions or uncertainty. Interestingly the excess returns generated by the risk aversion based strategy are found to have significant loadings on global momentum, suggesting possible commonality in the behavioral drivers of anomalies in the global equity and currency markets. The findings highlight the role of behavioral factors as predictor of currency excess returns with significant investment implications.

TIMING DECISIONS OF HOUSING SALES AND DEVELOPMENT BASED ON REAL OPTION THEORY

Based on the real option theory, this paper studies the impact of uncertainty on the timing decisions required in housing development and sales. Data of newly-built houses and corresponding plots in Hangzhou, China, are used for empirical analysis. In order to better reflect the changes in market demand under frequent policy intervention, in addition to the usual price volatility, this paper introduces the volatility of trading volume to measure the uncertainty of China’s real estate market. The results show that the volatility of trading volume has a significant impact on timing decisions. Also, trading volume volatility can better reflect the characteristic of deferred option than can price volatility, especially during the sales phase. This study provides evidence to support Bar-Ilan and Strange’s (1998) research of sequential investment. Because of the existence of the second option, i.e., sales timing, the starts in the first stage are not too sensitive to uncertainty. In the case of the second option, the longer the construction period is, and the lower the cost of the first stage is, the higher will be the probability of triggering the start. In addition, the characteristics of market risk aversion are obvious in the study area, especially in the suburban area.

Are Options Redundant? The Benefits of Synthetic Diversification

This paper examines an alternative avenue through which trading in options can expand investors' opportunity sets, unrelated to private information, differing opinions, endowments, or trading restrictions in the stock market. Investors can synthetically replicate the return profile of optionable stocks using options for a fraction of the cost of holding the underlying securities, which makes diversification more cost-efficient. We find that the option to stock volume ratio increases when stock price, idiosyncratic risk, stock illiquidity, borrowing cost, and market risk aversion are high. In addition, institutional holdings and option trading have a U-shaped relation.

Multi-Level Market Transaction Optimization Model for Electricity Sales Companies with Energy Storage Plant

Due to market price uncertainty and volatility, electricity sales companies today are facing greater risks in regard to the day-ahead market and the real-time market. Along with introducing the Time of Use (TOU) price for the customer as a type of balancing resource to avoid market risk, electricity sales companies should adopt the market risk-aversion method to reduce the high cost of ancillary services in the real-time market by using multi-level market transactions, as well as to provide a reference for the profits of power companies. In this paper, we establish a non-linear mathematical model based on stochastic programming by using conditional value-at-risk (CVaR) to measure transaction strategy risk. For the market price and consumer electricity load as the uncertain factors of multi-level market transactions of electricity sales companies, the optimal objective was to maximize the revenue of electricity sales companies and minimize the peak-valley differences in the system, which is solved by using mixed-integer linear programming (MILP). Finally, we provide an example to analyze the effect of the fluctuation degree of customer load and market price on the profit of electricity sales companies under different confidence coefficients.

Early 60s is not old enough: Evidence from twenty-one countries’ equity fund markets

Motivated by the fact that demographic structure influences market risk aversion, we investigate how demographic structure affects demand for equity funds by employing twenty-one countries’ data. Our main findings are as follows. First, we find that the old generation is active in equity fund investment, which goes against the life cycle risk-aversion hypothesis. In particular, investors who have newly joined the old generation demonstrates a more marked demand for equity funds than do other aged investors. Second, we find that the old generation’s greater demand for equity funds is associated with the size of this population and their increased life expectancy. Our empirical results reveal that persons who are in their early 60s, that is, who have newly joined the old generation, show less market risk aversion and increased demand for equity funds.

The Nexus between the Oil Price and Stock Market: Evidence from South Asia

The link between stock market prices and oil prices has drawn considerable attention in recent decades because the risk and uncertainties associated with oil price volatility affect investor’s portfolios, particularly, those investors seeking to make optimal portfolio allocations. This paper investigates the relationship between the oil price and the stock market index in South Asia. Based on a sample of four countries, namely Bangladesh, India, Pakistan, and Sri Lanka for the period 1997-2017, we use the nonlinear Autoregressive distributed model estimated by Pooled Mean Group (PMG) estimator. We show that there is a positive relationship between the world oil price and stock market index; and that the response of stock market index to positive and negative oil price shocks are asymmetric. Counter to prior research in developing countries, our findings imply that higher oil prices in the world market stimulate stock prices which suggests that the stock markets in the South Asian region do not follow the Efficient Market Hypothesis (EMH) for which the shocks in the crude oil market are not rationally signaled in the financial market. Another plausible justification of this movement in the same direction, as explained by Bernanke (2016), is that both oil price and stock prices are reacting to a change in some common underlying factor, which he calls the global aggregate demand and market risk aversion.

Investing in the size factor

This paper investigates the role of the size factor for constructing investment portfolios and proposes a dynamic extension that accommodates the risk-free asset and time-varying weights. These weights are determined by a set of state variables given by the term structure of sovereign interest rates, variables describing market risk aversion such as the VIX index and the CRB Industrial return, and indexes reflecting investor sentiment towards the economic outlook. The empirical section explores the suitability of these state variables and analyses the out-of-sample performance of size factors idiosyncratic to the US, the UK and European financial markets that are compared against the dynamic version that optimizes the weights in each period. The results provide support to the different size factors except for periods of economic distress in which the optimal dynamic strategies are clearly superior.

Speculation, risk aversion, and risk premiums in the crude oil market

Speculative activity in commodity markets has increased dramatically since 2002. This paper investigates how aggregate risk aversion and risk premiums in the crude oil market covary with the level of speculation. Using crude oil futures and option data, we estimate aggregate risk aversion in the crude oil market and find that it is significantly lower between 2005 and 2008 when speculative activity increases dramatically. Risk premiums implied by the state-dependent risk aversion are also negatively correlated with speculative activity and are on average lower and more volatile during this period. These findings, together with the increased index fund and managed-money infusion in the commodity market, suggest that speculators who demand commodity futures for the purpose of portfolio diversification are willing to accept lower compensation for their positions. Decreasing speculation after 2009 amid increased producers’ hedging demand has a reverse impact on the market risk aversion and risk premiums.

Economic and Financial Determinants of Credit Risk Premiums in the Sovereign CDS Market

We specify and estimate no-arbitrage models that value sovereign CDS contracts by assuming that the country's default intensity depends on observable economic and financial indicators. We estimate these models using a sample of twenty-eight countries, three CDS maturities, and over a decade of daily data. The models provide a good fit. The impact of the economic and financial variables on spreads varies substantially across countries and over time, but is consistent with economic intuition. Spreads increase as a function of stock market and exchange rate volatility, but decrease as a function of interest rates and stock market returns. Estimated risk premiums are highly time-varying and peak during the 2008 financial crisis for nearly all countries. For European countries the risk premiums are also high during the Eurozone debt crisis. In periods of market stress and high CDS spreads, the increase in market risk aversion is even larger than the increase in default probabilities. The cross-sectional variation in risk premiums across countries is high, also in non-crisis periods.

The Information Risk in the Latest Crisis: A Driver or a Driven Factor for Global Financial Markets Equilibrium?

The latest financial crisis has been impressive for strength, impact, duration and reduced efficacy of the economic and financial policies adopted by the Authorities. We use an original information risk model to contribute to the analysis of the crisis and to suggest some approaches for a possible early diagnosis. Using data referred to the three main financial markets and comparing the latest crisis with the previous one and with a long term quantitative evidence, we find out that the 2007-2009 crisis was very different in the information risk quality. That gap affected the market risk aversion and its equilibrium, reducing the efficacy of the Authorities’ intervention tools mainly based on payoff risk control and efficient market restoration. Since information risk is an endogenous element of the market dynamics that can be independent form contingent levels of market efficiency. Drivers of information risk in the European Markets differed strongly from the US and Japanese ones; that’s why some global decision had low impact while opportunities of local intervention was missed.

A Note on Banks and Sovereign CDS Premia Dynamics: Market Reactions and Determinants

Following the upset of the financial crisis, and especially after the collapse of Lehman Brothers, Governments in advanced economies have provided support to the fi nancial sector to help restoring its normal functioning and to avoid the widening of the meltdown. Banking CDS premia climbed from July 2007, while after the September 2008. Both prices started to have a broad comovement from the Lehman Brothers collapse, with a reduction in their differences. Furthermore, the differences between banking and CDS premia for PIIGS become negative. This study examines the relation between and banking CDS premia after July 2007 by analyzing both market reactions and the determinants of the spread between these premia. By using an event study approach, we find that: for a negative (positive) event related to a specific bank or to the banking sector, market reacts with an increase (decrease) in spreads for both the targeted and the other competitors, while premia do not change considerably; for a negative (positive) event related to countries, only CDS for PIIGS and their banking sector increase (decrease); the release of the stress test for European leads to a reduction in CDS premia for almost all in our sample. On the other hand, we search for determinants of the spread in CDS premia between banking and sectors. We find that iTraxx Europe and SovX Western Europe (as common risk factors), VSTOXX (as the market risk aversion proxy) and the ratio between the European equity index for and the overall European equity index (as a proxy for the financial sector vulnerability) are useful determinants for our basis. Moreover, the German Bund is equally important. Finally, the presence of three determinants for the basis banks vs sovereign is confirmed by a principal component analysis.

Market Prices of Orthogonal Risk and Risk Aversion in Complete Stochastic Volatility Models: Theoretical and Empirical

Considering a production economy with an arbitrary von-Neumann Morgenstern utility, this paper derives a general equilibrium relationship between the market prices of risks and market risk aversion under a continuous time stochastic volatility model completed by liquidly traded options. Empirical market price of orthogonal risk and risk aversion surfaces as well as their time series are obtained from traded option prices. It is found that implied risk aversion exhibits a smiling pattern across strikes and highly correlates with regular macrofinance variables.

A Fresh View on the Ho-Lee Model of the Term Structure from a Stochastic Discounting Perspective

In the present paper we reformulated a slightly generalised version of the Ho-Lee-model of the term structure of interest rates by using the method of stochastic discounting. The main results can be summarized as follows: The time discrete Ho-Lee-model of the interest rate structure can be developed by constructing a suitable stochastic discount factor from which the whole structure of the model can be deduced; interest rates become binomial random walks with a drift which is mainly determined by the initial term structure. Besides using the empirical probability distribution, the model allows for a specific market's risk aversion to be imposed. This parameter is reponsible for how futures contracts are valued by the market. In a limiting process which is similar to the work of Heath, Jarrow and Morton (1990), it is shown that the interest rate becomes a normally distributed process the drift of which is determined by the initial term structure and the market's risk aversion and by the jump probability of the underlying binomial process. The latter property is in contrast with the Heath, Jarrow, Morton (1990) result where these probabilities play no specific role. Whether or not they do play a role depends on the market's risk aversion being zero or not. Furthermore, it turns out that the stochastic discount factor is log-normal, but, surprisingly, it is driven by two independent normally distributed factors. One of these factors is completely correlated with the short rate. An expression which facilitates the valuation of futures contracts is also provided; clearly, it severely depends on the market's risk aversion and becomes unity if there is no risk aversion in the market; in this case futures prices are, actually, expected future prices. The importance of knowing the stochastic discount factor lies in its capability to consistently value any arbitrary asset in the market, derivative or not.