The Cross Sectional Dependence Puzzle

The analysis of unit roots and cointegration in panel data is becoming a growing research area. A number of issues have been raised in the literature (see Phillips and Moon 1999 and 2000, Banerjee 2000, Maddala and Wu 1999). The aim of the present paper is to contribute to the issue of cross sectional dependence in non-stationary panel data. We review some of the most recent econometric techniques proposed by the literature to dealing with cross sectional dependence and notice a sort of puzzle. We extend the bootstrap methodology proposed by Maddala and Wu (1999) and apply the resulting test to test for PPP. We find no evidence favouring PPP. Finally, we use Monte Carlo simulation to analyse the size distortion of the bootstrap test presented in this paper. The proposed test presents size distortion only when T = 100.

Valuing American Derivatives by Least Squares Methods

Least Squares estimators are notoriously known to generate sub-optimal exercise decisions when determining the optimal stopping time. The consequence is that the price of the option will be underestimated. We show how to use variance reduction techniques to extend some recent Monte Carlo estimators for option pricing and assess their performance in finite samples. Finally, we extend the Longstaff and Schwartz (2001) method to price American options under stochastic volatility. This is the first study to implement and apply the Glasserman and Yu (2004b) methodology to price Asian options and basket options.American options, Monte Carlo method

Valuing American style derivatives by least squares methods

We implement some recent Monte Carlo estimators for option pricing and assess their performance in finite samples. We find that the accuracy of these estimators is remarkable, even when more exotic financial derivatives are considered. Finally, we implement the Glasserman and Yu (2004b) methodology to price Asian Bermudan options and basket options

Dynamic option adjusted spread and the value of mortgage backed securities

We extend a reduced form model for pricing mortgage-backed securities (MBS) pass through and provide a novel hedging tool for investors in this market. To calculate the price of an MBS traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS). The latter allows investors in the mortgage market to account for both prepayment risk and changes of the slope of the yield curve

Does the Purchasing Power Parity Hold in Emerging Markets? Evidence from Black Market Exchange Rates

We examine the Purchasing Power Parity (PPP) hypothesis using a unique panel of monthly data on black market exchange rates for twenty emerging market economies over the period 19973M1-1993M12. We apply a large number of recent heterogeneous panel unit root and cointegration tests. Panel unit root tests do not favour mean reversion in the real black market exchange rate. The evidence for non-rejection of the unit root hypothesis remains robust even after allowing for structural breaks. Panel cointegration tests support evidence of cointegration between the nominal exchange rate and relative prices. These results contrast with those obtained from unit root tests. Since we believe that the former may be biased by the imposition of the joint symmetry and proportionality restriction, we test for such a restriction using likelihood ratio tests and find that it is strongly rejected.black market exchange rates, purchasing power parity, panel unit root and cointegration tests

Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities

We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS). The latter allows investors in the mortgage market to account for both prepayments risk and changes of the yield curve.Asset pricing, Mortgage Backed Securities, Term Structure Ambiguity, arrival rate of innovation, R&D investments.

The rise and fall of the ABS market

The financial crisis has raised some concern about the quality of information available on some traded assets on the securities markets to market participants and regulators. Asset-backed securitization in general got partial blame for the paucity of liquidity on bank balance sheets and the consequent credit crunch. After the Asset-Backed Security (ABS) market fell to near inactivity in 2009, the US federal government's Term Asset-Backed Securities Loan Facility (TALF) provided backing and a boost to the issuance of asset-backed securitization. In this market condition, given the nature of ABS, it is difficult for them not to be relatively illiquid, and this has resulted in unacceptable levels of market risk for most investors. Their liquidity before the crisis was driven by a market in continuous expansion, fed by Special Purpose Vehicle (SPV), Conduits, and other low capitalized term-transformation vehicles. Nowadays, the industry is concerned with the ongoing ABS reforms and how these will be implemented. This article reviews the ABS market in the last decade and the possible consequences of the recent regulatory proposals. It proposes a retention policy and the institution of a new financial body to supervise the quality of the security in an ABS pool, its liquidity, and the model risk implied by the issuer's valuation modeAsset Backed Security; Government Policy and Regulation

Black Market and Official Exchange Rates: Long-Run Equilibrium and Short-Run Dynamics

This paper presents further empirical evidence on the relationship between black market and official exchange rates in six emerging economies (Iran, India, Indonesia, Korea, Pakistan, and Thailand). First, it applies both time series techniques and heterogeneous panel methods to test for the existence of a long-run relationship between these two types of exchange rates. Second, it tests formally the validity of the proportionality restriction implying a constant black-market premium. Third, it also analyses the short-run dynamic responses of both markets to shocks. Finally, it tries to shed some light on the determinants of the market premium. Evidence of slow reversion to the long-run equilibrium is found. Further, it appears that capital controls and expected currency devaluation are the two main factors affecting the size of the premium and determining the breakdown in the proportionality relationship.black market and official exchange rates, panel cointegration, impulse response functions

Using Chebyshev Polynomials to Approximate Partial Differential Equations

This paper suggests a simple method based on a Chebyshev approximation at Chebyshev nodes to approximate partial differential equations. It consists in determining the value function by using a set of nodes and basis functions. We provide two examples: pricing a European option and determining the best policy for shutting down a machine. The suggested method is flexible, easy to programme and efficient. It is also applicable in other fields, providing efficient solutions to complex systems of partial differential equations.European options, Chebyshev polynomial approximation, Chebyshev nodes

Chebyshev polynomial approximation to approximate partial differential equations

This pa per suggests a simple method based on Chebyshev approximation at Chebyshev nodes to approximate partial differential equations. The methodology simply consists in determining the value function by using a set of nodes and basis functions. We provide two examples. Pricing an European option and determining the best policy for chatting down a machinery. The suggested method is flexible, easy to program and efficient. It is also applicable in other fields, providing efficient solutions to complex systems of partial differential equations.European Options, Chebyshev Polynomial Approximation, Chebyshev Nodes