Measuring market liquidity: An introductory survey

Asset liquidity in modern financial markets is a key but elusive concept. A market is often said to be liquid when the prevailing structure of transactions provides a prompt and secure link between the demand and supply of assets, thus delivering low costs of transaction. Providing a rigorous and empirically relevant definition of market liquidity has, however, provided to be a difficult task. This paper provides a critical review of the frameworks currently available for modelling and estimating the market liquidity of assets. We consider definitions that stress the role of the bid-ask spread and the estimation of its components that arise from alternative sources of market friction. In this case, intra-daily measures of liquidity appear relevant for capturing the core features of a market, and for their ability to describe the arrival of new information to market participants.

The Relationship Between Financial Risk Premia and Macroeconomic Volatility: Issues and Perspectives on the Run-Up to the Turmoil

This note sketches the issues that arise while interpreting the relation between macroeconomic volatility and financial risk premia from the perspective of the standard consumption-based asset pricingmodel. The relation arises from the fact that all assets are priced by the same "pricingkernel", given by the inter-temporal marginal rate of substitution in consumption of the representative investor. Since the pricing kernel is a function of aggregate consumption, financial risk premia are positively related to consumption growth volatility. Therefore, from the perspective of this workhorse often employed in the academic debate, the persistent reduction in macroeconomic volatility can be considered a cause for the low average risk premia prevailing during the so-called Great Moderation, namely the period preceding the recent turmoil in financial markets. We challenge this view by shedding light on the issues that generate an inconsistent interpretation of the model outcomes. In particular, since the consumption-based model is geared towards asset prices consistent with macroeconomic fundamentals, we argue that it is not suited for interpreting current developments where underestimation of risk may have subsidized asset prices. In particular, according to the evidence for the Great Moderation, the model view suffers from observational equivalence.

Optimal Trading Execution with Nonlinear Market Impact: An Alternative Solution Method

We consider the optimal trade execution strategies for a large portfolio of single stocks proposed by Almgren (2003). This framework accounts for a nonlinear impact of trades on average market prices. The execution strategy of Almgren (2003) is based on the assumption that no shares per unit of time are trade at the beginning of the period. We use a general solution method that accomodates the case of positive initial trades. Our results are twofold. First of all, we show that the problem admits a solution with no trading in the opening period only if additional parametric restrictions are imposed. Second, with positive initial trading, the optimal execution time depends on trading activity in the initial period.

Distortionary tax instruments and implementable monetary policy

We introduce distortionary taxes on consumption, labor and capital income into a New Keynesian model with Calvo pricing and nominal bonds. We study the relation between tax instruments and optimal monetary policy by computing simple rules for monetary and fiscal policy when one tax instrument at a time varies, while the other two are fixed at their steady-state level. The optimal rules maximize the second-order approximation to intertemporal utility. Three results emerge: (a) when prices are sticky, perfect inflation stabilization is optimal independently from the tax instrument adopted; (b) the optimal degree of responsiveness of monetary policy to output varies depending on which tax instrument induces fluctuations in the average tax rate; (c) when prices are flexible, fiscal rules that prescribe unexpected variations in the price level to support debt changes are always welfare-maximizing.

A welfare perspective on the fiscal-monetary policy mix: The role of alternative fiscal instruments

The need of fiscal consolidation is likely to dominate the policy agenda in the next decade; starting from statistical evidence on the conduct of fiscal policy in the EMU area over the last decade, this paper addresses the optimality of alternative fiscal consolidation strategies. We explore the welfare properties. In this paper we explore the welfare properties of debt-targeting fiscal policy implemented through, alternatively, distortionary taxation on consumption, labour and capital income or productive and wasteful government expenditure. We build a general equilibrium model with various distortions in order to evaluate the welfare ranking of alternative fiscal policy configurations under different monetary policy regimes. Our results show the welfare superiority of fiscal adjustments based on productive government expenditure, whereas the use of a capital income tax rate as fiscal instruments yields the highest welfare loss.

Forecasting Value-at-Risk with Time-Varying Variance, Skewness and Kurtosis in an Exponential Weighted Moving Average Framework

This paper provides an insight to the time-varying dynamics of the shape of the distribution of financial return series by proposing an exponential weighted moving average model that jointly estimates volatility, skewness and kurtosis over time using a modified form of the Gram-Charlier density in which skewness and kurtosis appear directly in the functional form of this density. In this setting VaR can be described as a function of the time-varying higher moments by applying the Cornish-Fisher expansion series of the first four moments. An evaluation of the predictive performance of the proposed model in the estimation of 1-day and 10-day VaR forecasts is performed in comparison with the historical simulation, filtered historical simulation and GARCH model. The adequacy of the VaR forecasts is evaluated under the unconditional, independence and conditional likelihood ratio tests as well as Basel II regulatory tests. The results presented have significant implications for risk management, trading and hedging activities as well as in the pricing of equity derivatives

Lo 'shock' Lehman Brothers: una tempesta dentro la tempesta? L'esperienza degli ETF LYXOR su Euro MTS

Questo studio considera l’evoluzione della relazione tra ETF su titoli di stato ed i relativi indici ‘benchmark’ durante il periodo di turbolenza dei mercati iniziato nel 2007. La nostra analisi si concentra sul cambiamento della trasmissione di volatilità in seguito al fallimento di Lehman Brothers. Usiamo dati sui prezzi giornalieri di tre ETF LYXOR su Euro MTS e dei rispettivi indici per stimare tre tipi di modelli di movimenti congiunti o ’contagio’ tra i mercati: a) modelli BEKK bivariati basati su Engle e Kroner (1995); b) il modello CAViAR di Engle e Manganelli (2004) che permette di applicare il test di Cappiello, Gerard e Manganelli (2005) per il cambiamento nei movimenti congiunti; c) modelli bivariati BEKK ‘strutturali’ riadattati da Rigobon (2003). I nostri risultati suggeriscono che l’evento Lehman non ha avuto implicazioni sulla trasmissione di volatilità tra gli ETF ed i rispettivi indici. Tuttavia l’attitudine alle reazioni estreme degli investori in entrambi questi segmenti è aumentata.