CONTAGION VERSUS FLIGHT TO QUALITY IN FINANCIAL MARKETS

None doubts that financial markets are related (interdependent). What is not so clear is whether there exists contagion among them or not, its intensity, and its causal direction. The aim of this paper is to define properly the term contagion (different from interdependence) and to present a formal test for its existence, the magnitude of its intensity, and for its direction. Our definition of contagion lies on tail dependence measures and it is made operational through its equivalence with some copula properties. In order to do that, we define a NEW copula, a variant of the Gumbel type, that is sufficiently flexible to describe different patterns of dependence, as well as being able to model asymmetric effects of the analyzed variables (something not allowed with the standard copula models). Finally, we estimate our copula model to test the intensity and the direction of the extreme causality between bonds and stocks markets (in particular, the flight to quality phenomenon) during crises periods. We find evidence of a substitution effect between Dow Jones Corporate Bonds Index with 2 years maturity and Dow Jones Stock Price Index when one of them is through distress periods. On the contrary, if both are going through crises periods a contagion effect is observed. The analysis of the corresponding 30 years maturity bonds with the stock market reflects independent effects of the shocks.

The impact of heavy tails and comovements in downside-risk diversification

This paper uncovers the factors influencing optimal asset allocation for downside-risk averse investors. These are comovements between assets, the product of marginal tail probabilities, and the tail index of the optimal portfolio. We measure these factors by using the Clayton copula to model comovements and extreme value theory to estimate shortfall probabilities. These techniques allow us to identify useless diversification strategies based on assets with different tail behaviour, and show that in case of financial distress the asset with heavier tail drives the return on the overall portfolio down. An application to financial indexes of UK and US shows that mean-variance and downside-risk averse investors construct different efficient portfolios.

Regime specific predictability in predictive regressions

Predictive regressions are linear specications linking a noisy variable such as stock returns to past values of a more persistent regressor such as valuation ratios, interest rates etc with the aim of assessing the presence or absence of predictability. Key complications that arise when conducting such inferences are the potential presence of endogeneity, the poor adequacy of the asymptotic approximations amongst numerous others. In this paper we develop an inference theory for uncovering the presence of predictability in such models when the strength or direction of predictability, if present, may alternate across dierent economically meaningful episodes. This allows us to uncover economically interesting scenarios whereby the predictive power of some variable may kick in solely during particular regimes or alternate in strength and direction (e.g. recessions versus expansions, periods of high versus low stock market valuation, periods of high versus low term spreads etc). The limiting distributions of our test statistics are free of nuisance parameters and some are readily tabulated in the literature. Finally our empirical application reconsiders the literature on Dividend Yield based stock return predictability and contrary to the existing literature documents a strong presence of predictability that is countercyclical, occurring solely during bad economic times

Modelling and measuring price discovery in commodity markets

In this paper we present an equilibrium model of commodity spot (St) and future (Ft) prices, with finite elasticity of arbitrage services and convenience yields. By explicitly incorporating and modeling endogenously the convenience yield, our theoretical model is able to capture the existence of backwardation or contango in the long-run spot-future equilibrium relationship, (St-ß2Ft ). When the slope of the cointegrating vector ß2>1 (ß2

Threshold effects in cointegrating relationships

In this paper we introduce threshold type nonlinearities within a single equation cointegrating regression model and propose a testing procedure for testing the null hypothesis of linear cointegration versus cointegration with threshold effects. Our framework allows the modelling of long run equilibrium relationships that may switch according to the magnitude of a threshold variable assumed to be stationary and ergodic and thus constitutes an attempt to deal econometrically with the potential presence of multiple equilibria. The framework is flexible enough to accomodate regressor endogeneity and serial correlation.

Summability of stochastic processes: a generalization of integration and co-integration valid for non-linear processes

The order of integration is valid to characterize linear processes; but it is not appropriate for non-linear worlds. We propose the concept of summability (a re-scaled partial sum of the process being Op(1)) to handle non-linearities. The paper shows that this new concept, S (d): (i) generalizes I (d); (ii) measures the degree of persistence as well as of the evolution of the variance; (iii) controls the balancedness of non-linear relationships; (iv) opens the door to the concept of co-summability which represents a generalization of co-integration for non-linear processes. To make this concept empirically applicable, an estimator for d and its asymptotic properties are provided. The finite sample performance of subsampling confidence intervals is analyzed via a Monte Carlo experiment. The paper finishes with the estimation of the degree of summability of the macroeconomic variables in an extended version of the Nelson-Plosser database.Co-integration, Co-summability, Integrated processes, Non-linear balanced relationships, Non-linear processes, Summability

Detecting big structural breaks in large factor models

Constant factor loadings is a standard assumption in the analysis of large dimensional factor models. Yet, this assumption may be restrictive unless parameter shifts are mild. In this paper we develop a new testing procedure to detect big breaks in factor loadings at either known or unknown dates. It is based upon testing for structural breaks in a regression of the first of the ¯r factors estimated by PC for the whole sample on the remaining r−1 factors, where r is chosen using Bai and Ng´s (2002) information criteria. We argue that this test is more powerful than other tests available in the literature on this issue.structural break; large factor model

Simple Wald tests of the fractional integration parameter : an overview of new results

This paper presents an overview of some new results regarding an easily implementable Wald test-statistic (EFDF test) of the null hypotheses that a time-series process is I(1) or I(0) against fractional I(d) alternatives, with d?(0,1), allowing for unknown deterministic components and serial correlation in the error term. Specifically, we argue that the EFDF test has better power properties under fixed alternatives than other available tests for fractional roots, as well as analyze how to implement this test when the deterministic components or the long-memory parameter are subject to structural breaks.Fractional processes, Deterministic components, Power, Structural breaks

Out of Sample Predictability in Predictive Regressions with Many Predictor Candidates

This paper is concerned with detecting the presence of out of sample predictability in linear predictive regressions with a potentially large set of candidate predictors. We propose a procedure based on out of sample MSE comparisons that is implemented in a pairwise manner using one predictor at a time and resulting in an aggregate test statistic that is standard normally distributed under the global null hypothesis of no linear predictability. Predictors can be highly persistent, purely stationary or a combination of both. Upon rejection of the null hypothesis we subsequently introduce a predictor screening procedure designed to identify the most active predictors. An empirical application to key predictors of US economic activity illustrates the usefulness of our methods and highlights the important forward looking role played by the series of manufacturing new orders

Dynamical generation of wormholes with charged fluids in quadratic Palatini gravity

The dynamical generation of wormholes within an extension of General Relativity (GR) containing (Planck's scale-suppressed) Ricci-squared terms is considered. The theory is formulated assuming the metric and connection to be independent (Palatini formalism) and is probed using a charged null fluid as a matter source. This has the following effect: starting from Minkowski space, when the flux is active the metric becomes a charged Vaidya-type one, and once the flux is switched off the metric settles down into a static configuration such that far from the Planck scale the geometry is virtually indistinguishable from that of the standard Reissner-Nordstr\"om solution of GR. However, the innermost region undergoes significant changes, as the GR singularity is generically replaced by a wormhole structure. Such a structure becomes completely regular for a certain charge-to-mass ratio. Moreover, the nontrivial topology of the wormhole allows to define a charge in terms of lines of force trapped in the topology such that the density of lines flowing across the wormhole throat becomes a universal constant. To the light of our results we comment on the physical significance of curvature divergences in this theory and the topology change issue, which support the view that space-time could have a foam-like microstructure pervaded by wormholes generated by quantum gravitational effects.Comment: 14 pages, 3 figures, revtex4-1 style. New content added on section VI. Other minor corrections introduced. Final version to appear in Phys. Rev.