Recent years have been disastrous for financial institutions because of sharp and abrupt asset price declines, liquidity dry-ups, and fear for chain risk transfers of counterparty risks. This paper presents examination of the transmission mechanism of the global financial crisis onto credit default swap (CDS) spreads of major financial institutions including commercial banks, investment banks, and insurance companies. Special attention is devoted to the effect of common factors on the CDS spreads as well as their interdependence.
During the global financial crisis, we observed CDS spreads skyrocket, which can be explained only slightly by changes in the probability of default. That soaring of the CDS spreads should reflect changes in market participants’ attitude related to risks as well as their perception of uncertainty in future macroeconomic conditions. Gai and Vause (2006) argue that risk premia must depend not only on the riskiness of assets but also on the degree to which investors accept uncertainty (risk aversion) and the level of uncertainty itself (uncertainty about macroeconomic prospects). The Bank of Japan (2008b) also asserts that a market participant’s attitude related to risk can further depend on liquidity constraints; financial institutions under severe liquidity constraints are unwilling to bear risk. Funding liquidity and uncertainty in the macroeconomic environment are therefore likely to affect CDS spreads as common factors.
The principal motivation for studying survival of irrational traders and their long-run price impact comes from the theory of efficient financial markets. If irrational traders do have long-run impact on asset prices, there will be persistent market inefficiencies, and prices will constantly deviate from fundamental values and give rise to inefficient allocations.
Starting with Friedman (1953), it has long been argued that irrational traders cannot survive in a competitive market, as they will constantly lose money betting on the realization of very unlikely states of the economy. Basing on this intuition, Friedman argued that irrational traders cannot influence long-run asset prices. In a recent seminal contribution, Kogan, Ross, Wang and Westerfield (2006) (henceforth, KRWW (2006)) demonstrated that survival and price impact are two independent concepts: even if irrational traders do not survive, they can still have a substantial long-run impact on asset prices. They also show that irrational traders portfolio policies can deviate significantly from what the asymptotic moments of stock returns suggest. KRWW (2006) suggest the following intuitive explanation of these surprising phenomena: “Under incorrect beliefs, irrational traders express their views by taking positions (bets) on extremely unlikely states of the economy. As a result, the state prices of these extreme states can be significantly affected by the beliefs of the irrational traders, even with negligible wealth. In turn, these states, even though highly unlikely, can have a large contribution to current asset prices.” This intuition naturally gives rise to the following questions: what, precisely, are the extremely unlikely states responsible for the price impact, and what is the exact economic mechanism by which these states generate price impact? In this paper, we provide detailed answers to these questions.
In finance, agency theory deals with the problems and conflicts arising when a principal–agent relationship exists. The agent is hired by the principal and acts on the principal’s behalf. But how does the principal ensure that the agent always considers the interests of the principal first? What if the agent is working for his or her self-interests and not making the best decision for the principal? Essentially agency theory involves the costs of resolving conflicts between the principals and agents and aligning interests of the two groups.
The mutual fund managers act as agents for the principals, the investors in the mutual fund managed by the particular manager. What investment strategies are the managers following that allow them to be considered great in light of the recent financial crisis? What rules of agency theory are being utilized or are rules being ignored to allow these funds the success they have managed to gain? The research question relates to the mutual fund’s performance. What strategies have the managers followed to allow the fund to have above average performance in severe financial times? What is it about these funds that make them able to “weather the storm?”
