Peter G. Dunne

Size and book-to-market factors in a multivariate GARCH-in-mean asset pricing application

Abstract The analysis of Fama and French (1993) , is broadened to include time varying risk. This is achieved by an MGARCH-m application which extends the approach taken by Bollerslev et al. (1988) to a multiple index context. Appropriate weightings of the conditional cross-moments of returns on portfolios that make-up factor proxies are modelled as MGARCH. The mean equation of the model is designed to determine whether proxied sources of time-varying non-diversifiable risk can explain movements in excess returns on various types of portfolios. Time-variation in conditional excess return appears only to have a significant relation with time-varying conditional variance associated with a book-to-market factor.

A Tale of Two Platforms: Dealer Intermediation in the European Sovereign Bond Market

Interdealer trading in the European sovereign bond market is characterized by low spreads and high liquidity. This paper examines whether the dealer-customer segment of the market also benefits from low spreads. Customers are smaller banks and buy-side financial institutions who request quotes from primary dealers. They generally do not enjoy access to the interdealer trading platform. Surprisingly, we find that customer trades are on average competitively priced and often occur inside the interdealer spread. Moreover, higher market volatility increases interdealer spreads more than customer spreads. The theoretical part of the paper develops a new dynamic model of dealer intermediation which captures the segmented market structure of the European bond market. The model explains differences in the volatility dependence of interdealer and customer spreads. The predicted inventory dependence of customer trade quality is also confirmed in the data.

The market response to information quality shocks: the case of Enron

Relying on the market to provide incentives that would bring about optimal information quality is potentially a cost effective alternative to regulatory oversight. However, this depends on the ability of the market to recognize and price this attribute. In this article, we gain insights into the disciplinary role of the market by examining its response to Enron-related accounting scandals. We report evidence that information quality was in decline, leading upto the Enron-related scandals, but that the market was not sensitive to this decline. We confirm, however, that there was an abrupt decline in perceived information quality post-Enron. Furthermore, using an ex-ante methodology we provide strong evidence that auditor reputations were differentially affected by the scandals. We also find evidence that the Enron-related scandals adversely affected the market risk premium implying that information quality is part of systematic risk. Our results indicate that the market was operating effectively in recognizing lower quality information through an auditor reputation effect prior to the Sarbanes-Oxley Act. This calls into question the need for regulation to address the perceived deficit in information quality.

Commonality in returns, order flows, and liquidity in the Greek stock market

Using a unique high-frequency data-set on a comprehensive sample of Greek blue-chip stocks, spanning from September 2003 through March 2006, this note assesses the extent and role of commonality in returns, order flows (OFs), and liquidity. It also formally models aggregate equity returns in terms of aggregate equity OF, in an effort to clarify OFs importance in explaining returns for the Athens Exchange market. Almost a quarter of the daily returns in the FTSE/ATHEX20 index is explained by aggregate own OF. In a second step, using principal components and canonical correlation analyses, we document substantial common movements in returns, OFs, and liquidity, both on a market-wide basis and on an individual security basis. These results emphasize that asset pricing and liquidity cannot be analyzed in isolation from each other.

Macroeconomic Order Flows: Explaining Equity and Exchange Rate Returns

Macroeconomic models of equity returns perform poorly. The proportion of daily index returns that these models explain is essentially zero. Instead of relying on macroeconomic determinants, our model includes a concept from microstructure order flow. Order flow is the proximate determinant of price in all microstructure models. We explain aggregate equity returns as well as exchange rates in a model with heterogenous beliefs. Belief changes are shown to be observable through order flow. To test the model we construct daily aggregate order flow data from all equity trades in the U.S. and France from 1999 to 2003. Almost 60% of the daily returns in the S&P100 index are explained jointly by exchange rate returns and macroeconomic order flows.

ECB Monetary Operations and the Interbank Repo Market

We examine the relationship between monetary policy operations and interbank borrowing and lending of funds using sovereign bonds as collateral. We first establish that, in the precrisis period, there are important but rather weak relations between these funding sources and that this relationship varies within maintenance periods and at the end of the year. Official funding conditions did not meaningfully constrain repo market activity in the 2003-05 period but, in the immediate precrisis period, rate increases led to a sharp contraction in repo activity. Focusing on the crisis period, we identify potentially benign substitution effects between official auctions and repo market activity but our empirical analysis shows that positive innovations in the cost of official funding, due to aggressive bidding, and a limited allotment response, encouraged increased use of the interbank repo market. The analysis informs a discussion of the merits of returning to variable rate operations.

Transparency Proposals for European Sovereign Bond Markets

The debate over the possible extension of transparency regulation in Europe to include sovereign bonds has opened up a number of other issues in need of serious consideration. One such issue is the appropriateness of the entire infrastructure supporting the trading of European sovereign bonds. In recent years, sovereign issuers have supported the development of an electronic inter-dealer market but have remained unconcerned with the opacity of dealer-to-customer trading. The degree of segmentation in this market is high relative to what exists in nearly all other financial markets. This paper explores why European sovereign bond markets have developed in such a segmented way and considers how this structure could be altered to improve transparency without adversely affecting liquidity, efficiency or the benefits enjoyed by primary dealers and issuers. It is suggested that the structure of the market could be improved greatly if the largest and most active investors were permitted access to the inter-dealer electronic trading platforms. This would solve a number of market imperfections and increase the proportion of market activity that is conducted in a transparent way. The paper argues that sovereign issuers in Europe have the means to provide incentives that would influence dealers to support reduced segmentation. Some practical examples of how this could be achieved are provided and the potential benefits are outlined.

A generalised Bayesian model of market microstructure behaviour applied to the market in Irish government securities

Abstract This paper presents a critique and revision of a well-known Bayesian model of market microstructure behaviour. The existing behavioural model allows for a very limited form of information processing and results in an associated empirical form, which does not adequately account for the time-series dynamics of high-frequency transaction-price-returns and trades. The existing approach also fails to identify any worthwhile microstructure parameters. The revised model allows for a more realistic form of information processing and leads to an empirical specification general enough to facilitate a ‘general-to-specific’ modelling strategy. The new model identifies interesting behavioural parameters that go well beyond those currently available. The model is applied to market making in the Irish Gilts market.

Positive liquidity spillovers from sovereign bond-backed securities

There are competing arguments about the likely effects of Sovereign Bond-Backed Securitization on the liquidity of sovereign bond markets. By analyzing hedging and diversification opportunities, this paper shows that positive liquidity spillovers would dominate or at least constrain the extent of any negative effects. This relies on dealers using Sovereign Bond-Backed Securities (SBBS) as instruments to hedge inventory risk and it assumes that they diversify their activities widely across euro area sovereign markets. Through a simple arbitrage relation, the existence of low-cost hedging and diversification opportunities limits the divergence of bid-ask spreads between national and SBBS markets. This is demonstrated using estimated SBBS yields (a la Schonbucher (2003)).

The Portfolio Rebalancing Effects of the ECB's Asset Purchase Programme

We explore the transmission of the ECB’s public sector asset purchase programme (PSPP) via the portfolio rebalancing of investment funds and their investors. Evidence for this channel would validate several theoretical propositions and may help in fine tuning the programme. Using dynamic panel methods to identify significant rebalancing, we find that PSPP-holding funds reduce their holdings of government bonds and rebalance towards bonds issued by deposit taking corporations - but only after the scaling-up of purchases in March 2016. Deeper analysis shows that the purchased assets are predominantly issued outside the euro area. Non-PSPP-holding funds also tend to rebalance towards non-EA issued government bonds and those issued by non-financial corporations. We find no evidence of rebalancing towards equities or derivatives. Investment flows are found to be a catalyst for the rebalancing undertaken by funds themselves. Funds with significant redemptions do relatively more rebalancing of their portfolios. Overall, our results suggest that the programme currently operates through purchases of foreign assets. The scaling-up of the operation is closely aligned with the statistical significance of its effects.